Creating An Incentive For Murder & Suicide

Several other bloggers (including Mish and Paul Krugman) have discussed recently the perverse incentives created by the temporary one year abolition of the inheritance tax in the United States. I wrote about it already in 2007, and there's not much to add, except that whether or not you think inheritance taxes should be permanently abolished or whether they should never be abolished, a temporary abolition of a tax of that kind is not a good idea given the perverse incentives created. And that the failure to address this represents a government failure.

The Premature Closing Of Ignalina

The Ignalina reactor in Lithuania is now being closed. As it was built during the era of Soviet occupation, safety there is not as good as in modern Western nuclear reactors, so it is in a way understandable that the EU has insisted on its closure. Nevertheless, the risk of a meltdown is still minutiae, and right now is really the worst possible timing for such a closure.

Ignalina provides some 70% of Lithuania's electricity and its closure will therefore provide a further harsh blow to the Lithuanian economy, which has suffered from an economic depression. It would therefore have been a good idea to postpone the closure until the Lithuanian economy gained more strength and alternative energy production in Lithuania was developed.

As it is, Lithuanians will now see energy prices jump significantly, while many more Lithuanians become unemployed and Lithuania becomes dependent on the import of natural gas from Russia. The cost of extra measures to guarantee safety there would have been neglible compared to the cost of premature closure.

Is Euro Area Money Supply Rising Or Falling?

The latest euro area money supply figures showed that annual growth of the ultra-broad M3 aggregate turned negative in December (-0.2%, from 0.3% in October), causing for example Ambrose Evans-Pritchard to again complain about the "restrictive policies" of the ECB.

Yet the M3 aggregate makes little sense as a money supply measure, at least in Europe, as it includes for example debt securities with a maturity of up to 2 years. Holders of such securities cannot use it as a means of exchange so it is not money. It is true that such securities are liquid assets in the sense that they can relatively easily and quickly be sold for money, but that is true of company stocks as well, and surely stocks shouldn't be regarded as money.

Money supply should only include assets which can be used as a means of exchange, and in Europe M1 is the aggregate that best captures that. M1 includes currency in circulation and "overnight deposits", which includes both what in America would be called "demand deposits" and "savings deposits".

And M1 is growing at a very rapid pace, 12.6%, in the euro area, suggesting that both growth and price inflation is likely to continue to increase.

Protectionist Threat Increases

When I was in Brussells at the European Enterprise Institute in October to present my report on globalization, another participant at the seminar, André Sapir, argued that concerns about increased protectionism presented in my report were overblown, and that not much had really happened in that respect.

In response, I conceded that things could have been worse and that protectionist policies haven't been as far-reaching as in the 1930s, but pointed to several examples of it happening and also argued to pre-empt the emergence of more examples of protectionist policies we need to remind ourselves why such policies are bad.

Now we are seeing the U.S. deciding on higher tariffs on steel pipes and steel grating, further highlighting the very real threat of protectionist policies.

New Commodity Price Highs

Oil- and other commodity prices were at or very near new annual highs today in terms of U.S. dollars (and currencies pegged to the USD) The 4 commodity price indexes followed at Bloomberg are now up between 30 and 60% during 2009. That certainly suggests that inflationary pressures remains significant.

The gains in commodity prices are more moderate in terms of most other currencies (the exception being the yen) during the latest year, yet during the latest month commodity prices have increased even more in terms of other currencies.

The Value Of Fundamental Stock Analysis

Via Mish I see this article by John Hussman about the stock market. After arguing that the [U.S.] stock market is overvalued ,a conclusion I agree with as all long time readers know, he cautions that this doesn't mean that stocks will necessarily fall.

"From current valuations, durable market returns appear very unlikely. As I noted last week, whatever merit there might be in stocks is decidedly speculative. That doesn't mean that the returns must be (or even over the very short term, are likely to be) negative. What it does mean is that whatever returns emerge are unlikely to be durably positive."

Or in other words, what high current valuations means is that future long term return will be low. People who buy stocks and hold them for a long period of time will experience low, non-existent or even negative returns. That however, doesn't necessarily mean that short term return will be low. It could in fact be very high, but that high short term return only means that later return will be even worse.

Fundamental analysis can say that expected return is only 2% (in reality, such precise estimates about the future is not possible, the precision only exists to illustrate the point) per year during the following 10 years or so, but it can't say what return the following year will be. However, if return the following year is
-10%, then expected return will rise above 3% per year. If it on the other hand is over 20% then expected return will fall to approximately zero. If return is over 30% then expected return will be negative.

One example of this was the Japanese stock market in 1988. Any valid fundamental analysis made then would have revealed that the Japanese stock market was very overvalued in 1988, yet return for investors was very high in the year that followed. But that only meant that it became even more overvalued, contributing to the negative returns that stock investors have experienced in the Japanese stock market during the latest two decades.

While fundamental analysis can't say anything certain about future short- to medium-term return, it can help establish probabilities. And the higher expected long term return suggested by fundamental analysis, the higher is the probability of rallys and the lower the probability of sell-offs, and vice versa.

The Failure Of The Left To Understand Double Counting

Say that you received a certain sum like $1000 from some older relative for the specific purpose of buying a new computer. But at the same time you really want to go away on a trip. Common sense would tell you that you can't use that $1000 for both a computer and a trip (assuming that both cost exactly $1000 each).

But the Democrats in America has invented a new form of accounting that would enable you to do so. The trick is to establish two separate accounts. First you have a computer account which you put the $1000 in, so that you can meet the payment a year or so from now. Then you have a "unified" account which also receives that $1000 and which immediately spends it.

Most of you would recognice that the $1000 has been double counted to pay for both bills even though it can only pay for one of them.

But the Democrats would then respond that the unified account abides by cash payment accounting, and so it can spend that money now, and this has nothing to do with the fact that the money is really reserved for the computer account. But in reality you can't use the same money for two purposes, so even though one can say that the unified account now borrows from the future account, this only means that the unified account will have to borrow from others to pay back to the computer account later, and that the trip will create a need to borrow in the future from others, something which according to proper accounting principles should be attributed to the present time since this is when the cost occurs.

Substitute "Medicare" for "computer" and you have the fallacy of the Democrat's fraudulent double accounting in their health care bill clarified. Yes there are savings in Medicare and tax increases, but those savings and tax increases can't be used both to cover projected Medicare deficits between 2017 and 2026 and to pay for health insurance subsidies now. That Dean Baker and the New York Times fails to understand this is just embarrasing to them.

Does Sustainable Growth Depend On A Low Savings Rate?

Marketwatch published a really strange column by Jeffrey Korzenik. He claims that a sustainable recovery depends on a relatively high level of female participation in the work force. Not because the labor supply is needed (which perhaps would be a more valid argument), but because it lowers savings and because lower savings is supposed to be essential for a sustainable recovery.

The argument is that given a certain level of labor supply, a more even distribution of work outside the home between the sexes will lower savings. The reason for this is that in one income households, the probability is higher that the income will go lost because of unemployment than in two income households. This means that one income households will have stronger reasons to save for "rainy days" than two income households.

This argument is more or less true, though the effect is probably not as big as he thinks because two income families have a higher probability of losing half of their paychecks. Other factors, mainly Fed monetary policy play a greater role in lowering the savings rate.

His second argument is however completely false. A sustainable recovery does not depend on lower savings. Quite to the contrary, a sustainable recovery requires higher savings. Higher savings would enable higher investments (or a lower trade deficit), something which would help expand productive capacity and increase long term growth.

If lower savings had really been beneficial, we would have seen weak growth in China and a big increase in U.S. growth from the 1960s to the 2000s. In reality, China's economy is booming while growth slowed sharply in the U.S. from the 1960s to the 2000s.

