U.S. Recession Worse Than Previously Estimated

Today the advance second quarter GDP estimate was released. Perhaps more interesting, especially since that advance estimate will be revised at least half a dozen times, was the annual revision of previous numbers. I have previously noted that these annual revisions systematically revise down previous estimates (on average, a few individual quarters are in some cases revised up). That was the case this time too, though an extra twist for numbers released this time was included. More on that below.

Before I get to the revisions, I should briefly comment on the second quarter number. It showed that the second derivative was indeed positive, although the first derivative remained negative, or in other words that output continued to contract, but at a slower pace. Just how dramatic this slowdown was depends on whether you focus on the headline volume number or my preferred terms of trade adjusted number. The headline volume number was -1.0% compared to a downwardly revised -6.4% in the first quarter. But because terms of trade deteriorated in the second quarter after having significantly improved in the first quarter, the terms of trade adjusted was a lot smaller, from -3.1% in the first quarter to -1.5% in the second quarter.

Moreover, most of the improvement didn't reflect any improvement in the private sector, but increased government purchases. So if you look at the details, you can see that most of the apparent improvement reflects increased inflation and government spending, rather than any real private sector recovery.

The revisions of previous quarters show, as did all the previous annual revisions, significant downward revisions of numbers released previous quarters. Although a few quarters were upwardly revised (most notably Q4 2007, which was revised from -0.2% to 2.1% in volume terms (In terms of trade adjusted terms it was revised up somewhat less, from -1.6% to -0.1%)), most quarters were revised down. This was particularly true between Q1 2008 and Q3 2008, where (in volume terms) it was revised down from 0.9%, 2.8% and -0.5% to -0.7%, 1.5% and -2,7% respectively (In terms of trade adjusted terms it was revised down from 0.0%, -0.1% and -1.1% to -2.2%, -0.6% and -3.0% respectively).

After these revisions, this recession is now both the deepest and the longest since the 1930s.

Because this report also revised the annual benchmark from 2000 to 2005, even older numbers were also revised. These revisions were actually mostly positive unlike those for 2007-08. The upward revision was mostly for the years of 1998 to 2002, where GDP was upwardly revised by a total of 1.4%. If these new numbers are to be believed then the 2001 recession was even more shallow than we previously thought and the 1990s boom even greater. But this greater success was only achieved at the price of a greater crisis now.

Can Higher Minimum Wages Increase Employment?

The debate over minimum wages, after having been more or less dead for quite some time, has again been revived to a limited extent after last week's increase in the federal minimum wage in America from $6.55 per hour to $7.25 per hour. This was the third and final 70 cent increase decided in 2007 when minimum wages was only $5.15 per hour.

Most people, and that includes me, thinks that minimum wages (unless they're so low that they will have no impact on anyone) will increase real wages for some low productive workers, but will also make other low productive workers unemployed. However, because the federal minimum wage was so low to begin with (and because many states had already imposed a higher minimum wage) it seems likely that both the wage increasing and the job destroying effect will be small.

However, as anyone who has studied neoclassical labor economics in Universities know (if they paid attention), there is actually a theoretical scenario where (allegedly) higher minimum wages can increase employment of low productive workers.

For those of you who haven't taken such courses, or didn't pay attention, I'll give a brief summary of the theory:

In a perfectly competitive market, any minimum wage above the marginal value of some worker's work effort will increase unemployment as employers will not find it profitable to hire these workers. However, if the market is not perfectly competitive and employers have a monopsonic market position then this supposedly changes.

Monopsony, in case you didn't know is like monopoly, only it is the buyer, and not the seller who has the advantage. In this context Monopsony is more strictly defined as an employer whose marginal cost of labor (the increase in labor costs caused by the decision to hire a worker or several workers ) is significantly above the direct labor cost (the amount of wages/salaries and benefits paid to the worker plus payroll taxes).

If the employer is in a perfectly competitive market, where the decision to hire or not will not affect wages, then the marginal cost of labor will be equal to the direct labor cost. But if the market is monopsonic, then a decision to hire more workers will have a higher marginal cost of labor than the direct labor cost of these additional workers. The reason for that is that if the company in order to attract more workers must pay them a higher wage than they paid their previous workers, then this will supposedly also force them to pay their previous workers more. As a result, the marginal cost of labor for these new workers will be higher than the wages and benefits that the new workers received.

To illustrate this with a numerical example, take a company with say 1,000 workers earning $5.75 per hours. Assume then that the company wants to hire 200 more workers but that this will require them to pay say $6.50 per hours. Assume further that the company would then have to pay the old 1,000 workers $6.50 per hours. Assume further that the extra value of these new workers would be $8 per hours.

If the minimum wage was say $5.15 per hour, then the additional workers would bring in $1,600 per hours while costing directly $1,300. But since the hiring of these new workers would also mean that the old workers would have to pay $750 extra, the company would lose $450 by hiring these workers.

But if the minimum wage was say $7.25 per hours, then the additional workers would still bring in $1,600 per hour while costing directly $1,450. However, since the cost of the old workers wouldn't increase in this scenario (The company needed to pay $6.50 per hour to attract the new workers and since the $7.25 pay would meet that requirement and since the old workers already earned that amount no need would exist to raise their pay).

