Is The Savings Rate Rising Or Falling?

Considering that headline GDP contracted at an annual rate of more than 6% both in Q4 2008 and in Q1 2009, real disposable income has held up surprisingly well. Indeed, it rose by an annual rate of 4.8% between September 2008 and March 2009. But how could real disposable income increase at an annual rate of nearly 5% when real GDP contracts at an annual rate of more than 6%?

Part of it reflects that they are deflated by different price indexes. Real GDP is derived using the GDP prices index while real disposable income is derived using the PCE deflator. Because America's terms of trade has improved dramatically due to a lower price of oil and because the GDP deflator is not adjusted for terms of trade improvements while the PCE deflator is adjusted for that, the GDP deflator has shown more inflation/less deflation which when deflating a nominal number means that real GDP will be a lot weaker than real disposable income.

But that is not the entire explanation. Even when adjusted for terms of trade, real GDP is still significantly down, while again real disposable income is strongly up.

So why the discrepancy? This can be explained by the specifics of disposable personal income. Between September 2008 and March 2009, nominal personal income rose 0.9%. Private sector wage and salary disbursements fell 2.7%, "proprietors income" (essentially small business income) fell 3.2%, income from assets (interest and dividends) fell 8%. The statistical construct called "rental income of persons" rose significantly, but that's a very small post so it had little overall impact and it is not really an income in the strict sense of the word (more like a cost saving for home owners).

The reason why disposable income rose despite these significant declines in market based income was that cash flow from government improved dramatically. Government wage and salary disbursements rose 2.1% and transfer payments receipts (with unemployment benefits increasing particularly much) rose 5.6%. Meanwhile, even as people are receiving more and more from government, they are paying less and less to it. Personal tax payments nearly collapsed, falling 16.5% while "contributions for government social insurance" fell 1.1%.

(Note that the numbers in the two above paragraphs aren't annualized).

Hadn't it been for the dramatically improved cash flow from government, then real disposable income would have fallen too. It should also be noted that while dividend income have been reduced, it hasn't fallen anywhere near as much as corporate earnings. Meaning that the implicit income that retained earnings constitute has fallen dramatically and if that had been factored in as well, real income would have fallen even more.

One obvious implication of the above is that real disposable income is misleading as an indicator of economic growth. Another, perhaps not immediately obvious implication, is that even though the official household savings rate has risen from 1.4% in September 2008 to 4.2% in March 2009, overall savings has in fact fallen dramatically because of the dramatic increase in the government deficit and the dramatic decline in corporate retained earnings.

Inflation Expectations Rising

Today's shall we say questionable (based on the view that even though overall growth was weaker than expected, the report was still positive because the consumer spending component was stronger than expected) stock market rally contributed to bond yields finally rising above the level where they were when the Fed announced. The 10 year yield tonight closed at 3.10%, above the roughly 3% the day before the March 18 announcement Fed announcement and way above the roughly 2.5% after the Fed announcement

However, that only goes for the yield on nominal bonds. The yield on so-called inflation-protected bonds closed at 1.55%, far below the 1.9% level before the March 18 Fed announcement.

The spread between inflation-protected bonds and those that aren't has thus risen from about just 1.1%: points to 1.55%: points, indicating rising inflationary expectations.

The other popular inflation indicator, gold, hasn't performed as well, but it hasn't really performed bad either, and at any rate that simply reflects worries over central bank gold sales as well as the general decrease in the demand for safe havens that the stock market rally has generated.

Chilean Peso Rally Reflects Copper Rally

Claus Vistesen reports on the strong performance of the Chilean peso, something which he appears to attribute to the Chilean government saving the windfall from the previously very high price of copper (copper is Chile's main export product).

A more obvious and important factor would however be the fact that after a dramatic price decline late last year, the price of copper has recovered, rising some 40% in 3 months.

Bernanke Is A Friedmanite-Not A Keynesian

While Bernanke in his policies is side-stepping the classical Monetarist prescription to stabilize money supply growth at a moderate level (3 to 5%), there is also a strong case for arguing that he is in fact just following the recommendations of Milton Friedman in his book A Monetary History of the United States. See more here.

I have read that book, but it was a few years since I did it, and I don't own any copy of it, but assuming that this description is correct, it would seem that Friedman believed that during circumstances like this, his own money supply rules should be suspended or overshooted. That interpretation is supported by Friedman recommending double digit money supply growth for Japan during the 1990s.

Tax Rates & Tax Revenues

In hindsight, I think I should have elaborated more on the point of the supply-side tax theory in the previous post. But now that I didn't, I think it is worth writing a separate post on it.

As I wrote then, while Austrians and supply-siders do agree that marginal tax rate reductions will increase productive activities, Austrians are usually skeptical of the exaggerated claims of supply-siders that even at more moderate tax rates, further reductions will increase tax revenues. See for example Murray Rothbard's analysis of this in his essay "A Walk on The Supply Side" (he also analyses the supply-side view on monetary policy there).