Fourth Israeli Rate Hike

Bank of Israel raised short term rates for the fourth time, making it the biggest interest rate increaser since the beginning of the financial crisis.

More hikes are likely since inflation is above target while economic growth is relatively high and since interest rates are still relatively low (1.25%).

Lost Decade For Stocks & The U.S. Economy

Jim Hamilton points out that the latest decade was a lost decade for stocks. Nominal stock prices are actually lower than a decade ago. And although that was partly compensated for by dividends, inflation took away even more.

One reason for this dismal performance was weak earnings-the other that valuations have gone down. The relative role of the two factor depends on whether you look at 1 year earnings or 10-year earnings. With 1 year earnings the key factor was falling earnings. If you instead use 10-year earnings the keý factor was falling valuations.

However, that certainly doesn't mean stocks are cheap as the 10-year P/E ratio is significantly above the historical average. Instead this reflects the extreme overvaluation we saw at the peak of the tech stock bubble.

The 00's was a lost decade not just for stocks but also for the overall economy. GDP growth was for example the weakest since the 1930s.

Here are terms of trade adjusted growth for different decades (Q4 to Q4, 2.8% annualized growth assumed for Q4 2009, compared to Q3 2009)
1950s 4.2%
1960s 4.4%
1970s 2.9%
1980s 3.1%
1990s 3.3%
2000s 1.6%

The 00's thus had far lower growth than the 70s, 80s and 90s, not to mention the 50s and 60s. Terms of trade adjustment made little difference, except for the 1970s, where it reduced growth by 0.3%: points.

If you take into account that population grew by about 1% per year, this means that real income growth was very weak.

Because employment rose only 3% even as the population grew by more than 10%, the employment to population fell from 64.4% to 58.5%, reflecting both a drop in the participation rate and an increase in the unemployment rate from about 4% to about 10%.

Lower economic growth means that the potential for earnings growth will be limited as profits cannot in the long run grow faster than the overall economy. The lower rate of growth would imply that the P/E ratio should in fact be even lower than in the past, making stocks look even more overvalued. On the other hand, lower interest rates justifies higher valuations. These two factors should more or less cancel each other out, so the historical average is a good gauge of whether or not stocks are overvalued, and right now that indicator suggests that stocks are overvalued.

U.K. Price Inflation To Increase Above 3%

U.K. inflation has for the last few years been significantly above the euro area average. In the last two years between November 2007 and November 2009 consumer prices rose a cumulative 6.1% in the U.K. (4.1% in 2008, 1.9% in 2009), versus 2.6% (2.1% in 2008, 0.5% in 2009) in the euro area.

The main reason for this is the weak pound of course. On the other hand, the temporary VAT cut enacted this year helped reduce the gap. Not by as much as 2.1% (2.5/117.5), because first of all this rate doesn't apply to food and many other goods and services and secondly because some producers, wholesalers and retailers used part of the cut to boost their margins rather than to cut prices. Even so, it probably lowered inflation by perhaps 0.5% to 1%.

Now that the VAT cut is reversed, this will help increase the inflation rate by a similar amount. Together with rising commodity prices, this could increase the inflation rate from the current 1.9% to above 3%. At that point, Mervyn King will be forced to write a letter of explanation to Alistair Darling, the Chancellor of the Exchequor. No doubt that explanation will mention the VAT factor and rising commodity prices, but that leaves the question of why inflation didn't fall more in early 2009 despite the fact that the VAT and commodity price factors had the opposite effect then.

The reversal of the cuts will also weaken economic growth. To the extent prices are increased this will of course reduce purchasing power and it will also reduce real output to the extent margins are again reduced as lower margins will make it less profitable to expand operations and hire workers and more profitable to cut back on operations. In some weak businesses, it will cause the entire company to fail.

The effects of the reversal of the VAT cut will thus be stagflationary. For economic growth however, other trends will counteract the negative effect, whereas for inflation other factors will enhance it.

The Misleading Numbers Of U.S. Health Care Reform

The U.S. Senate passed its version of health care reform today as reluctant centrist Democrats were either bought of (Senators Nelson and Landrieu) or were able to get some aspects they didn't like removed (such as Senator Lieberman with the public option). The problem is that the House, where bills can pass with a simple majority instead of the 60% supermajority required in the Senate, passed a bill with a public option and without the payoffs to Nelson and Landrieu. The most likely outcome is that House Democrats will reluctantly agree to these changes.

Supporters of the reform argues that it will really not cost that much. Yet these numbers are misleading for two reasons:

First, as Ann Coulter and Jay Cost points out, the 10-year number is misleading because taxes will be collected during 10 years while benefits will be paid out only during the latest 6 years. But during later decades taxes and benefits will both be collected all years, meaning that the costs will be much greater.

And secondly, Democrats double-count some tax hikes and budget cuts, causing the negative effect on the deficit to be underestimated, as James Pethokoukis points out.

Will Cash Soon Be Regarded As A Barbarous Relic?

Edmund Conway argues for the abolition of physical cash-notes and coins.

Doing so would indeed have its advantages-including making traditional robberies for money impossible, and it would save us the cost of making physical cash.

Yet for those of us skeptical of unlimited government power there are reasons to oppose the abolition of cash.

First of all, it would further increase the ability of the central bank to manipulate the economy as the zero bound barrier would disappear and central banks could impose negative real interest rates. Conway the Keynesian of course thinks this is an advantage and the use of quantitative easing is reducing the advantage or disadvantage associated with it, but it remains a factor and if you realize the role of central banks in creating the problems they claim to fight, this is a reason to oppose it.

Secondly, it would further increase the dependence on banks, which in turn will increase the demand for government support and regulation of. Conway argues that we are already well advanced on that path, which is true but from that it doesn't follow that we should go furter.

Thirdly, it would remove the possibility of protecting the privacy of your transactions, and move us further towards an "1984"-style control society. Conway mentions this objection, but claims that cryptographic techniques can be invented to make protect people's privacy. I'm not an expert on this field and so it may be possible, but I doubt it.

Conway contradicts himself by saying that this would stop "black market" activities and so prevent people from evading taxes. But if these great cryptographic techniques exists how can "black market" activities be prevented?

And the elimination of "black market" activities might not be a good thing even for tax payers, as the elimination of the treat that tax increases could increase "black market" activities could encourage politicians to raise taxes even more. At the same time, many useful activities which can't be performed in the official economy because of high tax rates won't be done at all if they can't be performed in the "black market".

Cash, in short, fills the same function as gold once did in limiting government power (though not nowhere near as well as gold did). But for government officials and supporters of more government power, that is likely just another reason to abolish cash, which is why more and more of them are likely to argue for it in the future. Just like gold is will therefore soon be dismissed as a "barbarous relic" by statists.

Why Christmas Is Efficient

Christmas is beginning and so I was going to write a post about why Christmas, contrary to the assertions of many "dismal scientists" (a really appropriate term given the view displayed) is not inefficient, but then I remembered that Jeffrey Tucker wrote a good column several years ago, making almost all the points I would have made, so I'll link to that instead.

One point he left out was that Christmas gifts sometimes in fact consists of money, usually when someone wants to show appreciation yet have little or no idea of what the recipient would appreciate.

And incidentally, Christmas gifts in the form of donations (click on the "donate"-button in the right side bar) to show appreciation of (and therefore promote) this blog's activities are certainly welcomed. Donations of all sizes and at all times are certainly appreciated, but larger donations are especially appreciated and the Christmas season is an especially appropriate time to display appreciation.

Most Commodity Prices Reaches New Highs

While gold is way below the $1,200, other commodities are at or close to the highs reached earlier this year even in terms of U.S. dollars. Cocoa is one example of this and the overall CRB index (which includes gold) is just 2% below its high. And with the dollar up more than 4% against the euro and most other currencies, this means that overall commodity prices are at their highest level this year in terms of most currencies, reflecting strong global demand.

