Bank Credit Down-Money Supply Up

One interesting fact in this weekäs U.S. monetary reports is that even as money supply increases, bank credit is contracting. While M2 in the week to February 16 is up 1.55% compared to the monthly average in December and while MZM is up 2.7% during that period, Bank Credit is down 1.8% in the week to February 18 compared to the monthly average in December. Those changes might seem small, they are in fact large considering how we are only talking about roughly 2 months.

Given how money creation these days is processed mainly through the banking system, it might appear puzzling that bank credit could contract even as money supply increases.

One possible explanation would be that it reflects increased printing of paper and metal money, also known as cash or currency in circulation. But while currency in circulation has indeed increased rapidly, 2.7%, but as it was only about a tenth of these aggregates to begin with, that is nowhere near enough to explain it.

Another explanation would be that money creation has occurred outside bank
balance sheets, through money markets. But while big increases in holdings of Institutional money funds explain some of the strong MZM growth, that is not enough either.

So, to find out the main explanation you have to look more closely at the different items of the bank balance sheets. As it turns out, it is 3 items that can explain the above apparent discrepancy.

First of all, while deposits included in M2 and MZM is increasing, large time deposits (which is not included in either, but was included in the now discontinued M3 statistics) have declined in value by almost $50 billion.

Secondly, "net due to related foreign offices" (borrowings from foreign offices) is down $145 billion. That number increased dramatically during 2008, but has now started to shrink.

The third item that is shrinking on the liability side is "other liabilities". It is not immediately apparent just what that is supposed to mean, but if you scroll down, you can see that it means mostly "Derivatives with a negative fair value", meaning losses on derivatives that banks hold. That too increased sharply during 2008, only to fall in recent weeks.

The first factor simply reflects decreased customer preference for large time deposits relative to other accounts. The two latter factors reflects that while people are depositing more, banks at this point prefer to (or are forced to) use those funds to pay off debts to foreign offices and settle the implicit liabilities in these derivative contracts instead of lending more money.

S&P 500 Back To December 1996 Levels

The Obama stock market crash continues, with the S&P 500 reaching 735, the lowest since December 1996 (or more specifically December 19, 1996).

Bulls points to how valuation levels (based on 10-year earnings) are the lowest since 1986, but they are still a lot higher (almost twice as high) than in the cyclical low of 1982.

It will probably not fall to as low levels as in 1982, considering the far lower interest rates, and there is a good chance of some form of temporary stock rally soon, but given how deep this slump is and given the negative long-term outlook for earnings, stocks have probably not yet reached their cyclical low.

Why The SEK Is So Weak

The Swedish krona (SEK) has been one of the weakest currencies in the world in the latest year. From last year's peaks when a euro cost only somewhat more than 9 SEK and a dollar cost less than 6 SEK, it has lost more than a fifth of its value against the euro and more than a third against the USD, so that it is now trading at 11.45 against the euro and 9.06 against the USD.

Why has it lost so much value? There are 4 reasons:

-Sweden is a relatively small currency zone, meaning its asset markets are relatively illiquid. In a time when liquidity preference among investors increases, this causes the SEK to lose in value.

-Another reason is for the weak SEK is worries about the potential losses of Swedish banks in Eastern European countries in general and the Baltic countries in particular. Assuming they practice honest accounting, their losses so far has been relatively modest, but the losses will almost certainly grow. Just how much it will grow is uncertain-but the uncertainty is in itself something which makes investors shun the SEK.

-Sweden's export industries have a disproportionate exposure towards the crisis struck Baltic countries and cyclical industries like cars and wood products. As a result, the Swedish trade surplus has been falling in recent months despite the weak SEK.

-The Swedish Riksbank has made a 180 degree reversal in monetary policy. Until recently, it appeared as one of the greatest inflation hawks among world central banks, raising interest rates as late as in September last year to 4.75%. But starting in October, it reversed course completely and implemented radical interest rates cuts of 3.75 percentage points in just 4 months, with interest rates now being 1%. Given the extremely weak Swedish GDP number for the fourth quarter of 2008, expectations are now growing that the Riksbank will join the central banks of Japan, Switzerland and America and implement ZIRP, Zero Interest Rate Policy.

What will happen to the SEK now? Well, while it is possible that the SEK could fall further in the short-term because of the above mentioned factors, we are most likely close to its low for this cycle. A Swedish ZIRP is increasingly priced in, so that factor can not depress the SEK much more. The Baltic crisis will remain a worry, but the uncertainty about that too is probably mostly priced in. In the medium- to long-term, the SEK looks very attractive.

Atlas Shrugged Boom

The Economist reports that sales of Ayn Rand's classic novel Atlas Shrugged are booming, because reality is becoming more and more similar to the world described in the novel. For reasons that should be obvious for everyone who has read the novel, Ragnar Danneskjöld is however for several reasons not very similar to real world Somali sea pirates.

UPDATE: This news is also confirmed by the Ayn Rand Institute itself.

U.S. Slump Getting Worse

While Australia is doing fine for now, the same certainly can't be said of the U.S. The 3 numbers released today said:

-Durable goods orders fell another 5.2% and are now down 26.4% in the last 12 months. Specifically, "core capital goods" orders fell 5.4% and are down 20.2%. This suggest that actual capital spending, as measured in the "core capital goods" shipments will fall further as they are down "only" 11.1% compared to a year earlier. On a monthly bases, they fell 6.6% and will almost certainly fall further in coming months. This means that we could see a really dramatic decline in the "equipment and software" component of business investment, at least 20% at an annual rate, but possibly as much as 30%.

-Both initial and continuing jobless benefit claims rose to new highs, both with regard to the weekly numbers and the 4-week averages.

-New home sales plunged more than 10% compared to the previous month and 48% compared to 12 months earlier to reach the lowest level ever since records began in 1963. While inventories fell in absolut numbers, they reached a new high relative to sales. This happened despite a 17.6% decline in the average price.

Not only does the slump show no sign of ending or even abating, the rate of decline is actually accelerating now. Some argue that because of higher money supply growth (more on that in a later post), we will see a recovery later this year. That might happen, though it is first of all not certain as it might simply mean higher price inflation and secondly, it is not likely to be sustainable.

Australia's Strong Economy

You could be excused for thinking otherwise from observing the drastic actions of the Australian government and the Reserve Bank of Australia (RBA), but Australia's economy is one of the strongest in the world right now. While that reflects more on the weakness of other economies, than any absolute strength in Australia, Australia appears to have escaped recession so far.