Just what the exact effect of tax rate reductions on tax revenues will be is largely an empirical issue. Pure economic theory will not tell us what effect a reduction in the marginal rate of taxation from say, 39.6% to 35% will have on tax revenues.

However, we can use economic theory to conclude one important conclusion, namely: that the lower the rate of taxation, the less likely is it that further tax rate reductions will really increase revenues.

The reason is actually mathematical (so much for Salsman's nonsense of "disdaining math"): Namely that the lower the rate of taxation, the higher will the necessary increase in the tax base be in order to keep tax revenues constant, while a lower rate of taxation will mean that any further reductions will mean a smaller increase in the incentive to increase the tax base. The amount of the tax base being here so to speak a positive function of productive activities and a negative function of tax avoidance activities.

Take for example, the Kennedy tax cuts, which lowered the top rate of taxation from 91% to 70%. In order for tax revenues to stay constant, the necessary increase in the tax base is 30% ((91-70)/70). The increase in the tax base incentive is however all the greater, being a full 233% ((100-70)/(100-91)). With the increase in incentives being more than 7 times as large as the necessary increase in the tax base, it would seem likely that this tax cut would result in higher tax revenues.

Contrast this with the effects of the Reagan tax cuts. During Reagan, the top rate of taxation fell from 70% to 28%. That might seem like an even more dramatic tax cut than the Kennedy tax cuts, and indeed it was in terms of how big the necessary increase in the tax base was in order for tax revenues to stay unchanged. The required increase in the Kennedy tax cuts was again only 23.1%, while for the Reagan tax cuts it was a full 150% ((70-28)/28). However, the increase in the tax base incentive was actually lower, "only" 140% ((100-28)/(100-70)). The increase in incentives was here slightly less than the required increase in the tax base.

After Reagan, the top rate was increased under the Bush Sr. and Clinton administrations from 28% to 39.6%. Under Bush Jr., the rate was lowered to 35%. Here the necessary increase in the tax base was 13.1% ((39.6-35)/35). The increase in the tax base incentives was however even smaller ((100-35)/(100-39.6) or just 7.7%, more than 40% lower.

In short, the theoretical principle here is that the lower the initial rate of taxation the less likely is it that further tax rate reductions will increase revenues.

It could be objected that increased productive activities won't just increase the revenues of the tax being lowered, but also other taxes. For example, if a lower corporate income tax increases investments, it won't just increase corporate income tax revenues but also individual income tax and payroll tax revenues. But while that will create a downward bias in estimates of how much tax revenues higher productive activities will create, the higher interest rates created by tax rate reductions unmatched by tax cuts will create the opposite effect.

And at any rate, it will not really affect the principle that the lower the initial rate of taxation the less likely is it that it will increase revenues. It will only affect the estimate of where exactly the revenue maximizing rate of taxation is.

Per-Olof Samuelsson On Richard Salsman's Anti-Austrian Views

Apparently, Richard Salsman has written some kind of list detailing 12 complaints he has about Austrian economics, published on Facebook. Per-Olof Samuelsson has now written a point by point response to it which you can read here.

I basically agrees with most of Samuelsson's responses, though I would like to make a few additional points:

1) Contrary to what Samuelsson writes, praxeology per se is not linked to Mises' Kantian epistemology. Praxeology is a deductive system based on a few axioms, most importantly the action axiom. While praxeology like all other sciences of course needs some form of epistemological justification, it does not in itself contain any epistemology, and certainly not Kantian epistemology. It can just as well, or actually better, be justified with epistemological Aristotelianism or Objectivism.

2) I believe in Mises' view, as opposed to Reisman's, theory of the basic rate of profits. I similarly do not agree with Reisman's rejection of the concept of opportunity cost.

3) As Samuelsson notes, Austrian economícs do not "disdain" math in general. It only disdains its use where it is unnecessary or for other reasons improper. Mathematical techniques like Matrix algebra and Lagrange multipliers reduces, not increases, our understanding of for example consumer choices, and are moreover a distraction from the real issues. For more on this subject see my post "The Real Problem With Non-Austrian Economics".

4) Samuelsson comments on Salsman's criticism of Austrian economics for quote "10) their neglect (or ridicule) of the marginal tax-rate theory of supply-side economists." by saying he is not familiar with that issue.

My comment on this is that (most) Austrians do recognize that higher marginal rates of taxation reduce productive activities. I certainly do. And most Austrians would probably also agree that when tax rates are high enough, tax rate reductions can in fact increase tax revenues because of for example increased productive activities and decreased tax avoidance. It is highly likely that the Kennedy tax cuts of the 1960s (which reduced the top rate of taxation from 91% to 70%) in fact increased revenues.