So the conclusion is that with a $7.25 per hour minimum wage 200 more people would get a job than with a $5.15 per hour minimum wage.

When you first hear about it might seen like a sophisticated and also plausible theory. It is also correct-assuming two strict condititions:

1) That everyone at a company must receive basically equal pay.
2) That the decision to enter/leave a market is ignored.

The first condition seems very dubious to say the least. Most companies have individual wage/salary negotiations. If one worker is more productive and/or some other alternative job offer that other workers don't have, then it is likely that management will pay him more than others. Because workers often differ so much they are partially "monopolistic", canceling out the "monopsonistic" powers of the employers.

The second condition is simply outright false. But if the marginal product of workers is $8 an hour and their pay is $7.25 why would any entrepreneur want to leave the business or abstain from entering? Because business have a lot of other costs, you know like rent, interest, the cost of input goods etc. These fixed costs (from the point of view of hiring decisions) have to be covered by the gross profit earned from workers. With a $5.15 minimum wage, the gross profit is $2,250 per hour (($8.00-$5.75)*1,000). With a $7.25 minimum wage, the profit is only $900(($8,00-$7.25)*1,200). In all too many case this much lower gross profit will be too low to cover these fixed costs, putting these companies out of business.

So, I think we can clearly establish that the increase in minimum wage will destroy a great number of actual and potential businesses. Now many will wonder if it can be established whether this effect will be smaller or greater than the potential increase in employees in companies who will still have gross profits large enought to survive.

There are two reasons for believing that the job destroying effect will be larger. First of all because as noted above the monopsony assumption in determining wages is unrealistic. And secondly and more importantly because the effect of reduced gross profits will mean fewer suppliers, which directly or indirectly will raise prices which in turn will reduce demand for these products.

Wrecking Your Currency Key To Prosperity?

Europe's perhaps foremost pro-inflationist columnist, Ambrose Evans-Pritchard at the Telegraph, is holding up Iceland as an economic role model. No, I am not kidding, follow the link if you don't believe me.

His article are full of misleading or false assertions meant to deceive the reader. Contrary to his assertions of "stabilization", unemployment has risen far more in Iceland than in the euro area. While unemployment is now quite similar, it used to be (for structural reasons unrekated to monetary policy far lower in Iceland).

He further claims that Iceland has seen rising exports. Which is true, but only in terms of Icelandic kronas. In terms of just about any other currency it has however dropped significantly. To understand why measuring exports in terms of ISK, remember that Zimbabwe saw dramatic increases in exports in terms of Zimbabwe dollar before that currency vanished (Just like it saw dramatic increases in wealth generally in terms of Zimbabwe dollars)....

He of course also leaves out that with an increase in unemployment from 3.1% to 9.1%, even as the participation ("activity") rate declined from 84% to 81.9% and the average work week dropped from 40.8 hours to 38.9 hours and the average real wage dropped 8.2%, we're talking about a total real income reduction of about 20% in Iceland. That is not "magic[ally positive]", even in the context of this crisis.

The near collapse of the ISK hasn't exactly brought much good to Iceland, in other words. And recommending it as a general policy is even more senseless, because as I've explained before, relative exchange rates are zero sum games, meaning that it is impossible for everyone to devalue against each other. Yet the damage done to others through devaluation will help conceal the damage that policy does to the devaluing country.

Michigan Government As A Role Model?

Via the Planet Gore blog that Obama called Michigan Governor Jennifer Granholm one of "the best governors in the country."

If Obama really sees Michigan as a role model, then America is in for real trouble, given that Michigan has the by far highest unemployment rate in America, at 15.2% compared to the national average of 9.5% and 12.4% in Rhode Island and 11.6% in California.

To be fair, that can't entirely be blamed on Granholm. The state of Michigan is ground zero in the breakdown in U.S. car manufacturing and Michigan would likely have had above average unemployment under any governor.

But Granholm have made matters worse through here left-liberal policies, with for example a minimum wage significantly above the average (though the federal increase enacted two days ago have reduced that difference) and most importantly her environmentalist zeal that have not only included not fighting the federal fuel mileage standards that have hurt Detroit car makers, but also wasting hugh sums of money on "renewable energy" projects.

Now Granholm and her fellow Michigan Democrats plan to go even further by further increases in regulation, including an increase in the minimum wage to $10 per hour, increasing state unemployment benefits (using what money?)a one year moratorium on foreclosures, mandating businesses to provide health care for workers and force energy producers to reduce their rates by 20%.

The latter proposal is especially stupid since they at the same time tries to make energy producers to rely on more expensive ("renewable") energy sources. Unless the state of Michigan dramatically increases subsidies (again, using what money?) this will result in power shortages and blackouts, something which will further damage Michigan's business climate.

As these crazy policies are indirectly praised by Obama, America should be very worried.

Latvia vs. Argentina

Steve Hanke has an interesting column describing the differences between Latvia's current situation and Argentina's in 2001, superficial similarities notwithstanding.

A Challenge To (Non-Austrian) Readers

Last month I had a quiz for readers about interest rates, and wrote that I might have more of them, but not necessarily about interest rates.

