GDP Revised Up-National Income Down

The second revision of U.S. third quarter GDP change showed a slight upward revision, from -1.0% to -0.7% in volume terms and from -1.5% to -1.3% in terms of trade adjusted terms. Nominal GDP change was revised from -1.0% to -0.8%.

But while this alleged improvement was widely touted in the financial media, no one mentioned that at the same time national income (and gross domestic income(GDI)) was revised down. The only hint of this fact was that the news stories also reported that corporate profits were revised down.

Anyway, while nominal GDP was revised up from $14,143.3 billion to $14,151.2 billion, nominal national income was revised down from $12,161,9 billion to $12,129.9 billion. That was in part the result of falling net factor income from abroad, but mainly a result from an increase in the "statistical discrepancy". In theory (or so we are told), GDP should be equal to GDI, and national income should be equal to Net National Product ((NNP) which is to say GDP adjusted from net factor income from abroad and capital consumption).

We have seen a big change in recent years in "statistical discrepancy", from -$220.6 billion in 2006 (which is to say, GDI/NI was $220.6 billion larger than GDP/NNP) to +249.8 billion (Which is to say, GDP/NNP was $249.8 billion larger than GDI/NI). As a result, while nominal GDI/NI grew by just a few tenths of a percent between 2006 and Q2 2009, nominal GDP/NNP grew by about 5%. The implication here is that the current slump has been far more severe if you rely on GDI/NI than on GDP/NNP.

I will in a later post return to the issue of why this "statistical discrepancy" arises and whether GDP/NNP or GDI/NI are more reliable, but for now let's just say that the latter are at least as reliable and that the U.S. economy has therefore performed much worse than the GDP numbers suggests.

How Sustainable Is the U.S, Recovery?

How sustainable is the U.S economic recovery? Before I make a more definite statement on the subject, I'll have to look at the data released later this week. But given what we know now, it appears to be very weak and vulnerable.

First of all, the durable goods order report indicated weakening investment demand, considering both the negatuve monthly change and the downward revision od previous numbers.

Secondly, the Chicago Fed National Activity Index showed continued contraction in August.

And both the existing and new home sales reports were disappointing.

The one positive report was the retail sales number which showed strong growth. Because of that, it is highely likely that notwithstanding the above numbers, GDP growth was positive in Q3 2009-at least compared to the previous quarter and not adjusting for terms of trade effects.

However, that gain was largely built on people taking advantage of the "cash for clunkers"-scheme. But since that is a temporary scheme, there will likely be a hangover in the form of lower sales later.

In short, current data suggests that the risk of a "double dip" recession is very high.

Germany's Economic Prospects Brighten

The "grand coalution" between Christian Democratic CDU/CSU led by Angela Merkel and the Social Democratic SPD in Germany will now end, and be replaced with a pure centre-right coalition consisting of the CDU/CSU and the market liberal (moderate libertarian) FDP. The FDP had their best result ever with 14.6% of the vote.

As a result, Germany will now pursue more market oriented policies, including deregulation and tax cuts, something which will improve the German economy's prospects.

This would have happened 4 years ago if Angela Merkel in her first campaign hadn't pledged to raise the Value Added Tax (VAT), something which was very unpopular, and made many voters go over to the SPD. The SPD entered into a "grand coalition" with the CDU/CSU, only to agree to the VAT increase they campaigned against. For this they were justifiably punished by the voters with the by far lowest SPD result ever (or at least since World War II) of only 23%, down a full 11 percentage points from 2005.

The VAT increase not only damaged the German economy by postponing the arrival of a centre-right government by 4 years, but also by increasing Germany's export dependence, something which made Germany suffer greater declines in output than even many countries with housing bubbles, like the U.S. and Spain.