Explaining The Seemingly Puzzling Market Patterns

Apparent puzzle Nr.1 : U.S. Treasury yields are rising-yet the U.S. dollar is rallying. If there was an increase in demand for U.S. assets you'd expect yields to fall-and if there was a decrease in demand you'd expect the dollar to fall.

Apparent puzzle Nr. 2: Gold has been dropping in value suggesting decreased fear of inflation-yet the yield spreads between regular Treasury securities and inflation protected securities (TIPS) have increased (And since I wrote about it last week, the spreads have increased further), suggesting increased fear of inflation.

Some, like Robert Wenzel, have tried to explain the first apparent puzzle, as well as the drop in gold, with tight monetary conditions. But that is not consistent with a rallying stock market and the drop in real Treasury yields (as measured by TIPS). So while this factor is probably behind a limited part of market movements, it is not sufficient to explain the all the current market movements.

Is there an explanation that is consistent with all of the facts? Yes, there is, namely that market expectations of a stronger economy and higher inflation have increased, something which also increases expectations of the Fed tightening monetary policy.
Expectations of a stronger economy would explain why the stock market is rallying even while bond yields are rising. Higher yields also mean that demand for dollars are rising, causing its exchange rate to appreciate. And while higher expected future inflation is positive for gold, higher interest rates is negative for gold as the opportunity cost of holding gold rises. Furthermore, a stronger dollar is bearish for the U.S. dollar price of gold.

Note of course that expectations of a stronger economy and higher inflation doesn't necessarily mean that it is certain or even likely to happen (And I for one remain skeptical to say the least about the robustness and sustainability of the recovery), anymore than expectations of constant annual double digit increases in house prices a few years ago or the expectations a decade ago that most tech companies will grow as big as Microsoft turned out to be true. However, the thing that matters for current market movements isn't whether or not these expectations are rational or realistic, but on whether market participants act on them. And they are acting on them.

Encouraging Labor Mobility

The Irish have found a way to encourage international labor mobility: reduce unemployment benefits as part of their fiscal austerity plan.

"Yet some have criticized the government for what they view as a thinly veiled message encouraging members of a new generation of Irish to set forth overseas to find their fortune, as many of their parents, grandparents and great-grandparents did. The new cuts specifically target Irish 20-somethings who cannot find work, reducing their unemployment benefits, in some cases, by as much as 30 percent.

Analysts say thousands of young Irish have left for Britain, North America and Australia in recent months, with thousands more expected to emigrate next year.

"I feel like the government is telling us that Ireland can't support us anymore and we should take our chances elsewhere," said Shaun Kavanaugh, 25, an unemployed electrician. "I'm taking the hint. As soon as I save up enough money for my flight to Canada, I will be on that plane. I thought those days were over in Ireland."
"

But there is hardly anything wrong about people moving to where the jobs are. Quite to the contrary as it means lower global unemployment and increase global output. And reduced unemployment benefits won't just promote international but also intranational and intersector labor mobility.

America by going the other way is by contrast increasing unemployment.

Leftist Academic Bias

Kevin Hassett tells of how professors at universities have a bias to the left. That will surprise few of you and it sure didn't surprise me, but what did surprise me was that the leftist bias was in fact even stronger among natural scientists than social scientists.

While a majority of academic economists could be described as "left of center", leftist tendencies are probably less pronounced than in for example sociology and most other social scientists.

The fact that the leftist bias is greater in natural sciences than in social sciences have particular significance in the climate debate. In most natural sciences, theories have little or no political implications, meaning that there is little reason to believe that political preferences could distort results. However, with regard to climate science, the results have political implications, meaning there is a reason to believe that scientists could manipulate results for political reasons.

And "Climategate" does prove that some manipulation does exist. Just how widespread it is among other climate scientists is less certain, and it is unlikely that all deliberately distort results, but it would be naive to think that it is completely non-existent among those not specifically implicated by "Climategate".

The Glass-Steagal Myth

William Rees Mogg again repeats the myth that the repeal of Glass-Steagal act (which outlawed companies from being involved in both commercial banking and investment banking) caused the crisis. This is wrong for two reasons:

First, there is no evidence that the few combined commercial- and investment banks (so-called "Universal banks") that were created after the repeal were more heavily involved in the credit boom than others. Indeed, the companies most involved include mortgage companies Fannie Mae and Freddie Mac, insurance company AIG and pure investment banks Bear Stearns, Lehman Brothers and Merrill Lynch, none of whom were affected by the repeal of Glass-Steagall.

Rees-Mogg's only real argument was that if Glass-Steagall had been in place then "It would not have been legal for US commercial banks to buy for their own account the “collateralised debt obligations” or the “credit default swaps”, which led to such large losses".

True, but as the examples I gave illustrates it would have been entirely legal for others to do so. And that would have included the investment banking sections in the few universal banks that existed, only then they would have done it in the independent investment banks that would have existed instead of the investment banking units of the universal banks.

And secondly, and perhaps even more fundamentally, the key cause of the crisis was the monetary policy doctrine of the Fed. Even if we assume for the sake of the argument (and that assumption is for aforementioned reasons not valid) that the repeal of Glass-Steagal did increase credit given a certain monetary policy, the basic doctrine of the Fed was to achieve a certain credit expansion. If other factors had inhibited credit expansion, then the Fed would have lowered interest rates even more and once the zero barrier was reached they would have engaged in various forms of quantitative easing until credit expansion reached the same level as it actually did.

The focus on Glass-Steagal and other forms of regulation is really just a red herring that diverts attention from the key problem of the monetary policy doctrine advocated and implemented by Alan Greenspan and Ben Bernanke. Only monetary reform, not "financial [regulation] reform" can prevent similar problems in the future.

More Expensive Chocolate

Well, maybe not for this Christmas season, but it will likely become more expensive soon, as the price of the key ingredient of cocoa rises to new highs, mainly due to production problems in Africa. Dark chocolate will be more affected than milk chocolate as it contains more cocoa.

Politics & Bribery

Mark Steyn describes the difference between bribing a politician and political deal making:

"You can't even dignify this squalid racket as bribery: If I try to buy a cop, I have to use my own money. But, when Harry Reid buys a senator, he uses my money, too. It doesn't "border on immoral": it drives straight through the frontier post and heads for the dark heartland of immoral."

Cold Weather Cooling U.S. , European Economies

Cold & Snow during the climate summit in Copenhagen didn't discourage the climate crusaders from preaching the virtues of cold temperatures, so the latest rounds of blizzards in both Europe and North America will likely not discourage them either.

But could it discourage economic activity? It certainly will. When snow and cold gets as bad as now, not only shopping but almost all economic activities performed outdoors or requiring travel will be disrupted. If (as seems likely) the snowing ends before Christmas Eve and if snow removers do their job, the damage to retailers will be limited, but not eliminated. And for many other economic activities, the disruption will not be recouped. So while utilities and snow removers may boom, the overall economy will suffer because of the unusually cold and snowy weather. It remains to be seen however just how big and lasting this negative effect will be.

Ricardian Equivalence Anyone?

Ron Lieber at the New York Times notes that the household savings rate in America have risen in the recent year and tries to explain it.

Yet he strangely fails to note one of the more obvious explanations: household income have been boosted greatly by falling tax revenues and higher government spending. This have both increased the ability and the willingness of households to save.

The increased willingness to save reflects the so-called Ricardian equivalence. Because deficits today likely mean future fiscal austerity, higher deficits will make it rational for households to save some of the money they receive from (or don't have to send to) the government.

Because of short-sightedness, borrowing restraints, belief that government debt will increase permanently and other factors, Ricardian equivalence is unlikely to hold true fully in the sense that the increase in household savings will be exactly as large as the increase in government borrowing. However, it is likely to be partially true in the sense that household savings will increase, even if not fully as much as government borrowing.