But it is a lot less likely that at the more moderate tax rates we have today, tax cuts are self-financing. Bush's reduction of the top federal rate of taxation from 39.6% to 35% probably increased economic growth, but not by enough (even also considering decreased tax avoidance) to increase tax revenues.

Did Capital Goods Orders Really Rise?

Associated Press reports that core capital goods orders rose 1.5% in March compared to February. But in reality, they were in fact lower than the previously reported number for February.

The initially reported core capital goods order for February was $52.47 billion. The now reported number for March is $51.57 billion. The alleged 1.5% increase only happened because the February number was revised down to $50.78 billion. Given the quite consistent pattern in recent months for the initially reported number to be revised down, it seems likely that the $51.57 billion figure for March will similarly be revised down.

China Buys Gold

Recently, the price of gold has been under pressure because of a decision by the IMF to sell off much of its gold reserves. While I believe that most other factors support the bullish case for gold, I also recognize that the bullish scenario is threatened by decisions by the IMF and certain central banks to sell gold.

Now the price of gold increased somewhat on the news that the Chinese seems to have a different attitude towards gold than Western central bankers, as they have announced that they are buying gold. If China and other emerging economies starts to buy a lot of gold, then this will cancel out much of the effect of the gold sales of other central banks, and so improve the odds of future gold price increases.

Exchange Rates Are A Zero Sum Game

With just about all countries in the world suffering from the financial crisis (though to a varying extent), various solutions are offered to remedy this.

One of the least sensible, yet also one of the most popular, is currency devaluations, or depreciations. Particularly in the U.K. and Sweden, many pundits have argued that their own countries are so lucky to have a freely floating currency of their own, so that these currencies can not so much float, but sink in value against the euro. U.K. pundits usually tells of how much better off the U.K. is compared to Ireland (who is part of the euro area), and Swedish pundits usually tells of how much better off Sweden is compared to Finland (who is part of the euro area) and Denmark (whose krone has a fixed exchange rate versus the euro).

Often they go from asserting that their weak currencies benefits their economies to also implying or saying outright, that if only those other countries had floating exchange rates too, then they too would receive those benefits.

Yet all of this overlooks one key truth: exchange rate movements are a zero sum game. One country's currency devaluation/depreciation is always and by necessity a currency revaluation/appreciation for other countries.

Until the day we start trading with space aliens, the weighted exchange rate for the world as a whole will by necessity always be unchanged. And introducing extraterrestrials wouldn't really change the principle, as we could simply reformulate it into "the weighted exchange rate for the universe as a whole will by necessity always be unchanged".

The fact that the weighted exchange rate for the entire world will always be unchanged and that therefore any exchange rate depreciation/devaluation for one country will mean a exchange rate appreciation/revaluation for others, means that it cannot be said to be a cure for the global economic downturn.

Assuming for the sake of the argument the view that a weaker currency will make the economy stronger, then this also implies that a stronger currency will make the economy weaker.

If for example Ireland would follow the advice to reintroduce its pound and Finland would reintroduce its Mark and Denmark would let its krone sink in value, then that might make their economies stronger, but it would at the same time damage other economies, whose exporters would have an even harder time. What if the other euro linked economies also decided to drop out? Since exchange rates are relative, there must be some economy left standing with a strong currency. And who is that supposed to be? Germany, who is already suffering from a sharp drop in exports? Wait until you see how big that drop becomes when not just smaller economies like Ireland, Finland and Denmark but also bigger ones like Spain, Italy and France starts with competitive devaluations. Incidentally, such a trend of competitive devaluations would also eliminate the current assumed gains for the U.K. and Sweden.

Any gains from currency devaluations would thus be of the "beggar they neighbor" kind where you gains at the expense of others. But that only works if those others turn the other cheek and accepts getting fleeced. And more to the point, since everyone can't gain at the expense of everyone, it will obviously not work as a solution to the global economic crisis.

Some floating exchange rate theorists have tried to deny this by using some Keynesian models that says it is beneficial if a country with a strong economy gets some demand redirected to countries with weaker economies through the exchange rate. But apart from the many flaws of Keynesian models, this argument is obviously not applicable to the current situation where all countries are suffering from an economic slowdown.

Real Interest Rates & Economic Growth

One of the more commonly accepted assumptions in modern economics is that nominal interest rates can't go below zero. The reason for this is that if interest rates are negative, then it will be more beneficial to have your money in cash, and so no one will lend if interest rates are below zero.

This, some argue, is a problem because this limits the ability of the central bank to lower interest rates.

Greg Mankiw now proposes to fix that alleged problem. He starts by quoting a suggestion from one of his students that a year from now, the Fed would randomly pick a number and make all dollar bills with that number as its last serial number worthless, creating a negative expected return of -10% on dollar bills. That way, people would prefer to have their money in deposits even if those deposits had a negative interest rate of say 3%.