Best & Worst Performers In The Economic Crisis

All countries have been hit by the economic crisis in the sense that all countries have seen growth drop. However, great differences exist, as some have merely seen growth slow, others have seen only an insignificant contraction and yet others have seen a significant but not dramatic contraction and then there are countries that have experienced outright depressions (More than 10% contraction). Here is a list of countries that in the year to the second quarter experienced growth and those that experienced more than 10% contraction:

Growing economies:
China
India
Vietnam
Indonesia
Philippines
Poland
Australia
Israel

Economies Suffering A Depression:
Mexico
Russia
Estonia
Latvia
Ukraine
Lithuania

Source: The Economist

For a few countries, second quarter numbers remain unavailable, and for all countries terms of trade related factors could distort the picture. Still, this list gives a good picture of which economies have fared the best and which have fared the worst.

The really extraordinary case here is Poland which has managed to stay relatively strong despite the depression in several of its neighbors. This is likely in part due to a beneficial industrial structure and in part due to the aggressive tax cuts implemented this year.

"It Was Entirely The Fault Of Mervyn King"

I first heard the phrase "It was entirely the fault of Mervyn King" (Mervyn King, in case you didn't know is the head of the Bank of England) in the satirical conversation by comedians John Bird and John Fortune (with one posing as an interviewer and the other posing as "George Parr, investment banker") that I told you about here.

That was of course an exaggeration. While the policies of the Bank of England certainly contributed to the crisis, it wasn't the only and on a global scale it was a relatively insignificant cause of it (However, for Britain's specific problems, its role was a lot greater). Moreover, Mervyn King isn't the only one in the Bank of England influencing its policies, so the blame should be shared with more people in the Bank of England. But while being from a factual point of view clearly an exaggeration of the kind that is typical of comedians, there was certainly a lot of truth to it. Mervyn King does deserve part of the blame.

In this case, the pound's slide today, the phrase is probably a lot closer to being entirely true. It appears to have been triggered by comments by Mervyn King saying a weak pound is "helpful" for the British economy.

As I noticed last week, the pound has been sliding for some time now. These latest comments are one of the indicators that the slide is mostly or entirely the fault of the Bank of England. Bank of England officials have before tried to talk down the pound, and also matched it in action with their "quantitative easing".

Immigration & The Economic Crisis

Some people don't like immigration for various reasons. They should be happy to know then that the economic crisis has dramatically reduced immigration-and increased the number of immigrants that returns home.

We are now seeing several examples of this, the most notable being the United States and Ireland.

First of all, the U.S. Census Bureau estimates that for the first time in a long time, the number of foreign born has actually dropped somewhat. To be sure, because so many immigrants are in America illegally and because we can't know for sure the number of illegal immigrants, this estimate has a significant statistical margin of error, big enough to make it possible that there was a small rise. But there could have also been an even bigger drop, and there's little doubt that the number of new immigrants have dropped significantly and that the number of immigrants that return to their country of origin has increased.

The reason why the economic slump should reduce immigration is because it reduces job opportunities and so makes it more difficult for immigrants to get jobs. It is true that the slump has worsened job opportunities in the countries of origin too, but because [employment based] immigration requires a job in the new country, worsening job prospects will reduce immigration even if the job markets gets worse in both countries.

Also, immigrants have been over represented as workers in the construction industry, "Ground Zero" in the economic crisis. This means that job prospects for immigrants have deteriorated even more than for natives.

A similar trend can be seen in Ireland. In the year to April 2009, net migration was for the first time since the year to April 1995 negative. In 2006, net immigration was as 72,000, the equivalent of more than 5 million in America, and in 2007 the number was only slightly lower. By 2008, the number had been cut into almost half (38,500) and by 2009 it was a negative 7,800.

The group that accounted for most of the swing was people from EU12, which is to say the 12 new EU member countries in Eastern Europe and the Mediterranean. In 2006, net immigration from there was 42,700 and in 2007 it was 38,500. In 2009 it was -16,600.