The data does indeed suggest that the increase in government borrowing has increased household savings, but not fully as much as the increase in government borrowing.

Between the third quarter of 2008 and the third quarter of 2009, household savings increased from $235.7 billion to $489.9 billion, while government savings fell from -$724.8 billion to -$1359.8 billion. Net national savings meanwhile fell from -$15.8 billion to -$369.2 billion*. Or in other words, about 40% of the increase in government dissaving was compensated by a higher household savings rate.

Because other factors affect household savings the extent to which the increase in government dissaving caused household savings to increase may not be exactly 40%. Because the drop in asset prices can be expected to increase savings, the causal effect is probably somewhat lower, but probably still very significant.

*= All numbers are at an annualized rate. Note that government dissavings are not exactly equal to government borrowing because of government investment and capital consumption.

Why Wage Cuts Will Increase Employment

A basic truth of economics is that whenever supply exceeds demand, a lower price will reduce that excess and increase the number of actual transactions. On this issue, no disagreement exists between Austrians and neoclassicals.

Yet a surprising number of leading leftist economists deny this fundamental truth in the case of the labor market. Debating this issue with Tyler Cowen and Bryan Caplan, particularly Paul Krugman and Rajiv Sethi tries to deny this. Needless to say, I agree with the Cowen-Caplan view and not the Krugman-Sethi. That a lower price will increase demand is so self-evident at least under normal circumstances that I won't bother to elaborate upon it. So I will instead directly adress Krugman's and Sethi's argument for why it does not apply under the current circumstances. I'll start with Krugman. Here are his first argument:

"Here’s how the fallacy works: if some subset of the work force accepts lower wages, it can gain jobs. If workers in the widget industry take a pay cut, this will lead to lower prices of widgets relative to other things, so people will buy more widgets, hence more employment.

But if everyone takes a pay cut, that logic no longer applies. The only way a general cut in wages can increase employment is if it leads people to buy more across the board. And why should it do that?"

First of all, there is no need to assume that all wages will be cut. Some sectors suffer from higher unemployment than others so wages will likely be lowered there more than others, causing a relative shift of employment from sectors with a relative shortage of labor to those with a relatively high unemployment rate.

Secondly, even if all wages were cut by an equal amount there are good reasons to assume it would increase the demand for labor (at least given the currently high level of unemployment). The reason for that is that while wage cuts would create a negative income effect for workers who would have been employed anyway, it would create a positive income effect for their employers (the capitalists) Assuming employment won't be affected, wage bargaining is a zero sum game between employers and employees.

And since income in other countries won't be affected, lower wages would through the substitution effect increase demand for American labor by foreigners (or in other words increase net exports). And that same substitution effect would increase demand for products made by American workers by American capitalists.

And given the above factors, there are good reasons that aggregate income would rise as the losses of workers who would have been employed anyway is more than compensated by the gains of the capitalists and the workers who are employed because of the substitution effect.

Contrary to Krugman there is thus no need to assume that real interest rates would be lowered to realize that lower wages would increase employment.

As for Krugman's bisarre arguments in later posts that nominal wage cuts can't cut the real wage, it overlooks of course that the cost of products consists of more than just labor costs, and that demand for products doesn't just come from domestic workers, but also capitalists and foreigners.

Turning now to Rajiv Sethi, he quotes Bryan Caplan's post which makes similar arguments about the substitution effect and employer's income and then responds with these arguments:

"Let's take this step by step. First, consider the claim that cutting wages increases the quantity of labor demanded. Through what mechanism does this occur? Consider a firm (McDonald's, say) that can now pay its workers less. It will certainly do so. But will it increase the size of its workforce? Not unless it can sell more burgers and fries. Otherwise its newly expanded workforce will produce a surplus of happy meals that will (unhappily) remain unsold. And this will not only waste the expense of hiring and training new workers, it will also waste significant quantities of meat, potatoes and cooking oil. So the firm will make do with its existing workforce until it sees an uptick in demand. And no cut in the minimum wage will automatically provide such an increase in demand. As a result, the immediate effect of a cut in the minimum wage will be a decline in total labor income."

This of course ignores that a lower cost of labor will likely induce McDonald's to lower its price of happy meals and other items as the semi-fixed cost that labor costs constitute declines, something which given the above mentioned fact that wage negotiations are a zero sum games between employers and employees and will thus not affect demand, will increase demand for labor.

After having assumed that employer's income would not rise in his analysis of the substitution effect, Sethi misleadingly jumps to an analysis of the income effect where the substitution effect is completely ignored

"Employer income, of course, will rise. Some of this will be spent on consumption, but less than would have been spent if the same income had been received by low wage earners. The net effect here is lower aggregate demand. But wait, what will happen to the remainder of the increase in employer income? It will not be placed under mattresses, on this point I agree with Caplan. It will be used to accumulate assets. If these are bonds, then long rates will decline, and this might induce increases in private investment. Then again, it might not, unless firms believe that additions to productive capacity will be utilized. And right now they do not: private investment is not being held down by high rates of interest on long-term debt.

Finally, what if employers use the unspent portion of their augmented income to buy shares? We would have a run up in stock prices not unlike that we have seen in recent months. Note that this would not be a speculative bubble: the higher prices would be warranted given that firms have lower labor costs. But would this asset price appreciation stimulate private investment in capital goods? Again, not unless the additional capacity is expected to be utilized."

First of all, his assertion that lower long-term interest rates won't affect investment demand is an assertion completely without any empirical or theoretical assertion. He simply asserts it. If long-term rates had been zero, he would have been able to point to the zero bound barrier, but since long-term rates are way above that, this defense won't hold

And secondly, because the increase in employer's income will come through higher margins, this will induce employers to hire more, and invest more in capital goods.

Moreover, the "wealth effect" of higher stock prices would increase aggregate demand further.

About The People Who Wants To Manage Hundreds Of Billions Of Dollar

Via Mark Steyn at the NRO Corner blog I see a story about how hundreds and often thousands of accredited delegates are left in freezing temperatures outside the conference hall about "global warming" in Copenhagen-a result of the organizers in the UN invited 45,000 people to a conference hall meant for only 15,000 people. When some started to distribute food to the people left outside, one man responded by screaming "I don't need food. I need socks! I'm freezing my ass off out here."

Aside from the obvious irony in delegates complaining about "freezing their asses off" while waiting to participate in a conference dedicated to prevent temperatures from rising, this makes the planned wealth transfer from developed countries looks even more questionable. The people who will organize this wealth transfer is the very same people who didn't even realize that inviting 45,000 people to a conference hall meant for only 15,000 people would cause problems. That is hardly the kind of people most of us would want to trust with hundreds of billions of dollars.

Yuan Rises Above 10 Euro Cents Again

The recent "mini-rally" in the U.S. dollar also means that the yuan is rallying against other currencies. It rose above the key 10 euro cent level against the euro (which in inverted terms means that the euro fell below 10 yuan) on Tuesday and with the euro dropping to $1.44 and with the dollar/yuan exchange rate fixed at 6.83, this means that it now costs only 9.84 yuans to buy a euro, down from a high of 10.32 just two weeks ago.

While the yuan is still weaker against the euro than it was early this year, it is a lot stronger than it was in the spring of 2008. And with the dollar rally likely to continue the yuan will rally further against the euro and other currencies.

As this illustrates that the peg isn't necessarily associated with a weaker currency, this will as I wrote last week decrease pressure to end the peg.

Inflationary Expectations Rising

The yields on Treasuries have again started to increase. But that reflects a big increase in inflationary expectations, not rising real yields.