Just look at the numbers:
-Business investments increased 6% during the fourth quarter of 2008.
-Private sector wages are up 5.7%, and even adjusting for inflation real wages are up some 2%.
-While total employment was stagnant in January (up just 1,200), this hides the fact that full time employment rose significantly while part time employment fell, meaning that hours worked is increasing
-Real retail sales are increasing, up 0.8% (annualized rate of more than 3%) compared to the previous quarter.
-In contrast to most other countries, the housing sector is still expanding. And while house prices have declined slightly, the decline is very small (only 3.3% during the latest year) relative to other countries and reflects largely an increase in supply rather than decline in demand.
-The previous trade deficit has now turned into a trade surplus for the last few months.

These numbers simply aren't consistent with the view that Australia is in a recession.

Regarding the last item, that is entirely a result of an improvement in Australia's terms of trade, so net exports might subtract from the headline volume GDP number that will be released soon, despite the fact that a trade deficit has been turned into a trade surplus. But GDP properly measured is clearly expanding in Australia, and even the volume measure might be positive.

But if the Australian economy is so string, why has the government introduced Keynesian stimulus packages and why has the RBA made a 180 degree reversal from its previous rate hikes and started to aggressively lower interest rates? Well, I'm not them, so I can't be sure of it, and I personally think they have over-reacted. But presumably they have wanted to pre-empt a coming downturn. Because while Australia is clearly not yet in a recession, a recession might come soon, as the decline in commodity prices starts to reduce Australian export earnings. For many of the commodities that Australia exports, the price is negotiated in annual contracts, and luckily enough for Australia they managed to lock in big price increases in June last year. Once these contracts expire, many Australian commodity exporters will probably have to agree to partially reverse some of these price increases.

So, while Australia is clearly not yet in a recession, a significant risk exists that a recession might (with emphasis on might, as there is also a good chance that it won't come) come later this year. But even if a recession comes, the Australian economy is not in as bad shape as many others, which is one reason why the badly battered Australian dollar looks undervalued at its current level of about US$0.65/A$, €0.51/A$ or 63yen/A$.

Obama Will Raise Taxes For Every American

Obama says:

"In order to save our children from a future of debt, we will also end the tax breaks for the wealthiest 2% of Americans. But let me perfectly clear, because I know you’ll hear the same old claims that rolling back these tax breaks means a massive tax increase on the American people: if your family earns less than $250,000 a year, you will not see your taxes increased a single dime. I repeat: not one single dime."

That is true only in the sense taxes won't be raised with a single dime. They will be raised a lot more than that. To some extent that will in the short term be compensated for many with tax payment reductions in the stimulus package, but they are set to expire after 2011 (and they also have problematic effects on the marginal rate of taxation).

The first example of this is that just 3 weeks ago, Obama signed legislation that will raise cigarette taxes by more than 6 dimes (62 cents to be more precise) per pack. Does Obama and his speech writers really have such bad memories that they can't remember what they did 3 weeks ago? Or do they imagine that all smokers earn more than $250,000 (whereas in reality smokers have below average income).

The second example is how Obama wants to introduce so-called "cap and trade", something which he mentioned in the speech. "Cap and trade" is just a fancy euphemism for a carbon tax. It differ from astraightforward carbon tax in some technical aspects, but it is nevertheless a carbon tax*, something which will hit a lot of Americans with a family income below $250,000.

A third thing to remember is the fact that tax increases even for the highest income earners will hit others. The claim that tax increases will only hit those that pay taxes presupposes that behavior will not be affected. That is like arguing that sales taxes and other consumption taxes will only hit merchants, and will not be detrimental to consumers. Under the more realistic assumption that productive efforts are reduced as a result of this tax increase, this will reduce the supply of goods and services and so raise prices of these goods and services and so reduce the purchasing powers of people earning less than $250,000 per year as well.

*= Some have argued that it will not be a carbon tax if the permits are given away for free. But as Greg Mankiw points out, that still makes it a carbon tax for companies that have to buy additional permits, while being at the same time a corporate subsidy for firms that can sell them. It is really no different from having a carbon tax that funds corporate subsidies.

Japanese Exports Plunge 46%

Japanese exports fell a record 46% in the year to January. The Japanese can happily look back to the good old days (the previous month) where exports only fell 35%........

While imports fell too, they fell a lot less, creating a record 953 billion yen (roughly $10 billion) trade deficit. With a trade deficit of that size, the Japanese current account balance will likely show a deficit too for the first time in decades, especially as the investment income surplus is falling.

Long time readers are familiar with the causes for this collapse in Japanese exports: first of all there is a general decline in world trade due to the global economic downturn. And secondly, the yen has for the last few months been highly overvalued. If the levels it was trading at last month would have been sustained, the Japanese would be forced to kiss sayonara to most of its tradable goods industries.

Given the fact that Japan doesn't exactly have the kind of good investment opportunities that could finance the huge trade deficits this would create, and given the fact that no foreign central bank is likely to be willing to specifically prop up the yen, it was obvious that the January (and early February) exchange rates were a bubble that would eventually burst. It was only a question of when.

While one can never be sure when it comes to short-term market fluctuations, it may have been the case that last months peak level for the yen was indeed the peak of the bubble. The U.S. dollar is up some 9% against the yen since February 2. The yen has lost even more against the U.K. pound and has also lost (somewhat less) ground against most other currencies. Troubling enough for Japan though, the South Korean won has also lost further ground, and is at a record low against the U.S. dollar and near a record low against the yen as well. The won is particularly important for Japan not just because of the fact that South Korea is an important trading partner, but perhaps even more because Japan and South Korea have eerily similar industrial structures (cars, consumer electronics, steel, shipping etc.) and they are therefore trading rivals on the global markets. At current exchange rates of 15.8 won per yen (more than twice the 7.5 it stood at in 2007), Hyundai and Samsung have an enormous competitive advantage against Toyota and Sony.

The yen will therefore have to fall a lot more, especially if the won doesn't recover.

Boomtown D.C.

Just about the only significant city/metropolitan in the U.S. that is experiencing economic growth right now is...Washington D.C..

Perhaps not too surprising if you think of what institution dominates the economy of that city and the growth trend of that institution.

The Key Problem With Quantitative Models

Felix Salmon has a really interesting article about a particular finance model created by a Chinese mathematician by the name of David Li, based on a statistical technique called Gaussian copula formulation, that was applied to the pricing of financial assets.

I don't agree that this model, of similar ones for that matter, was what caused the crisis. The key problem was monetary policy. And I don't think this was the only flawed quantitative model that was used. But it was clearly a flawed quantitive model that caused great losses for financial institutions. It was based, as you can read in the article, on the kind of thinking Dogbert expresses here.