There are numerous practical problems associated with such a scheme, but perhaps they can be resolved or limited. The same goes for the similar scheme by Silvio Gesell to tax cash holdings.

And the trouble of people moving to hold more gold and similar real assets could perhaps be resolved in the way FDR solved it: by banning people from investing in them.

Perhaps a more fundamental flaw in the scheme is that it presumes that lower real interest rates are always beneficial for the economy. That may be the assumption in the kind of New Keynesian models used by Mankiw, but in reality lower real interest rates is a symptom of the phenomena’s which are beneficial to the economy.

Lower real interest rates in a pure market economy, or simply an economy with a stable money supply, would be the result of lower time preferences, or in other words a higher willingness to save. That will boost investments and so also increase productive capacity.

If we instead assume that the decline in real interest rates was the result of monetary inflation, then it can too provide a short-term boost to the economy, provided certain assumptions specified in the Austrian business cycle theory holds true.

But under other circumstances, lower real interest rates will not boost the economy even in the short-term. If no entrepreneur is willing to invest despite negative real interest rates, then the decrease in money demand will simply lead to higher prices, something which causes money demand to simply fall further, which in turn leads to yet higher prices in a hyperinflationary spiral. Countries with hyperinflation have strongly negative real interest rates, and are thus the perfect example of what happens if such schemes are initiated.

This will do nothing to boost output even in the short-term and will have disastrous consequences later as there will either be a breakdown of the monetary system through hyperinflation like in Germany in 1923 or a severe contraction when monetary authorities in order to stop the hyperinflationary spiral must iniate a sudden, dramatic monetary contraction.

Not Much Risk Of That

From Zimbabwe (not surprisingly). Somehow I don't think the owner of that store will have to worry very much about shoplifting.

Velocity Is An Accounting Identity

Jeffrey Hummel and David Henderson continues to insist that Greenspan had nothing to do with the bubble. Since they use the same arguments that they used before and since they don't even try to reply to the criticism they've received from me and others, there's no real point in me specifically replying to any of their arguments, then there is no point in me writing anything new. Instead I simply link to my old post criticizing their original report.

However, there was one point I did not address, since it wasn't directly related to the issue of Greenspan's guilt. However, Henderson and Hummel also argues that the Fed under Greenspan created free market conditions in the monetary area, using a very strange argument:

"Combined with subsequent administrative deregulation under Greenspan through January 1994, these changes left all the financial liabilities that M2 adds to M1--savings deposits, small time deposits, money market deposit accounts, and retail money market mutual fund shares--utterly free of reserve requirements and allowed banks to sweep a large portion of M1 checking accounts into M2 money market deposit accounts. M2 and the broader measures became quasi-deregulated aggregates with no legal link to the size of the monetary base.

One result, which the late Milton Friedman noted in 2003, is that fluctuations in the velocity of M2 were automatically offset by fluctuations in the amount of M2. Interestingly, this is exactly what monetary economists George A. Selgin and Lawrence H. White predict would happen under free banking, that is, a market-determined monetary system without any government involvement.

They argue that free banking would automatically adjust the quantity of money to changes in velocity. If velocity rises, signaling a fall in money demand, market mechanisms would cause banks to reduce the quantity of money they created. And if velocity falls, signaling a rise in money demand, banks would enlarge the quantity of money."

But what needs to be understood here is that velocity is an accounting identity.

Using the classical formula MV=PY, where M stands for money supply, V for velocity, P stands for price level and Y for real output, and PY thus stands for nominal output it should be noted that V is defined as PY/M. If say, nominal GDP is $12 trillion and M2 is $5 trillion, that means that velocity is 2.4. If M2 is $6 trillion, then velocity is 2, and so on.

While velocity represents an indirect indicator of non transaction demand for money, it is thus not something which really exists as an independent phenomenon. It is simply a name given for the quotient you get by dividing nominal GDP with money supply.

There are two possible interpretations of what Henderson & Hummel wrote about fluctuations in M2 growth offsetting fluctuations in velocity. Taken literally, the assertion is simply false since there have been significant fluctuations in nominal GDP growth. If it is instead held to be true in a ceteris paribus sense (given a certain level of nominal GDP), then it is true that fluctuations in money supply has offsett changes in velocity since 1994, but then again it did so before 1994 too and must always do so in all countries at all times. Crediting Greenspan's monetary policy with the fact that fluctuations in velocity will ceteris paribus be offset by fluctuations in money supply is about as silly as crediting him with the fact that total assets in bank balance sheets were equal to total liabilities (including equity).