Though real yields both for 5- and 10-year notes temporarily dipped to even lower levels in late November, they have generally been a lot higher than they are now.

For example, the yield on 5-year inflation protected securities was 1.5% in early March while the yield was still more than 1% as early as in the beginning of Septemer. For 10-year securities, the real yield was more than 2% in early March and 1.7% in early September.

Now, however, the real 5-year yield has plummeted to as low as 0.28%, while the real 10-year yield has dropped to 1.28% (as of this writing, when you read this the numbers may have changed up or down by a few basis points).

Yet, nominal yields have generally not changed in the same direction. The 5-year yield rose from slightly less than 2% in early March to about 2.3% to 2.4%, a level at which it remains now. The 10-year yield rose from less than 3% in early March to nearly 3.5% in early September. Since then, the 10-year yield has risen slightly to about 3.6%.

The upshot of these differentials is that implicit inflationary expectations have risen from less than 1% in early March to 1.3% to 1.4% in early September to more than 2% now for 5-year securities, while implicit inflationary expectations have risen from less than 1% in early March to about 1.7% in early September to about 2.3% now.

It is possible and even likely that part of these changes in yield differentials have been driven by changes in liquidity preferences. Inflation-protected securities are not as liquid as nominal securities, so these movements likely reflect in part changes in liquidity preferences. But while liquidity preference probably was a factor, it was likely not the only one or even the most important one. Clearly, investor’s inflationary expectations are rising right now.

Since investors aren't infallible that of course doesn't mean that inflation will necessarily rise. The recent stagnant money supply developments makes a significant increase in inflation beyond what we've already seen (and are likely to see in the December numbers) unlikely. But increasing inflationary expectations is something which will increase demands of higher prices, interest rates and wages and so have a stagflationary effect on the economy.

Annual Inflation Returns In U.S. & Euro Area

Both the U.S. and the Euro area reported inflation numbers for November, and as expected, both saw a return in annual price inflation.

In the U.S. the annual rate of price inflation rose from -0.2% to 1.8%. This was mainly a base effect, as the dramatic price drop in November 2008 was removed from the comparison, but prices rose 0.4% compared to the previous month. As in previous months, the increase would have been much higher if rents and "owner's equivalent rent" hadn't dropped.

Because of base effects, the annual rate of inflation will increase further in December, but it will likely stabilize or even drop in January because of the recent "mini-rally" in the dollar and the drop in the price of oil this has caused.

The increase in the Euro area was much smaller, from -0.1% to 0.5%, thanks to the elevated exchange rate of the euro versus the dollar in November and a much smaller base effect.

The inflation rate will increase further in December, and because of the recent drop in the euro, the likelihood of further increases in January is higher than in the U.S.

The so-called "core rate" actually fell back in November, from 1.2% to 1%, but that number has always been a lagging indicator.

3 Euro area countries, Ireland (-2.8%), Portugal (-0.8%) and Malta (-0.1%) still had annual price deflation, as did 2 countries with fixed exchange rates to the euro, Estonia (-2.1%) and Latvia (-1.4%). In particularly Latvia but also Estonia (And Lithuania which had 1.3% inflation) the rate of inflation will likely continue to decline (or more accurately, the rate of deflation will increase) as part of their adjustment from the excesses of the bubble years.

Can Reduced Carbon Emissions Boost The Economy?

While most advocates of government intervention to lower carbon emissions concede that it will be associated with an economic cost (though they argue that these costs are lower than the cost of "climate change"), a minority (particularly vocal here in Sweden(note Swedish language link)) argues that even aside from the alleged benefits on the climate from reduced emissions, carbon emission cuts will benefit the economy. These "green technologies" will supposedly create jobs and enhance efficiency.

Yet if that was really true, why would these new technologies require government intervention in the form of carbon taxes, subsidies, ban on light bulbs etc.? If they are so profitable then entrepreneurs would invest in them anyway.

Now many will think that this argument assumes that markets are perfect. The failure to bring the benefits of these technologies represents a market failure which government intervention must stop.

Well, markets may not be perfect for various reasons, but unless you have specific reasons for believing they will fail in a particular case, then the above framework is still useful.

If you assume that carbon emissions are harmful to the climate and that this creates costs, then it is easy to see why a "market failure" would appear in this case. But since the argument was that even apart from that, carbon emission cuts are beneficial; it really doesn't count in this context.

Going through the possible causes of market failure reveals no possible source of market failure.

No evidence exists that green investments will create any more positive externalities than other investments or reduce other negative externalities (the exception being emissions which are actually harmful to people's health, but most forms of carbon emissions aren't.)

Some would argue that one potential positive externality would be if workers in industries that benefit from carbon emission reduction policies had higher pay than those in industries that suffer from it. Yet as no statistics (as far as I know) is available for "green" industries, no evidence exists for it. And given how workers in the industry most obviously hurt by a policy to reduce carbon emissions, the oil and gas industry, earn a lot more than average, it is unlikely to be true if anyone had actually compiled such statistics.

And furthermore, even if it had been shown that "green workers" earned more it wouldn't necessarily prove that it is beneficial to the economy as high paying jobs usually are associated with higher capital investments and/or higher education spending, that crowds out other investment spending.

Nor does any evidence exist that entrepreneurs have foolishly underestimated the profitably of green investments. In fact, despite various forms of subsidies green technology in the car industry have been less profitable than other technologies, and the same is generally true for other industries. Only when subsidies are really high is it profitable, but since the subsidies represents a loss for the rest of society, that obviously doesn't count.

What we do know however is that a policy designed to reduce carbon emissions will make energy more expensive, something which will make it more expensive to trade and operate businesses and increase the cost of living, all of which is associated with a lower standard of living.

But won't the new "green industries" create job? Well, yes, in the same sense that a ban on all cars and reversal to horse and cartridge transports would create jobs, or in the sense that a ban on tractors in favor of spades in construction work would create jobs. But those new jobs would come at the expense of other jobs-and would be far less productive.

Bankers Should Be Blamed-Both If the Make Risky Loans And If They Don't

I noted before that leftist analysis of the economy is very contradictory. They first of all claim that the financial crisis simply is the results of banks making too many risky loans-and that we need radical reform to prevent banks from again making risky loans. But at the same time they also attack bankers for abstaining from lending because new loans are perceived as too risky.

Now Obama is at this again. He first says that bankers caused the crisis by making risky loans-and that now they should approve more loans "to help the recovery" (which even if Obama tries to deny it can only mean loans for borrowers more risky than those who now get loans) because they previously caused a crisis by approving loans for risky borrowers......

Try to figure out the logic in that...

I can't see any "logic" except to blame bankers regardless of what they do and absolve government of any guilt regardless of what it do.

The New Socialism

Charles Krauthammer has a good column where he shows how the "climate change" movement or whatever you want to call it is the new socialism (something which Czech President Vaclav Klaus has long argued).

Socialists have long wanted to impose extra taxes, control the economy and redistribute wealth to the third world on the basis of alleged wrongs done to the third worlds by industrialized nations. The "climate change" movement offers them all of this.

This explains why leftists almost universally have signed up to it.

UPDATE: One reader argues that a key difference between classical socialism and the new enviro-socialism is that classical socialism at least claimed to want to improve people's life, while the new enviro-socialism demands that people lower their standard of living. That is true for many or even most enviro-socialists, but quite a few of them is in fact arguing (especially here in Sweden) that the new "carbon free" energy will ultimately deliver higher productivity.

Update II: Another reader gives the following sarcastic review of enviro-socialism:

The enviro-socialists are effecting a Kuhnian paradigm shift in the socialist model. This revolution in socialist science derives from their discovery of an essential aspect of socialism that Marx and his intellectual heir could not have known until recently.