Another key problem with the model, which is also a more general problem with these kinds of quantitative models, is that it assume that past correlations will always hold true in the future and that you can therefore use past correlations to predict future events. This is not just a problem in finance, but in economics in general, where for example it is assumed that certain forms of fiscal stimulus have fixed multipliers (with economists arguing over how high these multipliers are).

But as Austrian economics teaches us, there are no fixed quantitative correlations in economics (At least not any exact correlations. Relationships based on sound economic theory, such as that between monetary inflation and price inflation, will roughly hold for most of the time, but always to a varying extent and with a varying time lag). A quantitative relationship, even if estimated correctly for one period in time (and there are reasons to doubt that econometricians really does that in most cases), is a unique historical event applicable only to the time and place that the correlation was derived from. It is not a general economic theoretical relationship. The only general economic theoretical relationships are the verbal logic praxeological ones. Li's model, like so many others, assumed that quantitative relationships would always hold, an assumption that many on Wall Street acted on, and which created big losses once the fallacy of that assumption was revealed.

Obama's Fiscal Contradictions

After having pushed through an increase in the deficit in the coming years of a total of $800 billion, Obama now says that he is worried about the size of the deficit and will act to restrain it. But if he was really worried about the deficit, then why did he push through that increase?

Perhaps some would say that this is not a contradiction because he is guided by the Keynesian logic that during this slump it is proper to increase the deficit to limit the downturn, but once we see a recovery we should tighten again.

But that argument doesn't hold because first of all, as I discussed here before, much of the so-called stimulus is actually implemented in 2011 or later, the point in time when according to Obama we should start reducing the deficit. And secondly, Keynesians generally don't like fiscal restraint even years after economic growth resumed. Paul Krugman for example has criticized Roosevelt for fiscal tightening in 1937 even though economic growth resumed in 1933. Similarly, Keynesians has criticized Japan for a fiscal tightening in July 1997, even though economic growth was fairly rapid in 1996 and the first half of 1997.

In short, Obama's plan for fiscal restraint makes no sense at all given how they contradict the supposed logic of the "stimulus plan" and will to a large extent be implemented at the same time, contradicting (so to speak) each other in effect on the budget balance as well.

So, what is really the deal with this? The real point is, as I pointed out before, that this will permanently increase the size of government as most of the proposed fiscal tightening measures consists of tax increases, while most of the "stimulus" , especially after 2010, consists of spending increases. But instead of being open about this, Obama claims that the purpose of the spending increase part is "stimulus" while the purpose of the tax increase part is "deficit reduction". This was of course also the modus operandi of the great implicit role model for Obama, Herbert Hoover, who first dramatically increased spending in particularly 1930 and 1931 because of the stimulus effect this would allegedly have, only to raise taxes in 1932 using the deficit as an argument.

New York Times' Misleading Article On Japanese Savings

The New York Times has an article on Japan which essentially blames its crisis on insufficient consumer spending.

The truth is however that low consumer spending is a result of low economic growth, not a cause. If really low consumer spending was the cause of the crisis the you would have expected its household savings rate to have increased. In reality, it has fallen dramatically, from 14% in the early 1990s to 2.2% in 2007 (latest year available, I suspect it fell further in 2008).

To the extent the savings rate is related to the economic crisis, it is because the savings rate is too low, and not too high, as the low savings rate means that the investment rate will be too low.

It is true that the decline in the savings rate is to a large extent related to Japan's rapidly ageing population, which means that fewer people are saving for retirement and more people consuming their retirement savings. But that doesn't change the fact that savings are at an historic low in Japan, and that weak consumer spending growth therefore is a result and certainly not the cause of Japan's economic problem.

While the article does mention in the graphic that consumers are "neither saving nor saving", the impression you get from the headline and most of the article is that savings are too high.

The article also tries to blame the alleged excess savings on deflation which supposedly makes consumers postpone purchases so that they can buy things cheaper in the future. Yet apart from the already mentioned fact that savings are historically low in Japan, the problem with that theory is that it really applies to any country with positive real interest rates, and real interest rates aren't higher in Japan than most other countries.

Today's Chart

From Investor's Business Daily:


It would be wrong to attribute the entire decline to Obama. But it is likely that part of the sell-off is in fact attributable to him-and for good reasons as I explained in a post commenting on the sharp drop in stock prices that followed immediately after Obama was elected.

Brad DeLong & Stakeholder Theory

Brad DeLong comments on Larry Kudlow's comments that Obama's plan will benefit Fannie and Freddie by saying that "Larry Kudlow is as stupid as he is ugly".

Kudlow is as stupid as he is ugly? That's really low, even for DeLong. As for Professor Brad, I won't comment on whether or not, so to speak, it is likely that people frequently thinks that his last name is Pitt and not DeLong as that is not really relevant and as I as a straight man don't care about other men's appearance. I will however say that his intellectual abilities (or alternatively intellectual honesty) don't appear to be as good as you should expect from a professor.

The argument that it is stupid to say that the plan will benefit Fannie & Freddie is that they are now wholly owned by the federal government, and so it is absurd to say that the plan can benefit them. Paul Krugman echoed that theory, though without the kind of crude ad hominem attacks that DeLong used.

But this really shows who are stupid in this case. It is true of course that subsidies s at this point in time from the government to Fannie & Freddie won't benefit any private (or state, local or foreign governmental for that matter) owners.

But owners aren't the only ones with a stake in a company or other form of organization. This may not be something that was taught at any of the universities where DeLong and Krugman have been active, but there are other so-called stakeholders, including most relevantly in this case management and other employees. They will as a result of the expanded funding get greater power and possibly also greater pay, and possibly also a greater number of co-workers, something which they clearly like, making it very much accurate to say that these Fannie & Freddie stakeholders will benefit, and as they are part of Fannie & Freddie, it is also accurate to say that Fannie & Freddie will benefit. And that is of course exactly what Kudlow meant.

Fed Inflates Again

After declining since late December, the Fed balance sheet (Reserve Bank Credit) expanded for the first time this year, by $76.9 billion to $1,907.3 billion in the week to February 18. If you look at the details, Commercial paper funding facility and Central bank liquidity swaps continued to contract as falling commercial paper and LIBOR interest rates makes Fed funding in those areas less attractive. Term auction credit and Securities held outright however expanded a lot more, causing total Reserve Bank Credit to expand.