Now I have a new one, though it differs in important aspects from the previous quiz. Most importantly perhaps is that while I knew the answer the last time, I don't know the answer this time. Or more correctly, I don't think there is an answer. The reason I am having this quiz is to make me more sure about this: To either confirm the belief by absence of valid answers, or to finally enable me to see at least some positive aspects of this practice.

The question is about the use of mathematical modeling in economics. I have repeatedly pointed out the problems with that approach (for example here). What really strikes me though is that I have yet to find a single advocate of that approach really point to any positive function with it in helping to understand the real world. I have directly asked a lot of them, both teachers and others, yet no one has come up with a positive answer.

Usually they have either chosen to ignore the question (as was the case when I asked Menzie Chinn about it in this comment thread), or they come up with irrelevant answers. Examples of the latter include that they think the math is (and I quote) "beautiful" (Which is nice for them, but not for those of us with different esthetical preferences), that math is more "precise" (Which might be true in some cases (though not all), and even in those cases this comes at the cost of the realism of the theory) or that in order to be a science, economics must use math (which is nonsense, as there are lots of sciences that don't use math).

Some defenders also try to deter criticism by the use of insulting hints about the intelligence of heretics. Another line of defense against critics that point to the unrealism created by mathematical modeling is that bad theories have arisen without mathematical modeling. That is true, but is no real defense of the practice, anymore than the fact that some people die prematurely even though they receive good medical care is a defense of the use of witchcraft to cure diseases. Verbal praxeological reasoning enables you to reach the truth, but since people can do it wrong it doesn't guarantee it. Mathematical modeling will by contrast at best (like witchcraft in the case of medical care) be useless in reaching the truth, and will usually be counterproductive.

The quiz, or challenge here, is then for someone to name a (or several) theoretical insight about the real world that mathematical modeling has produced. Obviously, "theoretical insights" that are unrealistic don't count. And neither does empirical findings through econometrics count, as they, even if valid in some sense, are not theoretical. I'll return later to that issue. For now, the focus will be on theoretical mathematical modeling. Since the Austrian part of my readership presumably agrees with me, they will likely be as unable as I am to name a theoretical insight about the real world created through mathematical modeling. The question here is then whether any of the many non-Austrians that I know are reading this will be able to come up with a valid example. I doubt it, but I will find attempts to do so interesting.

China Lifts Asia

Today's GDP report from South Korea confirmed what earlier reports from China and Singapore indicated: that the East Asian economies are recovering.

Unlike the U.S. "recovery" which really hasn't been a recovery since output has continued to contract (only at a slower pace), this is a real recovery with expanding output. After the initial shock from the financial turmoil last year and the big drop in exports to America and Europe, Asians are now relying on growing domestic demand in China. In the case of South Korea, we are for example seeing a record trade surplus, mainly due to increasing exports to China.

This recovery will likely continue, though it faces two threats, one near-term and another somewhat further into the future. The near-term threat is the risk of a "third wave" of financial turmoil this fall (similar to the financial turmoil in the fall of 2007 and 2008) as monetary conditions are becoming tighter in America. The second threat is the excess money supply growth in China, which could create more malinvestments there and slow future growth.

Bernanke's Exit Strategy

Seeking to calm fears about future inflation, Ben Bernanke wrote an op-ed in the Wall Street Journal, which essentially simply stated that if the FOMC wanted to tighten policy, they can. Well, thank you for telling us what most of us already knew.

However, the point is that while no one doubts that the Fed can tighten policy, the really relevant question is will they dare to do so. As I pointed out in a previous post, inflation will reappear long before "full employment" or "closed output gap" will be reached, meaning that the Fed will have to either allow inflation to get out of hand or allow a 1937-style double dip depression.

But either way, it won't make the problems created by previous inflation go away. It will only affect when and in what form they will be manifested.

The Latest On The Baltic States And The Swedish Banks Who Operate There

The current account surpluses in Estonia and Lavia continues to increase to increasingly significant levels. Both are now experiencing significant surpluses after having just two years ago experienced extremely large (We're talking of current account deficits of 15-25% of GDP) deficits. In relative terms that makes the American adjustment that Brad Setser is so excited about appear trivial in comparison.

I am not sure about whether actual balance of payment accounting takes these effects into account, but whether or not the statistics reflects it, it seems clear that certain Swedish banks (meaning primarily Swedbank and and only to a slightly lesser extent also SEB) that through reckless lending standards was responsible for the boom-bust cycle that wrecked the Baltic economies, are paying the price for that by showing significant losses in the case of Swedbank and no profits in the case of SEB.

By contrast, another major Swedish bank, Handelsbanken, who is renowned for more prudent lending standards and who never had any significant Baltic exposure, is actually showing a small increase in its profits. This illustrates that strategic choices by management does matter in rewarding winners and losers-as Swedbank and SEB are now paying the price for the reckless lending standards of their Baltic subsidiaries while Handelsbanken is seeing its more prudent strategy vindicated.

Mario Rizzo On Failure Of Macroeconomics

I've already discussed the subject twice (first and foremost here, but also here) after The Economist's articles about the failure of academic (non-Austrian) macroeconomics.

A reader tipped me about this take from Mario Rizzo, which is also good.

Chinese Imports Behind Job Decline? I Don't Think So....