Marx thought that communism would bring about universal material prosperity, but a century of experience demonstrates that socialism results in widespread material poverty. In the mid-20th century, the Frankfurt School explained the failure of the proletariat to embrace Marxism due to a “false consciousness” brought about largely by the material success it enjoys under capitalism. However, this explanation hardly inspired the workers to throw off their chains.

The contribution of the enviro-socialists is that they discovered that widespread poverty isn’t a bug in socialism; it’s a feature.

Let's Settle For "Not Being Bubble Creator"

James Hamilton asks "Should the Fed be the nation's bubble fighter". I for one would be quite content with the Fed abstaining from creating its own bubbles, by pushing interest rates too low for too long.

As for the analysis by James MacGee quoted, see my analysis of it here, in case you haven't read it already or do not remember what I wrote there.

Fixed Exchange Rates Are Fixed

I usually read the weekly "Credit Bubble Bulletin" at the Prudent Bear website, as it gives a good summary of the week's economic news. One somewhat puzzling aspect of it is however the summary of exchange rate movements, which reports on both the movements of the euro and of the Danish krone.

As it happens, the movements are always the same. This week, both fell 1.6% against the U.S. dollar, last week both declined 0.9% and the week before that both rose 0.7%.

This extremely high correlation is no coincidence as Denmark has pegged its currency to the euro. Though the krone is formally allowed to fluctuate up to 2% up or down against the euro, in practice it almost never move by even tenths of a percentage point.

Thus reporting separately on how the Danish krone moves is really unnecessary, just as it is unnecessary to report on the movements of the Hong Kong dollar versus the U.S. dollar, which is always zero or very close to zero. Despite this, Bloomberg news strangely feels that these nonexistent exchange rate movements between the dollars of America and Hong Kong should be one of the four exchange rates (the others being the USD exchange rate of the yen, the Singapore dollar and the Australian dollar) in the Asia Pacific regions which they display in their Asia Pacific edition. It would be more interesting to see the movements of for example the [South] Korean won or the Indian rupee.

External Pressure On Yuan Peg Will Likely Ease

Tensions over China’s U.S. dollar peg have risen recently because of the strong growth rate in China and because of the dollar's decline against other currencies (which have caused the yuan to decline against these currencies by a similar amount).

However, because of two factors, external pressure could ease. First of all, trade data shows that the Chinese trade surplus is already dropping as Chinese exports dropped 1.2% while imports rose 26.7%.

And secondly, the dollar bear market seems to have ended. If, as seems likely, the dollar starts to appreciate in value this will also cause the yuan to appreciate.

On the other hand, internal pressure for yuan appreciation or some other form of monetary policy tightening is growing given the abnormally high money supply growth and the increase in output growth and inflation this have generated. Combined with measures to deter "hot money" inflows from taking advantage of yuan appreciation that would be the most effective way of reining in the expansion of the central bank balance sheet and money supply that we are now seeing. Higher reserve requirements could however also be implemented.

News In Brief

-Australia saw employment rise again, by 31,200 (equivalent to about 450,000 in America). This increases the likelihood that the Reserve Bank of Australia will again raise interest rates at their next meeting.

-Rising stock and real estate prices causes the aggregate net worth of Americans to rise for a second quarter during Q3 2009. However, downward revisions of previous numbers means that reported Q3 2009 net worth was only slightly above initially reported Q2 2009 net worth.

-In this New York Times article, it is noted that in terms of volume of key consumer goods like cars and refrigerators, China has already taken over America (though at a per capita level, America is still of course way ahead). The article does rightly note that the current boom in China is however partially based on an unsustainable credit boom, which makes a cyclical setback in the near future likely.

The other caveat that the authors make is however less legitimate, as they note that while the number of cars and other consumer durables sold in China is higher than in America, the dollar value is lower. While it is possible that this could to some extent reflect differences in quality, a more likely explanation is that the general price level in China is lower. China is after all widely criticized for having an undervalued currency.

-Paul Krugman compares the followers of the Austrian School to the followers of infamously deranged sectarian Lyndon LaRouche (his theories are best summarized by Homer Simpson in the "Citizen Kang" segment of the Simpsons episode "Treehouse of horror VII": "aliens, bio-duplication, nude conspiracies. Oh my god, Lyndon LaRouche was right!"), and implies that he prefers the LaRoucheans to Austrians. He has however not answered the critique against his criticism of the Austrian school that I and others have raised.

-Latvia, Lithuania and Estonia all saw their goods trade deficits drop dramatically compared to the previous year. Combined with rising surpluses in service trade and investment income, this has caused their current account balances to go from large deficits to large surpluses. The Baltic States have thus clearly achieved the desirable correction of their imbalances-though at the painful price of significant drops in output and increases in unemployment.

And finally, another thanks to those who have contributed and a reminder to those who still haven't contributed.

Supporting This Blog

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So, to enable this blog to continue at the current rate of activity or to expand, readers really need to start donating. I am letting future activity depend on this. No donations means no blog. Few and/or little donations means little activity.Many and/or large donations means unchanged or more activity. The future of the blog is in your hands.

Donate according to how much value this blog gives you and your ability to donate. So, press the "donate"-button in the right side bar, and donate now (or as soon as possible)!

Credit Booms Causes Financial Crises

Interesting article by Moritz Shularick and Alan Taylor that concludes that financial crises usually aren't the result of endogenous shocks, but of previous booms. They also note that after World War II, central banks have largely prevented deleveraging after booms, but that these policies haven’t led to less severe slumps. And they even acknowledge that central banks may have had a role in fueling booms.

The only serious flaw with the article is that the authors use only Human Minsky's theories to explain these facts, despite the fact that those theories are only consistent with some of the above mentioned conclusions, whereas Austrian business cycle theory is consistent with all.

Monetary Time Lag & Money Demand

I recently discussed the issue of a monetary time lag and why it exists. Anyone observing data on money supply and prices can see that the immediate empirical link between money supply changes and price changes at a certain point in time is weak to non-existent. That leaves us with two options: either the causal link doesn't exist or it exists with a time lag. As I and my good friend Daniel Halvarsson documented here and here, an empirical link seems to exist, but with a significant time lag of 1 to 2 years.

But why doesn't money supply immediately affect prices? Why does it take as long as 1 to 2 years?

Well, one reason is that many prices are relatively sticky in the short-term. Most retailers are for good reasons reluctant to change their prices up and down on a daily or even weekly or monthly basis because they know customers will resent price increases and because contracts with suppliers usually lasts for several months. Furthermore frequent price changes will create menu costs for businesses.

Another, more overlooked but arguably even more important factor is the role of fluctuations in money demand.

During cyclical downturns, investors often get more risk averse. And the latest downturn is a very good example of this, as the fear of a financial collapse led investors to avoid anything deemed risk and instead demand less risky assets. The demand for money in its various forms, not just physical notes and coins but also demand and svaings deposits and money market mutual fund (though the temporary loss in value for one money market mutual fund caused demand for it to go down temporarily until the Fed had restored confidence in it) holdings therefore increased dramatically.

So, during cyclical downturns the demand for money suddenly increases, something which both causes the price of money to increase (causing the price level of goods in terms of money to drop since money is now more expensive) while it also causes an increase in the supply of money by banks and other money producing financial institutions.

Because this increase in supply was largely (though usually not entirely since at this point in a business cycle, monetary authorities will try to produce "monetary stimulus") caused by this increase in money demand, it will usually not be associated with immediate price increases.

However, once people believe that the crisis has abated, people will reduce their demand for money and instead demand more risky assets. That reduction in money demand will at the same time reduce money supply growth and raise money prices of various goods. That is why money supply growth has been particularly strong in the end of downturns and beginnings of booms (like in 1983 and 2001) and then been more moderate even as the boom has continued. And that is also why booms usually have preceded even some time after money supply growth halted. 2008 differed somewhat from that pattern as a downturn followed and was combined with significant price deflation just a few months after money supply growth ended. But that was a result of the dramatic increase in money demand caused by the increased and very justified worries about the soundness of institutions like AIG, Fannie Mae, Freddie Mac and Lehman Brothers and securities associated with them.