Contributing further to this drop has been that Poland, the biggest country of origin among EU12 immigrants, has had a much stronger economy than the rest of Europe.

Note however that this logic is primarily applicable to labor force migration. Immigration based on asylum applications or marriage/family relations is likely to be a lot less affected by this factor.

Incidentally, it could be noted that the relatively high level of immigration during the boom and the [at least so far] more limited degree of emigration during the bust implies that labor immobility really isn't such a strong factor in Europe as many opponents of the European Monetary Union have claimed.

Lessons Of The Recent New Zealand Dollar Rally

One currency that unlike the British pound and the Ukrainian hryvnia has continued a fairly predictive pattern is the New Zealand dollar. Between March 2008 and March 2009, it dropped nearly 40% against the USD, from 81 US Cents to 49 US Cents, with most of the drop coming after August when stock markets started to plunge. But since then it has staged a spectacular rally, reaching a new 2009 high of 72 US Cents (Up nearly 50% from the March low!). Part of that reflects the general weakness of the U.S. dollar, but it also reflects a particular strength of the NZD, as it has risen against the euro by nearly 20%.

There are two (or actually three) lessons of this: First of all, there's little or nothing in the fundamentals of New Zealand's economy that motivate these kinds of wild fluctuations, but because it disrupts business planning it has a disruptive effect on the New Zealand economy (and to a much lesser extent (as New Zealand means less to the rest of the world, than the rest of the world means to New Zealand), the rest of the world economy). The Friedmanite myth that fluctuating fiat exchange rates would somehow stabilize economies based on different fundamentals is thus once again proven to be a myth.

This again illustrates the point that I've pointed out here and here that the [uncovered] “interest parity condition" doesn't hold and that countries with high yields will give investors higher return. Even factoring in last year's big drop in the exchange rates of high interest rate countries, high interest rate countries offered much higher return over a longer period of time than low interest rate countries. The big rally this year for the high interest rate currencies of the Australian and New Zealand dollars makes the statistical superiority of high interest rate countries even greater.

The third point is that the future of the New Zealand dollar's exchange rate depends on how global stock markets will perform. It (and more importantly assets denominated in it) is so to speak a "high beta asset". If global stock markets rally further, then so will the New Zealand dollar. If global stock markets sell off, then so will the New Zealand dollar. Since I personally think that the risk is high of a stock market sell off; the risk is also high that the New Zealand dollar will sell off.

End Of Zimbabwe Dollar Ended Zimbabwe Hyperinflation

After the the destruction of the Zimbabwe dollar, inflation has become relatively moderate in Zimbabwe again (at least using African standards). The numbers are probably more or less right, though the article leaves unanswered just in terms of what currency or currencies inflation is measured. The article says that "foreign currencies"[unspecified] are used in Zimbabwe, without mentioning exactly what currencies we are talking about. Just about any currency would however seem preferable over the late Zimbabwe dollar.

Implications Of The Weak Hryvnia

Two countries in Europe have a flag with the colors of blue and yellow: Sweden and Ukraine. Both have freely floating fiat currencies, and both saw their currencies plunge in value in late 2008, the Ukrainian hryvnia somewhat more so than the Swedish krona. The value of the two currencies in global foreign exchange markets really isn’t that different. However, recently, they have moved in opposite direction.

The Swedish krona has appreciated nearly 10% against the euro in recent months, reversing more than half of the drop it saw between the summer of 2008 and in late February and early March 2009.

The Ukrainian hryvnia however has dropped dramatically, from about €0.095 in mid-June to only about 8 euro cents now. In terms of SEK, the hryvnia has dropped from 1.05 in mid-June to 0.80 now.

Like the case of the U.K. pound that I discussed in the previous post, this illustrates that while currencies have generally moved in a fairly predictive pattern relative to stock prices, which is to say with the U.S. dollar, the yen, the franc and the euro having a negative relationship and other currencies having a positive relationship, some currencies can change their empirical relationship towards stock markets. This can be the case either because of a change in the causal relationship or because some other factor interfered.