Monetary Base Up-Money Supply Down

The Fed is really turning up the heat in its inflating. The Fed balance sheet continued to grow in size, with the weekly average rising $29.2 billion, from $2,069.6 billion to $2,098.8 billion. And the increase was even bigger if you look at the level at the end of the week, with the balance sheet rising to 2,169.4 billion on April 15.

If you look at the particulars, "securities held outright" continues to increase fast, while most other posts (particularly "central bank liquidity swaps"). Among securities, it is particularly mortgage backed securities that are increasing, though they are also increasing their holdings of Agency debt and Treasuries.

This inflating from the Fed however have in recent weeks been counteracted by increased deleveraging. Though the (in America) ultra-narrow M1 measure of money supply soared in the most recent week, broader aggregates like M2 and MZM fell back in the week to April 6, continuing a three week long decline since the week to March 16. For the first time since September last year, M2 fell below its 13-week average, with MZM falling back only slightly less.

While it is possible that part of this drop is due to over-zealous seasonal adjustment, and while it is also possible that this trend is just an aberration for other reasons, we should certainly watch how money supply develops in the coming weeks. If the trend continues, then this would make the economic outlook less inflationary.

However, the most likely scenario is that this recent trend will not continue and that money supply growth will be reignited. The main reason for believing so is the relentless inflating by the Fed.

More On Inequality & Bubbles

Justin Fox at Time magazine has discovered that there is a strong empirical link between asset price bubbles and economic inequality, and also argues that there is a causal link between the two, while conceding that this is not a new theory.

Which it certainly isn't, I have repeatedly (for example here and here) pointed to asset price inflation caused by monetary inflation as the primary cause of the increase in inequality.

Fox however offers no explanation for these bubbles, except he simply says that they were based on "some real economic reason, then got out of hand". That makes little sense, because first of all, to the extent an increase in asset values is based on improving fundamentals, it is not a bubble. And regarding the more relevant point of the effect on inequality, there is no reason per se that for example the improved productivity during the 1920s (or to a lesser extent, the late 1990s) would disproportionately boost corporate profits relative to labor income.

What instead happened is that there were gains in productivity that caused consumer prices to decline, something which caused the inflation targeting Fed to increase money supply, which in turn boosted corporate profits and also increased valuation levels (because of lower interest rates). In other words, it is monetary policy that causes the increase in inequality.

Testing Theories Of Inflation

Right now we have a situation with high money supply growth in America and most other countries. According to Monetarist (and in most circumstances also Austrian) theory, this should lead to higher price inflation.

Yet we also have a situation with high unemployment and low capacity utilization in America and most other countries, something which according to Keynesian theory should lead to deflation (or at least disinflation).

This leads former Fed governor Laurence Meyer to talk of how the near future development of price inflation will provide a test of theories of inflation, as the two theories have opposite prediction of how it will develop.

Such tests have however already been performed. As I pointed out yesterday, Zimbabwe has had extremely high money supply growth rate while also having extremely high unemployment (60 to 80%) and extremely low capacity utilization (20%). The result was an inflation rate of 231,000,000%.

More ECB Myth Making

Ambrose Evans-Pritchard criticizes the ECB for having exceeded its target for M3 growth rate during the previous boom. Although I don't think M3 (particularly not the ultra-broad European version) is the right monetary aggregate to focus on, he is essentially right about that.

Now, however, Evans-Pritchard claims that ECB does not inflate enough and claims that they pursue "deflation policies". Yet if you look at the latest M3 figures, you can see that they grew 5.9%, which is to say the ECB continues to exceed its 4.5% target. And the in my view more relevant M1 and M2 measures grew even faster (6.3% and 7%, respectively).

This is just another example of what I described in my recent post "The Myth of the hawkish ECB".

Zimbabwe Dollar Is No More

What has been a de facto reality for some time now has become official: The Zimbabwe dollar has been completely destroyed and annihilated.

This is hardly something to shed tears over. The interesting question is how the Zimbabwean government will finance itself now that it can't print money anymore. Well, I guess we'll find out soon enough....

Given the current economic orthodoxy that inflation is impossible as long as unemployment is high and capacity utilization is low, it is worth noticing that capacity utilization in Zimbabwe was only 20% when it suffered from the hyperinflation that destroyed the Zimbabwe dollar.

Jeremy Siegel's False Logic

Jeremy Siegel has in two articles argued that the current methodology for determing the stock market P/E ratio is misleading, because profits and losses aren't weighted by the market value of the respective company. According to Siegel himself, he has convinced Robert Shiller of this argument, and Greg Mankiw says that he is increasingly convinced of it.

In his first article, he doesn't provide any example of his methodology, but he does so in his second article:

"My methodology would weight the $45 billion earned by Exxon Mobil by 95 percent and the $99 billion loss of AIG by 5 percent to obtain a weighted average earnings of $39 billion for the portfolio. With a weighted average market value of AIG and Exxon Mobil of $335 billion, this would lead to approximately a 9 P/E ratio for the portfolio, not the infinite P/E computed by Standard & Poor's."