The increase in "Securities held outright" was not due to increased holdings of Treasuries (yet). Instead it meant increased holdings of mortgage backed securities. Right now, the Fed focuses on bringing down mortgage interest rates by buying such securities.

If this is not an aberration, and instead is the beginning of a trend with expanded or at least stabilized Reserve Bank Credit, this will enable money supply growth to remain high. M2 and MZM continued to expand the latest week, and will probably continue to do so. That in turn means that price inflation will likely pick up again soon, something which we are already seeing in the price of gold. Other commodities that are more dependent on industrial demand will have more difficulty to rally until China and other economies pick up.

Gold At Record High In Terms Of Most Currencies

The all time high for gold was reached on March 17, 2008, when it briefly traded as high as $1,030.80, right?

Well, yes and no. While gold has gradually recovered most of the losses it suffered in the ensuing sell-off, it is still at $975 below that peak in U.S. dollar terms. Note the emphasis on U.S. dollar. Because while gold is still somewhat below that March 17 peak in terms of U.S. dollars, as well as in terms of Chinese yuan and Japanese yen, it is in fact at record levels in terms of most currencies.

I could make the list almost endlessly long, but the below examples will be enough to illustrate how gold is at record highs against all currencies except the USD, the yuan, the yen and all currencies pegged to the USD. On March 17, the U.S. dollar was trading at:

US$1.5765/€
US$2.0008/£
C$0.9977/US$
US$0.9184/A$
US $0.799/NZ$
CHF 0.986/US$
SEK 6.0058/US$

Meaning that on March 17, 2008, the price of gold terms of these currencies was:
€653.9/ounce of gold
£515.2/ounce of gold
C$1033.2/ounce of gold
A$1122.4/ounce of gold
NZ$1290.1/ounce of gold
CHF1045.4/ounce of gold
SEK6190.8/ounce of gold

Today (February 19, 2009) these exchange rates are:
US$1.2705/€
US$1.43999/£
C$1.24896/US$
US$0.648315/A$
US$0.515352/NZ$
CHF1.1745/US$
SEK8.57828/US$

Meaning that given a USD gold price today of US$975/ounce, today's gold price in terms of these currencies is:

€767.4/ounce of gold
£677.1/ounce of gold
C$1217.7/ounce of gold
A$1503.9/ounce of gold
NZ$1891.9/ounce of gold
CHF1145.1/ounce of gold
SEK8358.5/ounce of gold

In terms of New Zealand dollars, gold is thus up more than 46% since the apparent March 17 peak. And in terms of all of these currencies, a buy and hold strategy for gold has been very profitable, especially considering the dismal performance of almost all alternatives.

Roubini On Laissez-Faire

Nouriel Roubini:

"To paraphrase Churchill, capitalist market economies open to trade and financial flows may be the worst economic regime--apart from the alternatives. However, while this crisis does not imply the end of market-economy capitalism, it has shown the failure of a particular model of capitalism. Namely, the laissez-faire, unregulated (or aggressively deregulated), Wild West model of free market capitalism with lack of prudential regulation, supervision of financial markets and proper provision of public goods by governments."

Oh, yeah, Roubini clearly has a point. It was clearly a big mistake to let Bush cut government spending by 90%. And it was a big blunder to let him repeal the Community Reinvestment Act and to abolish "government sponsored enterprises" Fannie Mae and Freddie Mac. Not to mention what a big mistake it was to abolish the Fed and replace it with a pure gold standard, something which prevented government from lowering interest rates to 1% after the end of the tech stock bubble. And did I mention that Bush also stopped federal subsidies to housing? If it hadn't been for those laissez-faire policies, clearly the housing bubble and the ensuing crisis would have been averted.

U.S. Manufacturing Production Below 2002 Average

U.S. Industrial production fell another 1.8% in January, following several months of steep declines. And it would have been worse if cold weather in the North East hadn't lifted energy production (utilities). Manufacturing alone fell 2.5% while the December number was downwardly revised by 0.7%. As a result the index level fell below 100. 100 represent the lowest annual average in the previous cycle, which is to say 2002. Thus, the entire increase in production during the previous boom has been swept away.

Another detail which illustrates the depth of the manufacturing slump is that capacity utilization fell to 68%, lower than the 68.5% low reached in the 1982 recession. Capacity utilization is thus at its lowest level since the 1930s.

Austria's Achilles' Heal

Ok, first a clarification. When I use the term "Austrian" I usually mean the school of economics, and not the nationality. But in this post, I use it in the "nationality" sense of the word.

Austria's economy does seem at first glance to be doing relatively great. Austria is one of the very few European countries that still have a positive 12 month growth rate. And adjusting for terms of trade, even its quarterly growth rate is positive.

The reason for this success is a reduction in government spending from 54% of GDP in 2004 to 48.4% in 2007, the biggest reduction in government spending in all euro area countries. This spending reduction enabled the Austrian government to both nearly eliminate the deficit and reduce tax rates, particularly the corporate income tax rate. You'd almost think that Austria has been governed by Austrian economists!

But unfortunately, Austria's economy does have its Achilles' heal. Along with Swedish banks, Austrian banks have among the biggest exposure to Eastern Europe relative to its domestic economy of all Western European countries, something which The Telegraph's Keynesian bearish columnist Ambrose Evans-Pritchard has discussed in several columns (for example here). Now, Evans-Pritchard isn't exactly known to be hesitant to exaggerate (He said for example in this column that the Polish Zloty has "halved" against the Swiss franc, whereas it in reality is down just 40% against a brief peak, and only about a third relative to the more year ago level), but even correcting for some exaggeration, the fact remains that Austrian banks have a heavy exposure to Eastern Europe. And considering how many Eastern European countries are falling into an economic depression, that means that Austrian banks will lose a lot of money.

Just how much they will lose remains unclear at this point. But it is not far-fetched to assume that these losses might (I'm not saying it's certain, only that there is a realistic possibility) grow large enough to threaten Austria's apparent economic stability.

12 Lost Years For S&P 500

S&P 500 fell back below the 800 level tonight. That is the lowest in this economic cycle apart from one trading day in November (November 20). The reason for this is of course that corporate earnings are deteriorating faster than ever, with the aggregate profit for all S&P 500 companies turning negative for the first time ever.

Another way of looking at it is going back to the first time the S&P 500 rose above 800. That is relevant because it illustrates how long a "buy and hold" strategy has been a losing strategy, something which in turn illustrates the depth of the slump.

While people who have held stock during that time have received dividends, the opportunity cost in the form of interest bearing assets (particularly those of a similar risk level) is in fact higher than dividend payments, meaning that simply looking at index levels if anything underestimates how bad the "buy and hold strategy" has been.