The Weak Pound

While most other freely floating European currencies have appreciated (risen) in value against the euro in recent weeks, the U.K. pound has now again seen its value depreciate, with the euro again rising above 90 pence.

Many analysts are now predicting that the pound will reach parity with the euro. I wouldn't be too sure about that, but it is certainly a real possibility. While the yen, the U.S. dollar, the Swiss Franc and the Euro to varying degrees have been "low beta" safe havens during the financial crisis, most other currencies have had the status of "high beta" assets, which appreciate in value during stock market rallies, and depreciate during sell-offs.

With global stock markets being very overbought, a big downside risk on "high beta" currencies exists. The relevant question with regards to the pound is whether the recent slide despite elevated stock prices reflects a transformation of the pound from a "high beta" to a "low beta" asset in the minds of investors, or if it reflects some independent (separate) weakness of the pound.

At this point, it is too early to tell. But either way, the pound does not look like a good bet. If it represents some independent weakness then it is almost per definition not a good bet. If it represents a transformation into a "low beta" asset it does not look good either given the overbought conditions of stock markets.

More On Government Failure

As a follow up to the post on market failure vs government failure. I would like to recommend Johan Norberg's article on the failure of government regulators in practice. This again illustrates that while free markets aren't "perfect" in the sense of always producing the right results, government regulations are likely to produce even worse results.

Big Increase In Euro Area Trade Surplus

The Euro area trade surplus posted a big increase in July, from -€3.5 billion in July 2008 to +€12.6 billion in July 2009. That indicates that the euro area GDP number will receive a big contribution from net exports. With indicators of domestic demand also stabilizing, this will almost certainly mean that third quarter Euro area GDP will increase significantly compared to the previous quarter (though it will remain down compared to four quarters earlier).

The Ongoing Dramatic Inflation Rate Increase

Between December 2008 and August 2009, the seasonally unadjusted U.S. consumer price index increased 2.7% or 4% at an annualized rate. Yet the yearly change was still -1.5%, due to a drop in the CPI of more than 4% between August 2008 and December 2008. But that number for the 12 month change was up from -2.1% in July and as the drop late last year is removed from the 12 month comparison during the coming 4 months, consumer price inflation will return to levels way above zero, and likely also above the official or unofficial 2% target pursued by most central banks.

A similar trend can be seen in the euro area, where the inflation rate rose from -0.7% in July to -0.2% in August. This trend will likely also be seen in other countries, though less dramatically (or in some cases not at all) as they for example in the cases of Sweden and Poland saw their currencies plummet in value late last year, but has seen it rise dramatically in value this year. Also, some countries with fixed exchange rates and deep economic crisis, most notably the Baltic countries, are also likely to see continued relative disinflation, limiting or preventing any absolute reinflation.

Government Failure vs. Market Failure

A common misperception is that the case for free markets rests on the assumption that markets are perfect. The free market supposedly always through "the invisible hand" always comes to the right decision in all economic activites.

That straw man version of the case for free market is clearly false, yet it is sustained both by neoclassical micro economists and New Classical macroeconomists who use these kinds of models. And since these models are obviously false, leftist/Keynesian economists makes sure to always present them as the case for free markets, something which they can easily refute.

A more proper case for free markets goes something like this: All people are imperfect, which is to say they aren't omniscient or infallible. As such, they are likely (indeed almost certain) to do things which at least in hindsight can be shown to be mistakes. I’ve made a lot of mistakes in my life, and that probably goes for everyone. For this reason, market processes will inevitably result in outcomes which aren't optimal. Something which by some people would be referred to as market failures.

However, just because markets often fail to produce the best possible outcome doesn't mean that there is a case for increased government intervention. People working for the government are likely to be as imperfect as people working for private companies, and they will therefore produce a lot of what one might call government failures.