This is what apparently passes as scholarship on Universities these days. Peter Morici, Professor at the Maryland School of Business comes up with this explanation of job losses:

"Since December 2007, the private sector has shed 6.6 million jobs-half in manufacturing and construction. Lousy banking practices and a surge in imports, mostly from China, are the main culprits but are not getting fixed."

Well, if surging Chinese imports really is the problem, then that problem has definitely been fixed. Because normally, an 18% decline (the percentage by which U.S. imports from China declined between May 2008 and May 2009) would not qualify as "a surge in".

Oh Really?

Mark Gertler, economics professor at New York University writes this in response to the articles in The Economist documenting the failure of economics:

"Here I think, though, that both the mainstream media and the blogosphere have been confusing a failure to anticipate the crisis with a failure to have the research available to comprehend it. Predicting the crisis would have required foreseeing the risks posed by the shadow banking system, which were missed not only by academic economists, but by just about everyone else on the planet (including the ratings agencies!)."

Oh really, I think I did predict it, without considering the effects of the shadow banking system. The reason for that was that the shadow banking system had, at most, only a trivial role in the crisis, as is illustrated by the great boom in official bank lending in America, and the fact that many other countries without a significant shadow banking system experienced similar bubbles.

Austrian business cycle theory was quite sufficient to predict the crisis. The fact that most economists instead focus on obviously irrelevant red herrings like the "shadow banking system" only further illustrates how failed their paradigm is.

Carbon Tariffs?

Paul Krugman endorses this NY Times editorial, somewhat surprisingly since apart from generally endorsing the goal of reducing carbon emissions it really contradicts what Krugman says.

First of all, it points out that unilateral carbon tariffs is likely to spark a trade war with countries like China and India, something which would harm America (or Europe) as much as these countries, and they therefore don't think it is a good idea.

Secondly, they also point out that unless carbon tariffs are imposed, efforts in America and Europe to reduce carbon emissions would only have a trivial effect on global carbon emissions, since these carbon emission reductions would lower the price of oil and coal and so likely increase its use in China and India, thus offsetting the reductions in America and Europe.

It could here be added that even carbon tariffs will not likely provide enough incentive since American and European goods will still be disadvantaged in markets outside of America and Europe.

And there is really little chance that China and India will really voluntarily agree to reduce its emissions. Here is what the Indian spokesman on the issue said:

"India will not accept any emission-reduction target -- period. This is a non-negotiable stand."

In case you wonder why they take that position and are unlikely to change their position, see this video from the Competitive Enterprise Institute about the suffering that carbon emission cuts would create:

The Failure Of The Economist On The Failure Of Economics

I once liked The Economist. While it was never perfect, it still made a lot more sense than for example Business Week and often implicitly or even explicitly praised Austrian insights. These Austrian insights were mixed with some Keynesian theories, but semi-Austrian still beats non-Austrian.

Since the start of the recession that The Economists and others warned about based on Austrian analysis, however, it has ironically abandoned its partial embrace of Austrian analysis and reverted back to pure Keynesianism.

One example of this is in the latest issue where they discuss the pressing issue of the failure of [non-Austrian] economics, both in a leader as well as in one article about macroeconomics and one about financial economics.

The article conspicuously leaves out any mentioning of Austrian economics, or the role that the use of advanced mathematics played in overlooking the problems. They do however focus on the false alternative of Keynesianism vs. New Classical "perfect markets" doctrines, with the upshot that the Keynesians were right all along.

The finance article is really the only one which makes at least some sense, as it points out the unrealistic nature of many of the assumptions of the Efficient Market Hypothesis and some of its logical contradictions. And it admits that neoclassical financial economics really can't explain (phrased in euphemistic terms as "Financial economists also need better theories of...") many aspects of modern financial markets. But again, it leaves out how Austrian economists like me have already solved most of these apparent puzzles.

So in conclusion, as refreshing as it is to see The Economist expose the failures of neoclassical economics, it is depressing to see that they fail to see why it has gone wrong and how they have forgotten the insights they once displayed-at the very time when those insights have proven themselves more correct and relevant than ever.

Scott Sumner's Stock Market Theory

Scott Sumner, who's "Nominal GDP (NGDP) target"-theory I analyzed here have a post with a misleading and (presumably deliberately) provocative title "The Fed should create the mother of all stock market bubbles, permanently".

It is misleading because the first impression you get is that he wants the Fed to target the stock market. But as he points out, you can't really target more than one thing at once, so that would conflict with his NGDP target.

No, if you read through the post you can see that what he is really saying is that his NGDP target will create a permanent high plateau for stock prices.

As empirical evidence for his theory, he cites how stock markets crashed right in 1929 and 2008, right before there was a dramatic drop in NGDP growth. What he overlooks is that stock market crashed (particularly in real terms) in the 1970s and in 2000-02, despite the fact that NGDP growth increased or were relatively stable.

Perhaps Sumner would protest that he focuses on "expected" NGDP growth and not actual, but since there is no way to measure these expectations, that would make empirical references completely meaningless.

Analyzing instead this from a purely theoretical point, Sumner's theory makes little sense. It is true that under certain conditions with for example nominal wage rigidity that a sudden sharp drop in NGDP growth will reduce profits, and therefore also likely stock prices. However, even under constant NGDP growth, profits can be under big pressure, if there is a sharp increase in cost pressures. In that case, businesses would be forced to either reduce gross margins (bad for profits) by not raising prices or reduce volumes and therefore also reduce capacity utilization (also bad for profits as it increases fixed costs per unit). Either way, profits will be squeezed-something which in turn will depress stock prices. This scenario is a pretty good description of the 1970s bear market.