He claims that this weighting is equal to how stock portfolio returns are calculated. However, he is simply wrong about that. It is pretty remarkable that a professor in finance doesn't understand how return is calculated.

When the return for a portfolio is calculated you do not weight the absolute gains or losses for each stock, you weight the percentage gains or losses for each stock. But Siegel weights the absolute implicit fundamental return by market cap, which is very different-and very misleading.

The reason why you weight percentage return of each stock is because the small absolute returns has been set in relationship to the small market value of that particular stock. It has in other words been divided by a small number. When you put that in to relation to total value, you need to undo that by giving it a smaller weight. But when setting the original absolute value of return to the total value, there is no justification for weighting. If you have two stocks in a $1 million portfolio, with one constituting 90% of your portfolio and the other 10%, it doesn't matter which one of them produced a $90,000 and which one produced a zero return. Or in other words, regardless of whether the smaller stock had a 90% gain or if the larger stock had a 10% return, the overall gain is still only 9%.

Or to use the companies discussed by Siegel: If a fund holds $19 billion of Exxon and $1 billion of AIG, and Exxon rises by 10% and AIG falls with 50%, then total return is of course 7% ((0.95*0.1)-(0.05*0.5)). But Siegel's methodology for weighting earnings is like weighting the $1.9 billion Exxon gain by 95% and the $0.5 billion AIG gain by 5%, which would produce a return of 8.9% (((0.95*1.9)-(0.05*0.5))/20). According to Siegel's logic, the return of a portfolio that rises from $20 billion to $21.4 billion in value is 8.9%!

Siegel's method in effect double counts the relative weighting of the percentage return. And since profit making companies are naturally valued higher than loss making companies that creates a big upward bias for earnings.

Siegel is however correct with regards to one limited point-namely that because some of the losses at some extremely unprofitable companies will be taken by creditors and/or taxpayers instead of the shareholders (who can only lose 100% of equity, so once equity is negative, they cannot lose any more), net profits available for shareholders will be underestimated because of the inclusion of companies like AIG and GM. But that problem is better addressed without the misleading double weighting of profits, by simply excluding companies like AIG and GM where we know that equity will be negative without government bailout money.

The Myth Of The Prius Success Story

One popular myth, spread even by Swedish libertarian writer Johan Norberg, is that the problems of Detroit auto makers and the (relative) success of for example Toyota is a result of the Detroit auto makers clinging on to gas guzzling models while Toyota has focused on "green cars" like Prius.

Immediately when you think about it, you realize one great problem with that theory: namely that any consistent environmentalist would reject all cars-after all even green cars will contribute to increased use of energy, which will ultimately through the price mechanism increase demand for all forms of energy. So, that is not a market which car makers can reach.

It is of course true that there are inconsistent environmentalists who, while worrying about "climate change", still want to drive cars. That group would presumably be willing to buy "green cars". Moreover, to the extent that "green cars" use less fuel, they can appeal even to people who don't care about "climate change". I mean, what car owner doesn't want to reduce his or her fuel costs, all else being equal?

But the problem is that all else is not equal in the real world. So people for whom "climate change" and fuel costs matter will often still choose gas guzzling vehicles. "Green cars" tend to cost more to build and they are generally less safe and have less comfort than for example SUVs. People who have a large family might be able to get them all into an SUV, but not into a Prius. And if you get hit by another vehicle, you generally have a better chance of survival if you're in a SUV than in a Prius. In short, "green cars" are simply worse cars in all aspect except fuel costs.

It should therefore be no surprise that "green cars" in fact generally sell very bad, and create even bigger losses than other cars. As George Will puts it:

"The stunning shift in consumer preferences that should make the White House's freshly minted auto experts feel vulnerable has been reported under headlines such as "Like a Rock: Hybrid Car Sales Plummet" (Wall Street Journal, Dec. 9) and "Hybrid Car Sales Go from 60 to 0 at Breakneck Speed" (Los Angeles Times, March 17). Absent $4 gasoline, customers, those nuisances with their insufferable preferences, do not want the vehicles the politicians want them to want, even with manufacturers now offering large rebates and other incentives.

The two best-selling vehicles in America this year are large pickup trucks (Ford F-Series and Chevy Silverado). In February, Toyota sold 13,600 Tundra and Tacoma pickups and 7,232 Priuses. It sells the Prius at a loss, which it can afford to do because it makes pots of money selling pickups."

The assertion that Toyota owed its previous profits to Prius is simply false, as they sell far fewer of them than they do of large pickup trucks despite selling them at a loss and having good margins for the pickup trucks.

Moreover, as Shikha Dalmia points out, it is simply not true that GM hasn't invested in "green cars". The only reason that these "green cars" make up such a small part of their sales is that hardly anyone have wanted to actually buy them.