The really relevant issue isn't then whether or not markets or governments are "perfect", as neither clearly isn’t. The issue is which system has a structure that will reduce or increase the number of bad outcomes.

The free market has such a structure. If a company decides to invest in the production of a product that no one wants (at least not at a price which would cover the cost of production), then it will automatically be punished by suffering losses. If it on the other hand had invested in products that people wants then it will automatically be rewarded by profits. Similarly, if someone makes the foolish decision of spending their entire monthly paycheck in night clubs and bars in a wild weekend, they will be unable to pay their bills and will be forced to live the rest of the month on leftovers or low price food they really don't like, unless they can come up with some new income (which would be a good act rewarded by the market).

It is true that even the market structure, and not just the people in it, is imperfect. By that I mean that if someone makes a foolish decision, sometimes others will unfairly suffer too. If some employer for example decides that for some reason (cronyism, irrational hiring practices or whatever) that a less competent job applicant or contractor should be hired instead of someone more competent, then the market process will punish the employer (because he has less competent workers or contractors), but the more competent job applicant or contractor will also suffer. But that problem will exist in any human interaction, that bad decisions will hurt more people than the people making the decisions. It certainly applies to governments hiring employees or contractors too.

But at least the market process will punish those responsible too, because government officials are funded by compulsory taxes (or loans or printed money), they will not necessarily suffer if they make bad decisions. Whether or not government officials make the right or wrong decisions, they will have the same income.

Some might object that for democratic governments, a similar process exists. Namely, that if government officials cause problems, then voters will elect new ones. That argument is partly true, and that is one reason why a democracy is preferable to a dictatorship.

However, while better than a totalitarian government, elections don't work as well as markets for two reasons. First of all, because in a market everyone gets what they want while in elections it often just a slim majority that gets what they want, while the rest is not pleased. And secondly, because the economy and other political issues are usually quite complex and not really something which most people truly understands. For example, even though government intervention caused the Great Depression, it resulted in further expansion of government intervention. By contrast, people usually understand clearly whether or not goods and services they buy in the market place are good for them.

In short, both markets and governments are imperfect. But the market process is much more likely to reduce the number of suboptimal or imperfect outcomes than government control is.

Does It Matter Which Currency Commodities Are Priced In?

Sometimes it has been predicted that the U.S. dollar could some time in the future lose its status as world's reserve currency and the currency in which commodities are priced on global markets to the euro or the yuan, in the same way that the U.K. pound once lost that status to the U.S. dollar. Because of that prediction, it is often discussed whether it matters whether commodities are traded in terms of dollars or in terms of pounds, euros or yuans.

The short answer to that is that it shouldn't matter, but that it in fact does.

The reason why it shouldn't matter is because it doesn't really affect the cost of commodities of anyone in any country. Assume for example that the euro dollar exchange rate is $1.5/€ and that oil is trading at $75 per barrel. The cost of one barrel of oil is than $75 for Americans and €50 for Euro area residents. If oil had been priced in euros and trading at €50 per barrel, then the result would have been the same. The cost of one barrel of oil would have still been $75 for Americans and €50 for Euro area residents.

If everyone did what they should do, which is to say to "translate" quoted prices into their own currency (or the currency relevant for the analysis), then it wouldn't make any difference if the quoted market price was $75 per barrel or €50 per barrel.

However, that is evidently not the case for most people. Most people even outside the United States tend to think of commodity prices in terms of the quoted dollar price. One example of this is how British Telegraph, as well as most other European financial media outlets published articles this week telling of how gold reached a new high at over $1,000 per ounce. For Britons, it shouldn't really matter how gold moved in terms of dollars but in terms of pounds. And while gold rose 1.1% in dollar terms this week, it dropped 0.6% against the pound because tyhe pound rose 1.7% against the dollar. Similarly in terms of Swedish krona, gold dropped 1.3%, in terms of Swiss francs it dropped 1.1% and in terms of euros it dropped 0.9%. So despite the fact that gold became cheaper for Europeans this week, most Europeans appeared to think it became more expensive because the dollar price rose.