Another way in which a bear market can arise under constant NGDP growth is if over investments causes so much overcapacity that businesses will have to cut prices given the increased volumes, something which will reduce gross margins (bad for profits), or they will have to restrict volumes and therefore also reduce capacity utilization (again bad for profits).Either way, profits will be squeezed-something which in turn will depress stock prices. This scenario is a pretty good description of the 1970s bear market.

So no, NGDP targeting will not create the permanent high plateau from Irving Fisher's wishful thinking.

Most Euro Area Countries Fails Inflation Entry Criteria

Today Eurostat released detailed inflation statistics for the EU-and a few non-EU countries. The trends that I previously described, where the relative inflation/deflation rate of countries with bursted bubbles continues to decline, remains intact. Ireland for example now has the by far lowest inflation rate, at -2.2%. Estonia has now seen its rate fall below the average to -0.5%. And while Latvia at 3.1% is still above the -0.1% average, its relative inflation rate is falling faster than anywhere else, at more than a percentage point per month.

One new, interesting observation is that with regards to the formal inflation criteria for euro area entry, only 6 out of 15 existing euro area economies(data for the 16th member, France is not available), or less than half, would meet that criteria. The criterion is that inflation shouldn't be more than 1.5% above the average of the three EU countries with the lowest inflation rate. The 3 countries with the lowest inflation rate are: Ireland (-2.2%), Portugal (-1.6%) and Spain/Belgium/Luxembourg (all having -1.0%). The average of -2.2, -1.6 and -1.0 is of course -1.6, and so any country with an inflation rate above -0.1% would be ineligible.

Apart from the already mentioned countries, only Austria falls below -0.1%, meaning that 9 out of 15 would fail the test. To those convinced the criteria’s makes sense that would provide evidence against the idea of monetary unions. For those of us (yes, that includes me) who however do not think the criteria’s makes sense, it simply illustrates why they don't make sense.

"Macroeconomists Couldn't Keep Up"

The Free Exchange, the blog at The Economist, offers this excuse to why the vast majority of macroeconomists couldn't see the housing bubble and the crisis that it caused:

"I have a hunch that not a great many macroeconomists paid much attention to all the different kind of credit systems we have. And I can't be sure because I don't keep up with everything they write, but I think maybe the financial markets became much more complicated than they used to be. And as a result, maybe the macroeconomists just couldn't keep up with all of that."

Actually, all you needed to see the problems was Austrian business cycle theory. If macroeconomists had only studied that instead of Lagrange multipliers, then maybe they could have made some predictions relevant to the real world.

Methodological Point Illustrated

In the introduction to America's Great Depression, Murray Rothbard writes:

"Suppose a theory asserts that a certain policy will cure a depression. The government, obedient to the theory, puts the policy into effect. The depression is not cured. The critics and advocates of the theory now leap to the fore with interpretations. The critics say that failure proves the theory incorrect. The advocates say that the government erred in not pursuing the theory boldly enough, and that what is needed is stronger measures in the same direction. Now the point is that empirically there is no possible way of deciding between them. Where is the empirical "test" to resolve the debate? How can the government rationally decide upon its next step? Clearly, the only possible way of resolving the issue is in the realm of pure theory-by examining the conflicting premises and chains of reasoning."

This hypothetical empirical test is not so hypothetical in today's America. Indeed, if I didn't know better, I would have thought that Rothbard described the current debate.

The U.S. government, obedient to Keynesian theories has pursued Keynesian policies. This has not ended the economic slump and the rise in unemployment. Republican critics like Rush Limbaugh say that the failure to lift the economy proves that the policy has a mistake, while Keynesian Paul Krugman argues that this only proves that the stimulus wasn't big enough and that a second stimulus is needed.

Since we can't study some kind of alternate universe where everything is equal to this reality except there was no stimulus, or where the stimulus was much bigger, we can't based on the empirical record alone decide who is right. Combined with theory and more detailed data, however, the empirical record can however give us a hint of how big the effect is-and whether the net effect is positive or negative.

Mish & Bob Murphy, On Deflation, Money Supply & Credit

Bob Murphy has an article on Mises.org criticizing Mike "Mish" Shedlock's deflationist views.

I basically agree with Murphy's main point, namely that what matters for price inflation is not the quantity of credit, but the quantity of money.

The reason why a higher money supply raises prices is because money represents a claim to real goods and services, and more claims to goods and services will given a certain amount of actual goods and services reduce the purchasing power of money. By contrast, a pure credit transaction which does not increase money supply will not raise prices, as the increased ability of the borrower to buy goods and services is cancelled out by the reduced ability of the lender to buy goods and services.

It was for this reason that Mish missed out on the big commodity price rally earlier this year, when money supply was booming while bank credit was stagnating (and even contracting somewhat).

Also, Mish is wrong to assert that central banks can't create inflation using sufficiently radical measures (Think about what legalizing counterfeiting would do, or if that is too anarchistic to you, how about the Fed sending a million dollar in cash to every American).