"Indeed, Obama has already declared that he wants to make GM the world's leader in "building the next generation of clean cars." Never mind that GM can neither build these cars well nor sell them. Out of GM's top 20 "profit-contributors" last year, only nine were cars—the rest were all politically incorrect SUVs and trucks. GM sold less than 15,000 hybrids last year, and this year is going to be worse because industry-wide hybrid sales have dropped by two-thirds from their peak last year. Indeed, last year there was a waiting line for a Toyota Prius—today there is an 80-day supply sitting on dealer lots. Meanwhile, the Obama task force was forced to conclude that the crown jewel of GM's green lineup, the $40,000 electric Chevy Volt it developed expressly to impress D.C. Democrats, is "too expensive to be commercially successful."

And do note that the miserable sales numbers for hybrid cars comes despite the fact that the government tries to bribe people into buying them through tax credits and other subsidies.

Aside from ridding itself from the far too high cost of labor and excess capacity, a key for making GM profitable is that they build cars that people want. But if they continue to take bailout money from Obama that will be impossible, as Obama will use that bailout to order GM to build the cars that he wants consumers to buy, instead of the cars that the consumers themselves want to buy. And that requires that GM goes to a bankruptcy court, instead of going to Obama.

Paul Krugman On Ricardian Equivalence

The issue of Ricardian equivalence is being increasingly debated today. Ricardian equivalence is the theory that if the government budget deficit increases then people will increase their savings by an equal amount in order to help them pay for the higher future tax bills. Given the massive increase in the budget deficit discussed in the previous post, this is of increasing interest.

I personally don't believe that it really holds true fully, because of for example liquidity restraints (meaning that it is easier to save than to borrow) and the fact that many people don't consider the negative effects of future fiscal austerity on their future disposable income when they make spending decisions today. However, because many others do consider the effects of future fiscal austerity, it likely holds true partially (which is to say, both savings and spending will increase). And for that reason, a discussion of its implication is not uninteresting.

Many people have recently spread misunderstandings about these implications. Here is for example Paul Krugman:

"if consumers have perfect foresight, live forever, have perfect access to capital markets, etc., then they will take into account the expected future burden of taxes to pay for government spending. If the government introduces a new program that will spend $100 billion a year forever, then taxes must ultimately go up by the present-value equivalent of $100 billion forever. Assume that consumers want to reduce consumption by the same amount every year to offset this tax burden; then consumer spending will fall by $100 billion per year to compensate, wiping out any expansionary effect of the government spending.

But suppose that the increase in government spending is temporary, not permanent — that it will increase spending by $100 billion per year for only 1 or 2 years, not forever. This clearly implies a lower future tax burden than $100 billion a year forever, and therefore implies a fall in consumer spending of less than $100 billion per year."

Note how Krugman here confuses two different issues: the effect of an increase in government spending at the expense of private sector spending assuming the life cycle hypothesis is correct and the effect of weakening the budget balance assuming Ricardian equivalence. If there is a permanent increase in government spending financed by higher taxes then this will reduce consumer spending by an equal amount. If on the other hand the increase in government spending and taxes is only temporary then people will reduce their consumption by less than the increase in taxes (assuming the life cycle hypothesis is correct).

A fiscal stimulus policy of temporarily increased government spending and unchanged taxes is really a combination of a temporary increase in government spending financed by higher taxes and a separate tax cut of equal size. Ricardian equivalence will mean that consumer spending will be just as high as if the increase in government spending had been financed with a temporary tax increase.

At the same time it should be noted that while the increase in government spending will exceed the decline in consumer spending if the increase in government spending is temporary, that doesn't mean that total demand will increase, as interest rates will be higher, something which will reduce private investments. To the extent that higher interest rates increase capital inflows this will limit the decline in investments, but on the other hand increase the trade deficit (A trade deficit is the flip side of a net inflow in capital).

Profit Collapse Continues

The CBO released its monthly budget report yesterday. It showed that during the first 6 months of fiscal year 2009, the deficit has increased to $953 billion, from $313 billion in the same period in fiscal year 2008. This means that the yearly budget deficit will likely be even higher than the $1.5 trillion I projected earlier.

One detail that is of particular interest is that corporate income tax revenues fell as much as 90% in March, and 57% for the first 6 month of fiscal year 2009. Some of that decline (particularly in March) reflects that many loss-making companies get refunds for previous tax payments they made during profitable years.

This confirms that corporate profits are basically collapsing. Another confirmation of this came tonight when the first Q1 earnings report from a large company, namely Alcoa. While a big deterioration was anticipated, the loss turned out to be even greater than expected.

Recovery On The Way?

Economic data were mixed but mostly weak. The most important report, the employment report showed continued significant job losses and a full 1% drop in hours worked. Initial and jobless claims also continued to rise.