If you then look at the historical data, it turns out that the first time the S&P 500 was trading above 800 was in February 13, 1997, slightly more than 12 years ago.

Rise And Fall Of The Baltic Boom

For years, the Baltic countries, especially Estonia and Latvia, were seen as something of economic role models. Now they are falling into an economic depression. What went wrong and when?

In the beginning, the boom was mostly sound, being based on reduced tax rates, reduced government spending and exchange rate stability. But during 2005 and 2006 the sound foundation began to erode while the unsound elements gained pace.

As I pointed out in this post, there is a strong empirical relationship between economic growth and change in the share of GDP going to government spending. Indeed, it held true for all countries except for Latvia and Ireland (and as later revised numbers would indicate also Estonia). Not coincidentally, Latvia, Estonia and Ireland have seen their booms turn into a bust.

The argument against assuming that the economic growth is caused by the spending reduction would be that the causal relationship can go the other way: namely that an economic boom in the private sector will cause the share going to government to decline. It is true that this opposite causal relationship also exist, but there are still two reasons for believing that reduced government spending will boost economic growth. First (and most importantly), based on economic theory as lower spending will enable either lower taxes which improve incentives, or lower deficits which reduce the crowding out effect on private investments. Secondly, because we have some examples of governments using booms to boost government spending even more than private sector activity. That is exactly what we saw in Estonia and Latvia which saw government spending relative to GDP rise from 34% and 35.6% respectively in 2005 to 35.5% and 37.7% respectively in 2007. At the time, the other factor driving these economies were strong enough to ensure that growth continued, but as the sound basis were eroded, that made these economies more vulnerable to a downturn.

The unsound element of the boom was the massive monetary boom that took place. For Latvia, money supply statistics is only available from 2003, meaning that annual growth rates are only available from 2004. M1 growth in Latvia rose from 22% in 2004 to 43% in early 2006 and remained at 40% in early 2007. By 2008, nominal money supply growth had turned negative, which given the price inflation rate of more than 15% meant that real money supply growth at the time had turned significantly negative. Now money supply is shrinking at a 12% rate, which combined with a 10% price inflation rate means that real money supply is contracting at a 20% rate.

Estonia's monetary boom and bust story is somewhat less dramatic, but only slightly so. Money supply growth rose from 14% in July 2004 to 40% in January 2006, fell back to 26% in January 2007 and 3% in January 2008. Money supply is now contracting at a 9% rate. Because previous monetary inflation was somewhat less dramatic in Estonia than Latvia (cumulative money supply growth from July 2003 to July 2007 was 128% in Estonia, compared to 188% in Latvia), Estonia's price inflation rate has plummeted much faster, to 4% in January 2009. But that still implies a 12.5% real money supply contraction-a sharp contrast to the over 30% real money supply growth in early 2006 and nearly 20% rate as late as 2007.

Estonia and Latvia are thus clear examples of the Austrian Business Cycle Theory in practice-with massive monetary inflation fueling an unsustainable boom followed by significant monetary deflation that reveals all of the malinvestments made during the boom (and perhaps also knocks out some sounder businesses as well). This inflation was in part a result of Estonia and Latvia pegging their currencies to the euro and therefore also the inflationist policies of the ECB and also the result of irresponsible lending practices by certain Swedish banks. Add to this the fact that the boom apparently made the Estonian and Latvian government so complacent that they thought it would be OK to significantly increase government spending during the boom.

Jim Rogers Blog

I was really disappointed when I first found a link to "Jim Rogers Blog" and actually looked at it. But that disappointment only reflects my extremely high expectations. I thought it meant that Jim Rogers had started to blog, which he hasn't. But while it doesn't feature any posts written by Rogers, it is still interesting as it links to all his media appearances and is updated whenever he makes a new one, which is frequently.

The skyline in the background is Shangahi's, BTW, presumably chosen because of his bullish view on China.

Why U.S. Gas Prices Haven't Fallen More

Interesting story about how U.S. gasoline prices haven't fallen nearly as much as the officially quoted oil price. "Price gouging" (and thus deflation fighting! If that would have been true, then they would have been heroes from a Keynesian perspective) gas retailers at work?

No, the reason for this is that the official quoted price is for West Texas Intermediate crude (WTI), a high quality sort drilled exactly where the name suggests it is drilled. But most gasoline is made of imported lower quality varieties. And because demand has fallen more in America than elsewhere, the WTI has fallen a lot more than other oil. Usually, the imported stuff has been cheaper which is why refineries have focused on them, but now unusually enough, the WTI is actually cheaper.

Refineries could of course invest so that they will be able to use WTI, but that will take years, and given how volatile oil prices have been, they can't be sure that WTI will really stay cheaper. And indeed, if these investments were made, that in itself would push up the price of WTI relative to other oil. So for now, gasoline in America won't be as cheap as you would expect from the price of oil usually quoted in the financial media.

Weaker Japanese Economy Makes Yen Stronger

The Japanese GDP report was worse than expected, with GDP falling 3.3% or 12.7% compared to the previous quarter. Compared to the fourth quarter of 2007, the decline was 4.6%. Nominal GDP fell 6.6% at an annual rate compared to the previous quarter and 3.8% compared to Q4 2007.

The quarterly change is a lot less dire if you take terms of trade changes into account. After all, a 6% inflation rate for Japan for Q4 2008 does look like a bit unreasonable. If you instead assume 2.7% deflation (the domestic demand deflator), the decline is "merely" 3.9%. But that is still worse than both America and the Euro area (after similar adjustments have been made for them), and on a yearly basis that factor is a lot less important, as the adjusted four quarter change is 4.1%.

Somewhat discomforting is also the fact that the main factors boosting GDP, apart from lower oil prices, was government consumption and inventory buildup. Final private demand fell even more than 4%, with net exports and fixed investments declining the most.

As long as the yen stays overvalued, it will be difficult for Japan to recover. Unfortunately for Japan, it is like America trapped in a situation where a weaker economy causes the currency to appreciate in value. The yen did indeed react to the worse than expected number by getting even stronger.

How Obama-san Copies Failed Japanese Policies

Even as Obama actually argued for his policies on the basis that they are needed to prevent a repeat of the Japanese "lost decade" experience, his policies are in fact strikingly similar to those pursued by the Japanese. This New York Times article points out the similarities between the approach that he and his Treasury secretary Tim Geithner has in dealing with the banks with the approach the Japanese had in the 1990s.