Earlier this year we saw a similar but reversed illusion, as most Europeans (I was an exception) failed to realize that gold rose to new all time highs in terms of European currencies (and most non-European currencies) because the dollar price remained well below the all time high.

And when the euro and the price of oil both reached record highs in the summer of 2008 against the dollar, some financial journalist talked of how European companies were hit by the double whammy of $145 oil and a $1.6/€ exchange rate. In a way that was less misleading than the aforementioned gold examples because oil was record expensive even in terms of euros then, but the euro price had risen a lot less than the dollar price, meaning that the strong euro, while causing problem for exporters, did provide relief for consumers.

So because all too many people use the quoted market price in their analysis even in countries where it is not appropriate, it does have some significance whether commodities are traded in pounds, dollars, euros or yuans. In a perfect world it wouldn't have any significance, but this is not a perfect world.

"Moderately Loose"?

The good news from the Chinese economy today was that industrial production and retail sales increased at its fastest rate this year.

The bad news was that this was partly caused by very high money supply growth. While China with its higher structural growth rate has room for higher money supply growth than other countries, the current 28.5% increase in M2 is clearly excessive even for China. I BTW found this paragraph in the Bloomberg news story about it remarkable:

"People’s Bank of China figures showed today that M2, the broadest measure of money supply, rose by a record 28.53 percent, as the central bank maintained a “moderately loose” policy stance."

28.5% M2 growth is "moderately" loose? I'd hate to see an extremely loose policy stance then.....

Does The Trade Deficit Threaten The U.S. Recovery?

The U.S. trade deficit increased more than expected in July, from an upwardly revised $27.5 billion in June to $32 billion in July. The main causes of that were higher oil prices and increased imports of car and car parts. The latter being a result of the "cash for clunkers" scheme and the way it particularly benefits buyers of Japanese and Korean cars.

Now Peter Morici, Professor at the University of Maryland School of Business claims that "the trade deficit threatens the recovery" based on a crude "imports destroys jobs" reasoning.

The empirical facts are hard to square with this theory. The U.S. trade deficit rose when employment grew between 2003 and 2007, and then it collapsed at the same time as employment started to fall sharply (from $65 billion in July 2008 to $26 billion in May 2009) , which is to say during the second half of 2008 and the first half of 2009. And if imports really is bad for the economy, then North Korea would be the most prosperous nation on Earth and being subject to trade sanctions should be a big boon to any economy. And if reduced trade deficit really created jobs, then Latvia should have seen a big drop in unemployment during the latest 18 months when a trade deficit of 20% of GDP has been turned into a trade surplus (if trade in services is included). In reality, Latvia has seen a dramatic increase in unemployment.

These empirical facts do not necessarily prove that his theory is wrong, especially since there are cases seemingly consistent with the theory, such as the slump in the German economy when its trade deficit decreased during late 2008 and early 2009 and the recovery in the last few months when the surplus increased. However, as it happens there are good theoretical arguments for believing that it is wrong.

Using the traditional GDP accounting, it would at first glance appear that the theory is correct, as Y=C+I+G+NX where Y is GDP, C is consumer spending, I is investment spending, G is government spending and NX is net exports (the trade balance). However, that is an accounting identity and accounting identities do not establish causal relationships. The theory that a lower NX will lower Y implicitly assumes that the size of NX does not affect C, I or G. But that is not a reasonable assumption because the flip side of a lower NX (smaller surplus or bigger deficit or shift from deficit to surplus) is that capital inflow increases, something which lowers interest rates and thus enables higher domestic demand. And the correct theory that a lower NX causes C, I and/or G to be higher is just as consistent with the accounting identity as the theory that NX causes Y to be lower. Furthermore a lower NX means that the aggregate supply of goods and services increases, something which puts downward pressure on prices and therefore increases purchasing power.