The ISM manufacturing index improved slightly, while the non-manufacturing fell slightly. The ISM manufacturing improvement incidentally contradicts the manufacturing numbers in the job report which indicated an accelerated downturn. Construction spending showed further declines in residential investments while nonresidential investments were stable after a really big decline the previous month. Car sales showed somewhat smaller declines, though as James Hamilton points out, that was a mere base effect caused by a very weak March 2008.

What this tells us is that the economy clearly continues to contract, but that the pace of contraction is no longer accelerating.

But perhaps more interesting than the issue of whether there is still a deep recession, is the issue of whether we are seeing the first signs of a coming recovery. Robert Wenzel thinks so, but I am not equally sure.

His main argument is that money supply has increased fast, something which will provide a short-term boost to the economy. And indeed, the high money supply growth clearly increases the chance of some kind of recovery, but there are strong forces working against a recovery.

Moreover, to the extent that higher money supply reflects higher money demand [for non-transaction purposes] and/or it causes higher price inflation, it will not boost real output. Money supply grew fast in late 2007 and early 2008, yet that didn't cause a recovery.

As for the stock market, it is true that it has had a rally for the last few weeks. But as Nouriel Roubini points out, the stock market has predicted six out of the latest zero economic recoveries. Or in other words, there have been 6 bear market rallies previously during this bear market, most recently between late November 2008 and January 2009. It is very likely that this is just another bear market rally, as it will again be apparent that the underlying fundamentals are very weak (The recent move to "mark to wishful thinking" accounting practices may mean that it will take longer time for investors to figure it out, but eventually the truth will come out).

But didn't durable goods orders boom in February? Technically yes assuming no further revisions, but not really in any meaningful sense. The apparent positive number was entirely the result of a massive downward revision of the previous months number. The initially reported number for non-defense, non-aircraft capital goods orders for January 2009 was $52.55 billion. The currently reported number for non-defense, non-aircraft capital goods orders for February 2009 is $52.16 billion. That number is 11% lower than 3 months earlier. Given this, it seems more likely that the apparent upswing reflects the measurement problems and inherent volatility in monthly numbers than any genuine upswing.

The fact that hours worked in the durable goods manufacturing sector fell as much as 2.6% in March compared to February(compared to a year earlier, the decline was 19.3%) certainly doesn't suggest that we've seen the beginning of a recovery in the most cyclical sectors (Other cyclical sectors like construction and mining saw even bigger declines).

In short, there is simply no sign yet of any recovery. At some future point in time, a recovery will of course come as slump (or boom) lasts forever, but it certainly hasn't come yet. And no evidence exists that it will come soon (by "soon" I mean the coming months).

The Myth Of The Hawkish ECB

Today, the ECB decided to lower its refinancing rate to 1.25%, the lowest level ever. The cumulative 300 basis point cuts in the last 6 months is its most aggressive easing ever. Yet it is still under constant attack from certain pundits who claim they should have been even more aggressive, pointing to central banks like the Federal Reserve, the Bank of England and the Swiss National Bank that have lowered short-term rates to near zero and at the same time initiated various "quantitative easing" schemes.

It is true that compared to many other central banks, the ECB has been relatively moderate in its inflating. But that only reflects how inflationist these other central banks have been-not any kind of deflationist bent from the ECB.

-With regard to interest rates, the current refinancing rate is the lowest ever in the history of the ECB and it has been reduced at a much faster pace than anytime before in the history of the ECB. Moreover, short-term rates are actually a lot lower than the refinancing rate. Money market rates are closer linked to the ECB overnight deposit rate, which is 1 percentage point lower. So for many of the most important short-term rates, the ECB is already pursuing a Zero Interest Rate Policy.

-With regard to money supply, after reaching a low of 0.2% in August 2008, the 12 month growth rate of M1 has accelerated sharply, to 6.3% in February 2009 (Note that these numbers exclude the effects of Slovakia's adoption of the euro in January 2009, and the similar inclusion of Cyprus and Malta in January 2008), mostly as a result of the aforementioned aggressive interest rate cuts. Note also that this 6.3% gain has come entirely in the last 6 months. The 6 month growth rate is as high as 13.3%, compared to a slight contraction during the 6 months ending August 2008. The 3 month growth rate is even higher, 15.7%.

-With regard to price inflation, it is true that it has fallen quite a bit (To 0.6% in March). The 12 month rate might even fall further in the coming months. But price inflation is not a leading indicator, it is usually a lagging and at best a coincident indicator. Today's relatively low price inflation is the lagged effect of the stagnant money supply the euro area had early in 2008, as well as the effect of the sharp drop in global commodity prices between July and November 2008.

Thus, the characterization of the ECB as "deflationist" or "hard money" is simply not true-at least not in the absolute sense of the word.