However, the recent deceleration of money supply growth suggests that in the short term, we may (It is not certain-but not implausible either) see another period of deflation.

In the current monetary system, where most money exists as deposits within a fractional reserve based system, money supply simply cannot (except for one scenario analyzed below) in the long run expand much faster than credit. Money supply growth can outpace credit growth for some time as long as banks substitute longer term financing for financing through money like deposits, but sooner or later (theoretically the end would be when 100% of financing comes through money like deposits, but in practice the process will end sooner)this substitution will not be able to go on.

So, while credit is not directly relevant as Mish claims, it is indirectly relevant, and for this reason it should be watched. And because of its role as a leading indicator of money supply, the recent contraction in bank credit certainly increases the odds that the recent money supply stagnation might continue for a while and even turn into outright contraction, which in turn means that the probability of renewed price deflation has increased.

As mentioned before, money supply can grow without any credit growth even in the long run if the Fed would implement some scheme (like my above suggested legalizing counterfeiting or sending a million dollar in cash to every American) to radically boost currency in circulation. However, such radical schemes are likely off the table, at least for the rest of the year, meaning that they do not pose a risk for the deflationist scenario during the rest of the year.

Speculation & Oil Price Fluctuations

Commodities tend to fluctuate a lot more in value than do prices of for example services or finished goods. Why is that? One popular explanation is that speculation is the root cause of it.

A more plausible theory is however that the cause is a low short-term price elasticity for demand and supply. The flip side of a low price elasticity is that changes in demand (or supply) not caused by price movements will cause very big price fluctuations.

If say, 5% of demand suddenly for some reason (say a sharp cyclical downturn) disappears and say that a moderate price decline will only cause an increase in supply or decrease in demand of a few tenths of a percentage points, then it is clear that in order to avoid surpluses, prices must decline really dramatically.

That was exactly what we saw both in the great run up in the price of oil to early July 2008 and in the dramatic (75%) price decline that we saw until December 2008.

How then do we know if a certain price fluctuation is due to speculation or other factors? The answer to that question is: by looking at inventory changes. In order for speculators to increase/lower prices they must increase/lower inventory levels. The reason for that is that if they take long positions in futures contracts they are left with two choices. Either they unwind that long position in which case they will lower the price to the level where it would have been if they hadn't taken that long position in the first place, or they'll have to keep the delivery they paid for as inventory. Meaning that in order for speculation to affect the price, inventories must increase.

If you look at the evidence (For the original data go here and then click "Complete History XLS) , you can see that in the months before the July 2008 peak, inventories fell significantly(about 50 million barrels below year ago levels), while in the coming 5 months inventories rose sharply (shifting to being nearly 50 billion above year ago levels). Since then they have been more or less flat adjusted for seasonal patterns. This means that speculators helped reduce the price increase that we saw until July 2008, and then helped reduce the price decrease until December 2008. The increase in price we've seen after that was by contrast purely driven by underlying supply and demand movements.

So while Paul Krugman was right noticing that inventories are now higher than a year ago, he completely misses the point. That inventory build up was happened not during the latest price rally but during the preceding price decline. Meaning that it was during the dramatic price decline that speculation helped raise prices, not during either the preceding or following rallies. Adjusting for likely base effects, inventories have if anything declined during the recent rally.

China vs America

Interesting column from Larry Kudlow about how China continues its relative increase in importance due to its less socialist policies. An excerpt:

"There’s no question that current government policies for taxes, spending, and regulation are causing the U.S. to lose competitiveness in the global race for capital, prosperity, and growth.

Of course, China has been moving in the direction of free-market capitalism for years. To some extent, this shows the positive benefits of America’s free-trade policies and its open-mindedness in helping nurture not only China growth, but also middle-class prosperity worldwide....

....Fortune magazine recently reported that the number of U.S. companies in the world’s top 500 fell to the lowest level ever, while more Chinese firms than ever made the list. Thirty-seven Chinese companies now rank in the top 500, including nine new entries. Meanwhile, the number of U.S. firms has fallen to 140, the lowest total since Fortune began the list in 1995. This is not good.

China also surpassed the U.S. as the world’s biggest automaker in the first half of 2009, with June sales soaring 36.5 percent from a year earlier. The Chinese registered 6.1 million car sales for the first half of the year. That way outpaced American sales, which were only 4.8 million.

And China has no capital-gains tax. It only has a 15-to-20 percent corporate tax. The U.S., on the other hand, is raising its cap-gains tax rate to 20 percent. It’s also increasing its top personal tax rates."

The Value Of Fed Independence

Fed governor Donald Kohn argues against Ron Paul's bill to audit the Fed:

"History provides numerous examples of non-independent central banks being forced to finance large government budget deficits. Such episodes invariably lead to high inflation."

Damn good thing the Fed is "independent" (as it happens, Paul's bill would not remove its "independence" in decision making, it would only make it easier for others to see what they're doing) then, so that we won't have to experience announcements by the Fed that they will help finance the large budget by buying $300 billion of longer-term Treasuries.....

Kohn's argument reminds me of former Fed chairman Arthur Burns' statement that the Fed needs to do what the President wants, or it will lose its independence....