But the similarities go way beyond that. In fact, the Japanese implemented almost identical policies in the form of budget deficits of 10% of GDP and zero interest rate policies, making it ironic, to say the least, that Obama argues that in order to avoid ending up like the Japanese we must implement the same policies that the Japanese implemented!

Perhaps it would be a better idea to copy the policies of Warren Harding?

Krugman's Defense Of Short-Term Protectionism

Many critics of Paul Krugman, including me, have argued that while Krugman may be good on trade, he is horrible on macroeconomics. Now it seems that he is letting his horrible macroeconomics infect even his analysis of trade. In this post, Krugman argues that under "normal circumstances" the standard comparative advantage argument for free trade is the end of the story. But these are not normal circumstances, Krugman argues, and under these circumstances a case exists for short-term protectionism. His argument essentially goes like this:

1) Because other countries will benefit from one country's stimulus package, while not sharing any of the costs in the form of a higher debt, positive externalities for fiscal policy exists, which means that fiscal stimulus will be smaller than it should be.

2) By adopting protectionism, these externalities will be reduced, and so will encourage more stimulus which will boost output everywhere.

This argument has 3 key flaws. First of all, it presumes that the effects of the stimulus really are positive, which is possible in some well designed versions, but is hardly universally true. Secondly, the argument really isn't about the protection per se, but about its indirect effect on the behavior on politicians. The direct effect of protectionism remains negative. And thirdly, it assumes that other countries will "turn the other cheek" and not retaliate. That is a very unrealistic assumption, and a global trade war would have very disrupting effects on global economies. Not just because of loss of comparative advantage effects, but in the short-term (and it is the short-term that the fiscal action is supposed to be beneficial for) also because of adjustment costs as factors of production in many cases can't instantly move from industries focused on exports to industries that sell to buyers that can no longer buy imported goods.

Corporate Earnings Turn Negative

For the first time ever, the 500 companies in the S&P 500 may report an aggregate loss. Both including and excluding financials. While non-financial earnings would have been positive if it hadn't been for a $25.7 billion goodwill impairment by ConocoPhilips, it nevertheless illustrates just how dire the trend for corporate earnings is.

Germany's Surprising Job Growth

Euro area GDP fell 1.5% in the fourth quarter, according to preliminary estimates, which in the American way of expressing growth would be a 6% annualized decline. Compared to Q4 2007, the decline was 1.2%. Of the specific countries that have released estimates, Cyprus, Austria and (perhaps surprisingly to many, given the riots there) Greece performed strongest while Germany as well as the constant laggards Italy and Portugal posted the biggest declines.

What is perhaps most surprising is the fact that despite the decline in GDP by 1.6% in Germany compared to Q4 2007, employment actually rose by 1% in the year to the first quarter. Compare that to the United States that saw a much smaller 0.2% GDP decline in the year to the fourth quarter, but still saw employment drop by more than 2%. But how could job growth be much stronger in Germany if Germany has a steeper economic contraction? There are four possible explanations for this.

1) GDP is actually stronger in Germany and/or weaker in the United States than these very preliminary numbers suggest, something which might be evident in coming revisions.

2) Employment is actually much weaker in Germany and/or stronger in the United States than these very preliminary numbers suggest, something which might be evident in coming revisions.

3) Germany has had more beneficial changes in its terms of trade, meaning that its official headline numbers underestimate its strength relative to the United States.

4) United States has stronger productivity growth than Germany.

Personally, I think it is a combination of these factors, or at least factors 1,3 and 4 (Though it can't be ruled out that German job growth is overestimated).

Many recent numbers suggest that the U.S. fourth quarter GDP was in fact much weaker than the preliminary estimate, and so will be revised down, beginning in the next U.S. release and probably continuing in the annual revisions. Historically, later revisions have also had a tendency to revise down U.S. GDP, while European revisions have if anything had the tendency to revise up GDP.

No terms of trade numbers are available for Germany yet, but the imputed inflation rate for GDP does look suspiciously high (over 2%, when the CPI has increased only about 1.5%), suggesting a terms of trade gain for Germany. By contrast, the U.S. terms of trade didn't change for the period as a whole.

And the great real wage gain for U.S. workers was probably not just reflecting falling corporate profits but also rising productivity.

Retail Sales Gain Could Be Seasonal Adjustment Error

When comparing changes in monthly activities, it is often misleading to compare raw data when trying to estimate trend changes. The reason for this is that some activities tend to change on a seasonal basis. Retail sales for example tend to be extra large before Christmas. Similarly, some data could change because of calendar factors, because different months different number of working days. That is why much data is adjusted for calendar and seasonal factors.

There's nothing improper about that principle, but the problem is that these adjustments aren't as easy to do in practice as one might think, because like other phenomena’s, the effects of these seasonal factors tend to vary. For example, while it is to be expected that January retail sales will be lower than December retail sales because of the seasonal factor of Christmas, just how much should you seasonally adjust? Given the fact that the relative preference for Christmas purchases over regular purchases fluctuate, it is not as easy simply running some kind of statistical regression over historical data fluctuations. Indeed, it is arguably impossible to correctly estimate each year that fluctuating preference and separate it from trend movements.

Because it is impossible, statisticians have little choice but to use historical data to estimate it, so you could hardly blame them. But what this means is that we should take monthly changes with a grain of salt and not pretend that they really exactly estimate trend movements.

It is in this light we should see the surprising increase in U.S. retail sales for January that were announced today, and that followed several months of steep declines. Some economists have argued that this was probably due to seasonal adjustment problems, and I agree. The unadjusted number actually fell 19.7% compared to December 2008, while the adjusted number rose 1%. In other words, there was an enormous seasonal factor imputed.

A too great seasonal upward adjustment of the monthly change from December to January could reflect that the seasonal downward adjustment for December was too great. A too big seasonal downward adjustment would in turn reflect that they overestimate how great the preference for Christmas purchases was. Is there any reason to believe that the preference for Christmas purchases over regular purchases could be lower this year than usual? Yes, I would argue that there is one good reason, namely the recession. In hard times, people would presumably make everyday purchases of food and other necessities a higher priority than expensive Christmas gifts than usual, and so the relative preference for Christmas purchases was lower than before.

This means that while the seasonally adjusted decline in December wasn't as large as reported, retail sales probably didn't really rise in January.

Oh Really?

Greenspan in a recent interview:

"So everybody in retrospect now knows that that boom was developing under the markets for quite a period of time, but nobody knew it. In 2004, there was just no credible information on that."

Oh really, what do you call the facts presented in this 2004 article then? One would have thought that Greenspan would be able to recognice the similarities of those facts and his own description from 1966 about what happened in the 1920s.