All About The Right Time Frame

Nicholas Larchi and Minni Munschi at Bloomberg News argues that gold is not a good inflation hedge because in real terms, and compared to other investments, gold is still a lot lower than in 1980.

True, but if you compare the current gold price to its 1999 price of $250, it has been a very good inflation hedge. The current price of $1,143 (when this is written, when you read this post it will probably be slightly lower or higher) represents a 250% real (with the "inflation calculator" used for inflation adjustment) gain. It has also been a good inflation hedge if you compare it to its 1971 price of $35, increasing some 500% in real terms.

Those levels might be said to be extreme lows comparable to the extreme high of 1980, but ff you compare gold to its 1975 prices in the range of $140 to $180 then the current price is 60% to 100% higher in real terms.

On the other hand, if you compare the 1975 level to the depressed 1999 level, it was 43% to 56% lower in real terms in 1999 compared to 1975.

Thus, whether or not gold has been a good investment historically depends on what time frame you use.

Krugman: Government Imposed Rationing Is Market Mechanism

Paul Krugman again comes out in favor of so-called "cap and trade". I'm not going to discuss his low cost estimates (Bob Murphy did an excellent job in doing that in response to a previous Krugman column) or his mischaracterization of Climategate as simply showing scientists to be "human" (as if it were a matter of honest mistakes, and not deliberate fraud) or his Keynesian argument for "climate investments" (which is really just a variation of the old broken window fallacy). What really took the price for distorting the truth was this paragraph:

"The truth is that conservatives who predict economic doom if we try to fight climate change are betraying their own principles. They claim to believe that capitalism is infinitely adaptable, that the magic of the marketplace can deal with any problem. But for some reason they insist that cap and trade — a system specifically designed to bring the power of market incentives to bear on environmental problems — can’t work."

In this short paragraph, no less than three falsehoods and contradictions can be found:

1) Conservatives (or libertarians or objectivists) do not really believe that capitalism is "infinitely adaptable" or that markets will create a perfect world. The case for the free market doesn't depend on the delusion that markets are perfect, but is instead based on the insight that it is better than the alternative of government control.

And free market advocates certainly doesn't believe that markets can undo any and all damage caused by government interventions, such as "cap and trade".

2) "Cap and trade" does not rest on market incentives since it is based on government creating an artificial shortage, something which by necessity will reduce output.

3) Incidentally, since Krugman is known to doubt "the magic of the market", shouldn't he be skeptical of the ability of the alleged market incentives here?

The U.S. Senate's Most Sensible Voice On Monetary Policy

Until the possible but far from certain future elections of Peter Schiff and Rand Paul, the most sensible Senator on the issue of monetary policy seems to be Jim Bunning of Kentucky, who will retire his seat when his term expires in January 2011 (Rand Paul, son of Ron, is campaigning for to replace him in that open seat). See his critique of Ben Bernanke here (Thanks Chris Leithner for the link).

Arnold Kling's Denial Of The Relevance Of Money Supply

Arnold Kling criticizes the view that money supply affects inflation and output:

"If you believe MV = PY, then something magical happens when the monetary authority purchases bonds with money. M goes up, V is approximately constant, and so spending (PY) goes up.

Instead, I think that when the Fed exchanges money for bonds this has almost no effect on spending.

Suppose that your net worth is $100,100, of which $100,000 is in various assets, such as home equity, mutual fund shares, and checking and saving accounts. You carry $100 in cash in your wallet. One day, you wake up with $99,900 in other assets and $200 in your wallet. By how much does your spending go up? Well, if V is constant, then PY doubles. Instead, I think that V will fall by half.

Personally, I prefer to believe that my spending rate has almost nothing to do with my wallet cash. If I have a lot of cash, I can still resist buying stuff I do not want. If I have only a little cash, I have no problem using a credit card or writing a check."

The key fallacy here is of course that it isn't just cash that is money. Any asset that can be used as a means of payment is money. That is why even narrow money definitions like M1 include a lot more than cash (or "currency in circulation" as it is called in money supply statistics). And that certainly includes the amount of money available through the use of credit cards or cheques.

It is true that it is not likely that a sudden big increase in money supply will really immediately increase PY (nominal GDP) by the same amount, as the full effect of money supply on both output and prices for various reasons works with a time lag of varying length, but usually 1-2 years. Nor is it necessarily the case that PY will necessarily increase exactly as much as money supply even over a longer period of time. But Kling goes way beyond that and says that money supply has almost no effect on inflation or output at any time.

It is also true that net worth also influences spending, and that therefore when a nation's aggregate net worth rises because of higher stock and/or house prices, this will increase spending. But money still affects spending more, and rising asset prices are usually the result of previous money supply increases.

Fed Makes More And More Money By Making Money

According to preliminary numbers, the U.S. federal deficit fell for the first time in years in November compared to the same month the previous year. However, that certainly doesn't reflect an improving economy, much less fiscal austerity measures. Tax revenues were down 17%, while regular spending was up more than 10% (with spending for unemployment benefits rising as much as 139%).

Instead, the improvement reflected in part calendar effects, in part a sharp drop in outlays for TARP and in part increased profits at the Federal Reserve. The massive asset purchase program has meant that the Fed holds large amounts of relatively high yielding securities, meaning their interest revenues have increased. Meanwhile, its formal liabilities in the form of currency in circulation and bank reserves costs the Fed nothing (for currency) or very little (for bank reserves which costs the Fed just 0.25%) in interest. Being in the money printing business has always been profitable, but it is now more profitable than ever.

About The Unusual Dollar Reaction To The Employment Report

Virtually always during the latest year, the U.S. dollar has reacted in a way to U.S. economic reports which would at first glance seem odd. Stronger than expected numbers have weakened the dollar-weaker than expected numbers have strengthened the dollar.

The explanation for this can be found in this analysis that I made of the yen (and then elaborated upon in this dollar specific analysis), which just like the U.S. dollar have been a "negative beta asset", moving in the opposite direction of stock markets. To summarize, because exchange rate movements are largely driven by interest rate movements, and because America is deemed to be farther away from rate hikes than other countries (except for Japan), and because other economies are expected to correlate positively with the U.S. economy, this means that a stronger U.S. economy are considered to be more likely to prompt other central banks to raise interest rates than to prompt the Fed to raise interest rates.

However, after today's stronger than expected U.S. employment numbers, the dollar reacted in an unusual way. While the particularly strong rally relative to the yen is consistent with the above analysis, the dollar also rallied significantly against other currencies (though somewhat less than against the yen), including the euro and the pound. What's up with that?

Well, it seems that market participants this time believed that the strong employment report raised the odds of a U.S. interest rate hike more than it raised the odds of foreign interest rate hikes, something which is confirmed by market interest rate movements, with the yields of 2 to 7 year securities rising about 12 basis points.

It remains to be seen whether or not reactions will be similar in the future. Because the key is whether or not Fed rate hikes are possible in the foreseeable future, bullish surprises are more likely to generate similar reactions than bearish surprises, something which increases the likelihood of a stronger dollar because that is what both a "positive beta" response to bullish news and a "negative beta" response to bearish news will mean. Because today's movement could be a temporary aberration, that is however less certain than the reactions of the more safe “negative beta” currency the yen or the more safe “positive beta” currency the Australian dollar.

Relatively Strong Employment Report

Today's employment report could be characterized as relatively strong-without sarcasm. Indeed, by the indicators that I look at, it was even stronger than the headline number of a mere 11,000 lost jobs.