Ukraine's Great Depression

At long last, Ukraine has finally released its first quarter GDP numbers, showing a full 20.3% decline for the volume definition compared to the previous year. Since Ukraine's terms of trade also deteriorated, with the export price index only increasing 17.2% versus 31.2% for the import price index, the decline in real income for the Ukrainian people is even greater.

This means that Latvia loses the first place many believed it had in terms of economic contraction, as Latvia's real GDP "only" contracted 18%.

Now I suppose that most economic pundits will call for Ukraine to devalue its currency to solve its problems, like they did for Latvia. Or maybe not given that Ukraine has already applied that alleged remedy of allowing its currency to collapse.....

Texas vs. California

Texas and California are in many ways very similar, being first of all very big states (second and third respectively in terms of geographic size, second and first in terms of population and output), also having roughly similar climates and both having very large Hispanic immigrant (to a large extent illegal immigrant in both states) populations.

Yet, economic performance differs greatly. The unemployment rate in Texas is significantly below the national average, whereas it is significantly above in California. While both California and Texas has significant net immigration from abroad, Texas also receives a net inflow of people from other states, whereas native born Americans are fleeing California. And while California's severe budget problem seems like a never ending story, Texas, while suffering from the general cyclical downturn, has only limited budget problems.

So why is Texas so much more successful than California? When it comes to the budget deficit, many blames California's constitution that allows voters to approve spending projects without approving the kind of tax increases (or spending reductions in other areas) which are needed to finance them. That is to some extent true when it comes to the budget problem, but since California already has higher taxes than just about all other states and since normal budget rules given the overwhelming Democratic majority would simply mean even higher taxes that is not the solution to its underlying economic problems.

In addition to high spending, California also suffers from excessive regulation, including a much higher minimum wage and far more draconian "climate change"-related regulations.

In its latest issue, The Economists highlights the greater relative success of Texas and readily acknowledge that fact and the causes of it, yet still throws in a disclaimer of "it still seems too early to cede America’s future to the Lone Star state".

The first reason for this is their claim that the growing Hispanic population in Texas will make it more left-liberal, and so end Texas' low tax policies. Perhaps, but I don't think it will happen soon, given the overwhelming majority against for example a state income tax today, and at any rate California is also changing in that direction so it too will become even more leftist. And at any rate, regardless of whether politics change in the future, there can be no denying that Texas low tax policies have been more successful.

The other argument is that there are still a lot of bright people in California. Which is true, but there are also many in California which are not so bright, and there are a lot of people in Texas that are bright. And returning to what should be the point of the story, California's policies are causing a net outflow of people, while Texas's are causing a net inflow of people.

Chinese Car Boom Continues

Passenger vehicle sales in China increases 48%, confirming how China is surpassing the United States as the world's largest car market. This also confirms that the Chinese economy continues to expand, even as most other economies contracts.

Today's Chart

About the assertion from Paul Krugman and other Al Gore-supportersthat global warming is going faster than anyone could have expected. This chart really says all you need to know about the validity of that statement-and the credibility of those who utter it. From the web page of climate scientist Roy Spencer.

Ed Glaeser's Pathetic Defense Of Greenspan

Ed Glaeser, economics professor at Harvard University, dismisses the theory that Alan Greenspan's low interest rate policy caused the housing bubble with this argument:

"Mr. Greenspan’s loose monetary policy may have been a mistake, but low interest rates cannot readily explain what happened to housing prices. Real rates actually rose slightly between 2002 and 2006. "

Huh? In 2002, the housing bubble was inflating, in 2006 the housing bubble was deflating. So, by his own criteria of relevant evidence, he is supporting the theory he is trying to deny. Apparently, Harvard doesn't have high standards when it comes to basic reasoning abilities or logical coherence. Needless to say, Glaeser was as clueless as most professors were in predicting the current crisis.

Sweden's New Inflationist Strategy

In this post at the Naked Capitalism blog, the new inflationist strategy of the Swedish Riksbank is discussed. The facts appears to be mostly correct, though it is misleading to claim that Sweden has price deflation. While the official CPI is in negative territory that is only because it counts interest rate cuts as price cuts (Meaning that in the short term, interest rate changes will have the opposite effect of the intended). Looking at the EU-harmonized price index which lacks that distortion instead, the HICP, Sweden has an inflation rate of 1.7%, significantly above the euro area average.

Anyway, what the Riksbank decided was to reduce its main interest rate from 0.5% to 0.25% and start with quantitative easing. There's nothing unusual or new about that these days, as near zero interest rates and quantitative easing are the rule rather than the exception for central banks in advanced economies. What was unusual was that this decision meant that the interest rate on bank deposits in the central banks was cut to -0.25%. That's right, a negative interest rate. The reason why they now have a negative deposit rate can be found in the reason why it is considered nearly impossible to bring market interest rates below zero: namely that people would then start to withdraw their money. By having a negative deposit rate, the Riksbank hopes to discourage banks from keeping the money they receive from quantitative easing as reserves. Instead, they want the banks to create more credit, something which in turn will increase money supply, something which in turn will increase inflation.