More Keynesian Destruction Worship

Mark Thoma links to a New York Fed paper that argues that under a zero interest environment, tax cuts will have a contractionary effect. It is presented using the standard method that academic (neoclassical) economics uses to hide sloppy economic reasoning, which is to say the use of Greek letters and mathematical equations, but that won't work here because I am not impressed by that and instead translates it back to English so he won't be able to hide, and the assumptions behind these equations are essentially these:

-Tax cuts will boost aggregate supply.

-Higher aggregate supply will mean lower prices.

-Lower prices means that real interest rates will be increased (as nominal interest rates can't be cut below zero).

-Higher real interest rates will lower output.

There are several fallacies here: first of all, it overlooks how point number one will in itself mean a higher output. And it also appears to assume that tax cuts unlike spending increases do not affect demand. And finally, it falsely assumes that an increase in real interest rates caused by higher supply will have a negative effect on output, which is not true for reasons that I elaborated upon here.

The absurdity of his argument can be illustrated by using a Bastiat-style reductio ad absurdum: If it were really true that reducing aggregate supply is good, why not then bomb Silicon Valley into dust (preferably using large quantities of conventional bombs rather than nukes to avoid radiation) after having evacuated everyone working and living there first, and then have the federal government compensate all asset owners and workers fully for any losses with newly printed money. That would leave aggregate demand unaffected, while reducing aggregate supply, and so boost inflation and so lower real interest rates and so according to the Keynesian model boost output!

Absurd idea? Indeed it is, but I don't think there's anything in those Keynesian models used by the New York Fed that could really be used to argue against this plan, so what this illustrates is the absurdity of those models.

How Swedish Bank Rescue Affects Current Behavior

Swedish banks have so far suffered less than banks in many other countries. All of the 4 big banks (Swedbank, SEB, Nordea and Handelsbanken) are still making profits, and Handelsbanken even saw its profit rise.

Yet if you look at their actions you instead get the impression that they are losing a lot of money as all of them except Handelsbanken have decided to issue new shares to increase their capital. And all of them have decided to either cancel dividends altogether or reducing them. Even Handelsbanken is cutting its dividend (though not by muc, only from SEK 8.5O per share to SEK 7 per share.) despite the fact that it is experiencing rising profits.

Assuming their profits aren't a result of them having hired some real life Dogbert to cook their books (which seems far-fetched), this behavior can only be explained as a pre-emptive move from the banks to increase their equity so much that there is no way that they'll need a government bailout. Why is it then so important for them to avoid that?

Well, because they learned from the Swedish bank bailouts of the early 1990s (that I've described in detail here) that the Swedish government will only bail out creditors. Shareholders by contrast will be wiped out instead of bailed out. It wasn't just a matter of taking an equity position (something which would still constitute a bailout of existing owners) but ensuring that existing owners would meet the same fate as if the bank went bankrupt. And the current Swedish government has made it clear that they would be no more generous. And so, this has clearly had the effect of inducing current owners to invest enough in the banks so that their previous investments won't be lost. This is a clear illustration of the absence of bailouts promotes good behavior.

By contrast, there are no indications that creditors have been more prudent in Sweden than anywhere else, as creditors were bailed out.

Keynesian Arsonists?

Southern Australia has in recent days been tormented by damaging bushfires that have killed at least 181 people (that number will unfortunately probably grow), which the Al Gore types have of course blamed on global warming (or "climate change"), ignoring the unusually cold temperatures in much of Europe and North America.

Anyway, now we see some economists arguing that the fires may not be such a bad thing after all. While acknowledging the tragic and sometimes lethal effects on some, they argue that the at least the bushfires are good for the economy. Here is a quote from the Australian (Thanks Chris for the tip):

"As an aside, the bushfires may help the nation fend off recession: Goldman Sachs JBWere economist Tim Toohey says rebuilding will generate an economic stimulus equal to 0.25-0.4 per cent of GDP over the next 18 months.

"As tragic as the events of the past two days have been, the rebuilding phase will provide a catalyst for economic growth in coming months, even if the personal and environmental cost takes years to recover," he says.""

Many suspect that arsonists may have had a role in the creation of these fires. Maybe these arsonists were Keynesians determined to help Australia fend off recession by burning down these houses! After all, if you really believe , like Keynes did, that it is a good idea to bury bottles in the ground and then digg them up again, why not also believe that it is a good idea to burn down houses and rebuild them?

If only people could learn to read Bastiat instead of Keynes.....

Latvia Enters A Depression

While a lot of countries around the world are experiencing economic contraction right now, some have a worse situation than others. Latvia today released numbers that suggests that their slump may be worse than a simple recession. It could more accurately be described as a depression.

The difference between a deep recession and a depression is somewhat vague, but one proposed definition of a depression is a decline in real GDP of more than 10%. Latvia's statistics bureau today reported that real GDP in Q4 2008 was down some 10.5% compared to last year, thus meeting the depression criteria. Latvia's slump is thus likely the deepest in Europe except for Iceland and perhaps also Ukraine.

The underlying cause behind this contraction can be traced to the massive monetary excesses of the preceding boom.The dramatic shift from that to the current situation where Latvia still has significant price inflation (9.8%), while money supply is actually shrinking, meaning that real money supply is contracting very rapidly, is why Latvia has experienced such a dramatic shift from 10% growth to 10% contraction.

The Effects Of The Proposed Housing Tax Credit

Paul Krugman is not a happy camper, denouncing Obama for being politically inexperienced and therefore naive and denouncing Republicans for not wanting to increase government spending. True to form, he also refers to a tax credit for home purchases as being for "the affluent", even though the $15,000 upper limit means that it will benefit the high end of the market much less (For a $150,000 home, it will mean a 10% subsidy, for a million dollar home, it will only mean a 1.5% subsidy).

Anyway, what will the effect of that tax credit be? Will it cause house prices to rise? Kash Mansori here argues otherwise, using several charts. And the point, illustrated in the last one, is that because there is so much unsold inventory, all a tax credit will do is to reduce the inventory level, not raise the price. That may be true in the sense that the prices may not (at least not in the near future) rise compared to now, but it will still probably raise house prices compared to the level it would have been in the absence of the tax credit. The reason for this is that while sellers now want to wait for a while longer in the hope of getting a better price, they probably wouldn't want to wait forever. The implicit assumption that Kash makes is that no owner of an unsold home would ever ahree to lower their price, an assumption which I think is unrealistic. And so, inventories would have probably fallen anyway, only this correction will require a smaller decline in price than otherwise because of the tax credit. And so, this tax credit will mean that prices will be higher than if the tax credit hadn't been implemented.