Trade deficits do not lower Y, they increase C, I and G. And because of the lower prices, real Y will in fact increase. Because of the mutual gains created from comparative advantage, real Y will increase from increased trade both in the country where NX increases and where NX decreases. This explains why the big drop in world trade was associated with slumps in both countries where NX increased (such as the U.S. and Latvia) and countries where NX decreased (such as Germany).

One exception however to the above is when government interventions distort incentives, as is the case with for example the “cash for clunkers” scheme. But the higher trade deficit is then only a symptom of the underlying problem which is the interventions.

German Exports Recover Strongly

German exports rose a seasonally- and calender adjusted 2.3% in July, following a 0.2% gain in May and a 6.1% gain in June, for a cumulative 3 month gain of 8.8%. As a result, the 12 month drop in exports has dropped from 28.8% to 18.7%. It appears to be mainly to countries outside the EU (meaning presumably mainly China) that exports increase.

As imports rose a more moderate 3.9% over the latest 3 months, net exports will likely give a large contribution to German third quarter growth.

Worth noting is also that German exports have now dropped less in terms of euros than Swedish exports have dropped in terms of SEK (22.6%). While the drop in Swedish exports would have probably been even larger without the weak SEK, this fact could indicate that it has provided a smaller boost than most people think.

Baltic Disinflation Continues

As is likely for almost all countries/currency areas, the euro area saw its inflation rate rise from in August, from -0.7% in July to -0.2% in August.

However, the Baltic countries saw their inflation numbers decline further. The EU-harmonized index is not yet available, however, the annual change of the non-harmonized measure declined 0.2% between July and August in Estonia, with 0.7 percentage points in Latvia and with 0.4 percentage points in Lithuania.

Relative to the currency area their currencies are pegged to, the euro area, the Estonian inflation rate likely declined 0.7 percentage points, the Latvian inflation rate 1.2 percentage points and the Lithuanian inflation rate 0.9 percentage points.

Since the annual inflation rate of most countries will increase dramatically in the coming months, the Baltic inflation rates will likely post more moderate declines in absolute terms. But in relative terms, Baltic inflation rates will continue to decline significantly in the near future.

Money Supply Growth Turns Negative

Compared to 52 weeks ago, the MZM money supply measure in the week to August 24 was up 8.9% and M2 is up 7.6%. However, just like with price inflation, the 1 year increase is deceptive, except that monetary trends are more deflationary than they seem while price trends are more inflationary (for now). Most of the increase came during the first 6 of those 12 months. MZM peaked in early June (after having increased slowly since March) and M2 in mid-March. For more than 5 and 2 months respectively then, we have experienced a mild form of monetary deflation. As the graph illustrates though, most of the drop has happened during the last 4 weeks which is why the effect so far has been limited.



Because of the lagged effects of previous money supply increases , we have seen a stock market rally, a pick-up in price inflation and a stabilization of output.

If the recent more deflationary monetary trends continue, then the risk of a stock market sell-off and a double-dip recession will be very high,

Cross Border Arbitrage Caused By Taxes

Via Robert Wenzel I see that a Massachusetts politician by the name of Michael Rodrigues that voted for higher alcohol taxes in Massachusetts is buying his alcoholic beverages in...low-tax New Hampshire.

What is arguably even more interesting about this than the personal hypocrisy of Michael Rodrigues, is that if you tax stuff too much people will turn to substitutes, including purchases in other jurisdictions.

A very similar story can be seen in Northern Europe. Norway has the highest alcohol tax in Europe, which is why Norwegians come in large numbers to buy alcohol in Sweden. The alcohol store (like in Norway and Finland, Sweden has a retail monopoly for alcohol sales) in the border town of Strömstad is the highest selling store in Sweden due to the massive inflow of Norwegians.