The most radical inflationist in the board, Lars E.O. Svensson, has advocated currency market intervention to bring down the exchange rate of the SEK, which in turn is meant to increase import prices and inflationary expectations. The rest of the Riksbank board decided against it, probably because other countries could interpret this as a way to subsidize exports and discourage imports, rather than as a way to increase inflation. The strategy they are now pursuing will also lower the exchange rate of the SEK, but probably not by as much and not in such a conspicuous way.

One interesting question that the Riksbank's negative deposit rate this raises is why the Fed insists on paying a positive interest rate on bank reserves. If you want to achieve inflation, which the Fed wants, then that is counterproductive as it encourages banks to keep the money at the Fed instead of lending them out to the public. As I've pointed out repeatedly, the monetary base has no direct effect on the real economy. It only has an indirect effect to the extent it helps increase the money supply. But as long as the banks keep the money they receive from the Fed's asset purchases at the Fed, money supply is not affected.

I am not sure why the Fed insists on having a positive deposit rate, since it counteracts the inflationist effects of their other schemes, but one possible reason is that it wants to subsidize the banks and boost their profits. By paying interest on their deposits, the Fed is essentially giving away money to the banks. Another possible reason is that they think that large reserves are essential to restore confidence in the banking system.

Defining Savings

Robert Murphy and Robert Wenzel have a dispute over the definition of savings. Wenzel appears to define savings as "demand for capital goods" while Murphy defines it in the traditional sense, as preserving (saving) a right to consume. In Wenzel's definition savings is thus defined as capital expenditure, whereas in Murphy's definition it is defined as refraining from consumer spending. The practical difference being that holdings of physical (paper/metal) cash and even bank deposit holdings that the banks don't lend isn't considered as savings under Wenzel's definition whereas it is considered as savings under Murphy's definition.

Murphy is clearly right on this subject. "Savings" means uhm well saving, (or preserving if you will) something, in this context meaning the claim on consumer goods. That is something that can be achieved by any act that refrains from consumption, including for example holding paper money, holding gold, holding stocks or holding bonds or bank deposits.

But isn't there a difference between putting money in a jar and using it for capital expenditure. Yes, but that's why you have words like "investment" and "capital expenditure", to differentiate between different forms of savings.

As Murphy points out, Wenzel's definition creates the absurd situation where someone who has deposited money in a bank really doesn't know whether or not he has saved until he knows whether or not it has been lended. And indeed that's not really sufficient, as he also must know whether or not the loan has ceteris paribus causally made the borrower invest in capital goods. It furthermore would imply that if the borrower didn't use it for capital expenditures, but for consumer expenditures, then people who saves their income really aren't saving. What is really going on is that the people lending (depositing) money to the bank are saving while the people borrowing from the bank are dissaving, but if you define savings as "capital expenditure" you would not be able to understand that these transactions involved some people saving and other people dissaving.

First Derivative Remains Negative

A popular way of analyzing the recession and whether or not there is any improvement is to make a distinction between the first derivative and the second derivative. The first derivative is about whether or not the economy is contracting or expanding, the change in the level of output. The second derivative is about whether the pace of contraction is increasing or decreasing, the change in the rate of change in the level of output.

A number of recent numbers now indicates that while the second derivative probably was positive in the second quarter, the first derivative remains negative. The most important example of this is today's employment report.

It showed a net job loss of 467,000 according to the Payroll survey and 374,000 according to the Household survey. And moreover, the average work week fell to a new low while growth in hourly earnings fell to zero (on a monthly basis), meaning that June not only may have had a negative first derivative but also a negative second derivative, at least compared to May and April.

Krugman's Revealing Defense Of Malthus

I am almost somewhat reluctant about posting this post, since I've already written so many posts about Krugman recently, so it might give the impression that I'm obsessed with him (which I'm not).

However, he is unfortunately a very influential pundit, and lately he has produced unusually many misleading and dangerous posts/columns, including his infamous "treason to the planet"-column.

Now Krugman claims that some unnamed commentators have accused him of being a Malthusian, something which he reacts to not by trying to differentiate his views from Malthus' but by defending him. While acknowledging that Malthus' dire views about population growth have been dead wrong for the last two centuries (which is to say the two centuries that have passed after Malthus made his predictions), he claims that Malthus was right before that.

This is a perfect example of an own goal from Krugman's part. I won't bother to argue with his data despite the fact that they are extremely unreliable given the fact that statistics authorities didn't exist until the twentieth century and given the fact that most people at the time were mostly self-sufficient farmers, because the data if true actually argues against his own views.

Remember that the accusation arose because of his views that because of the alleged threat from global warming/"climate change", we need to dramatically reduce and preferably end our use of fossil fuels (like coal and oil).

The thing is here that one of the reasons why the Malthusian worldview has proven to be dead wrong for the last two centuries is precisely because we have started to use fossil fuels in large scale (both coal and oil were used on a limited scale before the Industrial revolution, but it was only after that that large scale use of coal and oil started).

While the dramatically increased use of fossil fuels wasn't the only reason why the dire Malthusian forecasts were proven wrong, it was certainly a very important factor.

By emphasizing indirectly (without realizing it) how it was only after the large scale use of fossil fuels that mankind lifted itself from the predictions dire Malthusian worldview, while at the same time pushing for the end of use of fossil fuels, Krugman is indirectly acknowledging (without realizing it) that he is pushing for the creation of a dire, suffering ridden Malthusian world.