That is first of all because for the first time since July, the household survey showed a stronger employment number than the payroll number. The payroll number is more reliable when it comes to short term fluctuations, but if the household survey number deviates consistently then this suggests that the payroll survey number could under- or overestimate the strength of the job market. Still, this was just one month, and seen over several months the household survey number still indicates greater weakness.

And secondly, the average work week rose as much as 0.2 hours, or 0.6%, increasing hours worked by the same amount. Average hourly earnings were on the other hand week, rising just 1 cent, or 0.05%. That was still enough to increase average weekly earnings by 0.65%, something which means that real weekly earnings likely rose after several months of declines.

Are there any negative aspects in the report? No, not really, except for maybe the aforementioned weak average hourly earnings number. And given the increase in hours, not even that was really significant.

However, part of the strength could be the result of seasonal adjustment distortions. November last year saw a big drop, something which could be reinterpreted by the seasonal adjustment formulas to mean that employment should be weak in November, as opposed to reflecting cyclical weakness and a big real wage schock. Given how consistently weak other economic numbers, including other labor market related numbers, have been recently it seems reasonable to assume that this

This conclusion is confirmed if we compare November seasonal adjustment this year compared to previous years. If seasonal adjustment adds more or subtracts fewer than in the past than it is likely last year's weakness have been interpreted as seasonal rather than cyclical. And if we look at the employment report for November 2007, seasonal adjustment reduced job growth by 156,000, whereas now it reduced it by only 91,000. If seasonal adjustment had been the same as in 2007, job losses would have numbered 76,000 instead of 11,000.

Even so, this report strengthened the bullish case as job losses were still smaller than earlier in the year.

Another Fed Guilt Denial

James MacGee, research associate at the Federal Reserve Bank of Cleveland tries to deny that the Fed's monetary policy had any significant impact (though he unlike some others concede a trivial impact) on the U.S. housing bubble by comparing the U.S. housing market to the Canadian housing market, claiming that Canada did not have a bubble even though interest rates were essentially the same, something which proves that something else had to be involved.

But first of all, even initially conceding for the sake of the argument that his interpretation of the facts is correct, that does not exonerate monetary policy. If the U.S. market had a bigger responsiveness to monetary policy than the Canadian, than monetary policy is still responsible. To use an analogy, if someone ignited a fire on a pile of newspapers soaked in gasoline they would still be responsible even if similar actions with a lighter to a pile of newspapers soaked in water didn't cause a fire.

And secondly, while such a strong empirical correlation is not needed to establish a causal relationship for reasons mentioned in the previous paragraph, the fact is that there was a strong relationship between interest rate movements and house price movements. Compare these two graphs from MacGee's article (the first is the one depicting house prices, the second the one that depicts short-term rates).


As you can see, between late 2001 and mid 2004, when U.S. interest rates were below Canadian, U.S. house prices rose significantly relative Canadian. After that, when Canadian interest rates were higher, Canadian house prices rose a lot faster. So during the bubble years (though not before or after), the negative correlation between interest rates and house prices were almost perfect.

It should be noted that MacGee tries to deny this by comparing a 5-year fixed rate mortgage in Canada with a 30-year in the U.S., overlooking of course the great role of adjustable rate mortgages during the U.S. housing bubble. And as the house price graph shows, Canada did in fact have a housing bust too, though less serious than in the U.S.

That Robust Recpvery

A sample of the latest economic news: Construction spending down, purchasing managers index down, total jobless benefits claims up, retail sales down. Just what you would expect from a robust rcovery in other words....

With numbers like that, it's a real mystery why the "recovery can't get any respect".....

High Taxes Costs Pennsylvania A Lot Of Jobs

According to a new study by the Tax Foundation. The principle that has here applied to Pennsylvania is of course also applicable elsewhere.

More Expensive Gold Benefits Australia

The flight from the U.S. dollar caused gold to reach yet another all time high in terms of U.S. dollars-for the first time rose above the key $1,200 per ounce threshold.

This is a factor which provides further support for the Australian dollar. While the main cause of the Australian dollar's 33% appreciation against the U.S. dollar this year is higher interest rates in Australia combined with higher risk aversion, rising prices of gold and other commodities are also contributing.

While most people still believe that most gold production is in South Africa and Russia, their share of global gold production have dropped dramatically in recent decades. These days China is the world's biggest gold producer with Australia coming in second. And gold is actually Australia's third biggest raw material export. A higher price of gold will increase Australian export earnings and so push up the value of Australian dollar.

While the relative share of South Africa and Russia in global gold production is a lot lower than before, they too and their currencies also benefit from more expensive gold, as does Peru (the firth largest producer). The other two large gold producers, China and America, benefits a lot less because first of all their overall economies are far larger, making gold mining less important for them, and related to that is that nonmonetary demand for gold is bigger there, reducing net exports.

Stocks Are Overvalued

David Leonhardt points out that stocks are overvalued from a fundamental point of view, with the Graham P/E (stock prices relative to the 10 year moving average of earnings) being well above the historical average. Using a 10-year moving average has the drawback of being very backward looking, but this is in my view more than compensated by the fact that it removes short-term cyclical fluctuations in earnings and focuses on long-term profitability.

Since we have now been in a cyclical downturn, the traditional P/E comparing the stock price just to the latest year's earnings makes stocks look even more overvalued.

On the other hand, interest rates are relatively low now. But since that is largely a result of weak growth prospects, that may not justify high stock prices. An example of this is the case of Japan. Japan has had long term bond yields of 1 to 2% for more than a decade, yet stock prices there have kept falling because of weak Japanese growth.

South Korean Exports Rise Again

For the first in 13 months, South Korea's exports rose in November. And the increase was relatively significant, 18.8%. Imports rose a more modest 4.7%.

While most of this improvement from the decline earlier in the year reflect base effects, it illustrates that world trade, particularly trade in Asia, is recovering.

Israel recorded positive annual export growth already in October, and most countries will, if not in November, then at least in December or January also report positive annual growth in trade.

U.S. Construction Spending Down Significantly

U.S. construction spending flat in October, the headlines say. However, as was noted in this story, that is misleading. The reason for that is that the September number was revised down from +0.8% to -1.6%, meaning that the reported October number was actually 2.4% lower than the initially reported September number. The downward revision of construction spending will probably mean that the third quarter GDP number will again be downwardly revised.

Another thing noteworthy is the very different trends for residential construction and nonresidential construction. Residential construction is starting to recover, though it is still at a low level and will likely remain so. Nonresidential private construction meanwhile is dropping fast. The October number was nearly 6% lower than the third quarter average, meaning that even if it is unchanged in November and December, it will drop at an annual rate of 22% during the third quarter. And it is more likely that the drop will continue in November and December, meaning that nonresidential construction (which in GDP reports is the category “structures" under fixed nonresidential investments) will more likely drop at an annual rate of more than 25%.

News From Down Under

The Reserve Bank of Australia raises interest rates for a third time, taking Australian short-term rates to 3.75%. That is significantly above the level in other advanced economies, but still relatively low on a historical basis. Reading the RBA statement here, they appears to be of the opinion that their official targets will be met, which is why they no longer believe that interest rates need to be low (They are clearly uncomfortable with the significant increase in house prices). That indicates that further rate hikes will be implemented, though not necessarily (but possibly) at the next meeting.

Meanwhile, the Labour government's plan to implement a "cap and tax" (AKA "emissions trading") for Australia suffered a setback when the main centre-right opposition party, the Liberal Party , deposed its pro-"cap and tax" leader Malcolm Turnbull in favor of Tony Abbott, who opposes the "cap and tax" scheme. This reduces the likelihood that the scheme will be passed in the Australian Senate, though it is still possible that the Labour government will be able to convince the necessary 7 Liberal senators to vote against the new party line, enabling passage.