Still, while alcohol taxes are lower than in Norway, Swedish alcohol taxes are higher than in Denmark, and dramatically higher than in Germany. This is why many Swedes go to Denmark and Germany to buy alcohol (the recent weakness of the Swedish krona against the euro and the Danish Krone (which is pegged to the euro) has reduced that trade, but far from eliminated it). Meanwhile, many Danes buy their alcohol in Germany.

It should not come as that big of a surprise that differences in alcohol taxation between different American states have a similar effect.

Why The Japanese Economy Will Continue To Decline

If you want to know why Japan, unlike China, is in a secular long-term decline you can look at population statistics.

At first glance, nothing dramatic seems to have happened. 5 years ago, the population was 127.7 million, now it is 127.6 million, not much change. But look closer and you will see some very dramatic changes. In 2004, the population below the age of 15 was 17.7 million, the population aged 15 to 64 was 85.1 million and the population aged 65 and over was 24.9 million.

In 2009, the population below the age of 15 had dropped 3.5% to 17.1 million, the population between 15 and 64 had dropped 4% to 81.6 million, while the number of people older than 65 had increased 16% to 28.9 million.

During the next 10 year, this trend will continue as the working age population is set to drop at an even faster rate. In the age group of 5-14, the population is 11.7 million, while in the age group of 55-64 the population is 18.6 million, meaning that the working age population will drop by an average of 0.9% per year.

This will not only mean fewer workers but also less capital equipment as people tap into their savings (including the savings in government pension funds) at old age. We have already seen the beginning in this drop in savings as the personal savings rate has dropped dramatically and as overall savings has also dropped significantly. In 1994, private and government consumption was 69.8% of GDP, a number that increased to 77.4% in 2008, meaning that the implied gross savings rate dropped from 30.2% to 22.6%.

See also Steve Malanga's article on the subject.

Why China 2009 Isn't Like Japan 1989

When I in 2005 predicted that China would eventually become the world's leading economy, I was asked why the bullish view on China wasn't like the bullish view of Japan in the late 1980s and early 1990s, when some people believed that Japan would overtake America as the world's biggest economy, something which hasn't happened (or even come close of happening as the U.S. economy is nearly 3 times larger than the Japanese).

My answer in short was, because there are about 10 times as many Chinese as Japanese. And has been demonstrated in majority Chinese countries like Hong Kong, Taiwan and Singapore, the Chinese aren't incapable of high productivity and with China gradually moving away from communism, mainland Chinese per capita income levels should approach those in Hong Kong, Taiwan and Singapore. Something which given the size of China's population will make it the world's biggest economy.

Via the Naked Capitalism blog, I now however again see the assertion that China is the new Japan resurface.

One argument is that the Chinese government statistics are manipulated. That is probably true, but there still exists overwhelming evidence that the Chinese economy is indeed growing, and that moreover during some periods of time, official statistics have underestimated growth.

The second key argument is that there is currently excessive credit- and money supply growth. That is also true, and that means that there is a high risk of future cyclical slumps in China. But cyclical slumps don’t necessarily mean a permanent decline. America in the late 19th century experienced several cyclical slumps, but nevertheless quickly recovered and experienced rapid long term growth.

And China 2009 is in fact more like America 1879 than Japan 1989. The reason why the Japan stagnated in the 1990s (and 2000s) was first of all that they responded to the crisis with bad policies that inflicted permanent damage on the Japanese economy. And secondly because Japan later experienced a demographic implosion with a shrinking work force and rapidly increasing elderly population.

Now, while China's current population policies risks creating similar problems in the future, which is likely decades away. And more importantly, in 1989, Japan had almost its entire population employed in relatively high productivity urban economic activities. In China, by contrast, a significant portion of its population is still employed in low productivity rural economic activities. Moreover, even much of its urban population has the potential to move significantly up the value chain, something which was not the case in Japan in 1989.