This is not to say that the tax credit is necessarily a good idea, as this delays the restructuring of the economy away from excess dependence on housing. Moreover, the price increasing effect will probably be limited because some of the home buyers will move from their old houses to those newly bought houses, meaning that those old houses will be up for sale, something which in turn means that supply will also increase. The house price increasing effect will instead come to the extent that the demand for vacant homes (from people who now rent, or from young people that still live with their parents) increases.

Poll About Responsibility For Financial Crisis

Here is a poll about who is most responsible for the economic and financial crisis, with 10 different candidates to choose from (you can only choose one of them). I voted for Alan Greenspan (for reasons that I explained here), and when this is written, he has received most votes, 28.4% versus 22.5% for Gordon Brown and 16.4% for George W. Bush.

Sarcasm Or Not?

Usually it is pretty obvious if someone is sarcastic or not, but I can't really decide whether this New York Times article asking us to feel sorry for the Wall Street bankers that "only" make $500,000 per year is sarcastic or not.

Israeli Election Economics

On Tuesday. it is elections in Israel. Most likely, Benjamin Netanyahu's "right-wing" Likud Party will become the biggest party and lead the new government, though it is not entirely certain as many "right-wing" voters might be tempted to vote for Avigdor Lieberman's nationalist "Israel Beitenu" (Hebrew for "Israel is our home") party who haven't ruled out cooperating with the centrist Kadima party.

Because of the unfortunate security situation illustrated by the recent Gaza fighting, the election campaign has been dominated by issues of that kind. And foreign media reporting of the campaign have been even more exclusively focused on that issue.

But there is also another aspect, namely the division on economic policy. As is discussed in this Jerusalem Post article, there is also a big division on economic policy. Netanyahu's Likud is the most consistently market oriented party (Netanyahu's strong free market leanings have been discussed previously on this blog here) while Labor is the most socialist of the 4 biggest parties, with Kadima and Israel Beitenu coming in between. Israel Beitenu is closer to Likud than Kadima.

Fed Balance Sheet Contraction Continues

The weekly average for the Fed balance sheet (AKA Reserve Bank Credit) fell another $149.1 billion to $1840.7 billion, continuing the trend I reported about last week. It is now down 18.1% from its peak in the week ending December 31, 2008.


As the chart illustrates, it is still at a very elevated level (It is still upp more than 100% compared to 52 weeks earlier), but if the trend continues it could stop the recent high level of money supply growth. M2 continued to rise during the week, while MZM fell back during the week because of a big drop in Institutional Money Funds.

UPDATE: David Altig discusses this contraction here. He points out that much of the decline has come in the commercial paper funding facility and that demand for that has gone down as risk aversion and so also commercial paper yields have gone down. And that similarly currency swaps for foreign central banks have decreased because the factor that made central banks demand it, the high LIBOR rates, has similarly abated.

He is probably right about this, but even excluding these assets, Reserve Bank Credit has contracted.

The Great Real Wage Shock

The perhaps most significant untold story is the dramatic surge in real wages in recent months. I've mentioned this briefly in relation to my commentaries about the job reports of the last few months, but as far as I know the only economics bloggers apart from me that have mentioned this are Dean Baker on the left and Mark Perry on the right. And as far as I know, no one in the mainstream media has mentioned it. Indeed, some like Paul Krugman have as I mentioned in the previous post even tried to falsely claim that there have been "widespread wage cuts".

This is kind of strange, given just how much real wages have gained. If you go to the Bureau of Labor statistics web page and look at the table "total average private hourly earnings, 1982 dollars", you can see that while real average hourly earnings were stagnant between July 2001 and July 2008, at $8.12 in 1982 dollars at both the beginning and end of that period, it soared to $8.64 in December 2008. The average real compensation during the fourth quarter was $8.50, up from $8.16 in the third quarter, a gain of 4.17% or 17.7% at an annual rate. The increase from September to December was even more dramatic, 5.5% or 23.9% at an annual rate. And in January, nominal hourly wage rose another 0.3% and while the CPI for January is not available yet, it is more likely to post another decline than an increase, meaning further gains in real wages.

What this means is that the large job losses in recent months really don't reflect so much a decline in real output, as it reflects a massive real wage shock.

Krugman vs. Reality (Again)

Krugman: "In particular, the private sector is experiencing widespread wage cuts for the first time since the 1930s"

Reality: In the year to January, average hourly earnings are up 3.9%, more than the 10-year average of 3.3%. And no sign of recent deceleration can be detected as the 3 month increase is 1% (4% at an annual rate).

Wall Street & CEO Pay Issue Revisited

Back in 2006, I wrote a post defending high CEO pay. Yesterday I wrote a post mocking the ludicrous arguments advanced by Meredith Whitney for the excessively high Wall Street pay levels.

Am I being inconsistent? Or have I changed my mind on the issue? No, I am not being inconsistent nor have I really changed my mind (though I did err in not explicitly specifying the context), because the issue concerns two very different contexts: the context where high CEO pay can be defended is the context of firms competing in the market place. Wall Street companies today by contrast, are nearly all government subsidized enterprises. And that changes (almost) everything.

(Also, with regard to Wall Street companies, I was referring to the general pay levels, not just that of CEO's)

If you go back to the post you could see that I advanced two arguments for high CEO pay:

1. Because a CEO's decisions are so important for the well-being of a company, it is far more important to ensure that the most competent person is hired, than to minimize CEO pay.

2. If a CEO is overpaid, this doesn't really concern other employees, much less the rest of society, because the people who lose from it are the shareholders, not anyone else.

I still think these arguments are true, but only within the context of firms competing in the market place. With regard to Wall Street today, neither of these arguments are applicable.

Judging by their to say the least dismal performance, the extremely well paid people on Wall Street weren't selected on the basis of competence, but on other grounds, such as nepotism. In a free market economy, firms that hired people on such basis would eventually be weeded out as their objectively irrational hiring criterias would cause them to make decisions that made the companies go bust and out-competed by more rational companies.

But that hasn't happened, and the reason why this hasn't happened brings us to the other way in which the market context defense of high executive pay is not applicable. Namely, the fact that all of these Wall Street firms averted collapse because the government has bailed them out and now in effect pays for their continued operations.

Because Wall Street companies are now on government life support, this means that the people who lose if Wall Street employees are overpaid are the people forced to finance government, which is to say tax payers. And that means that there is a general interest to prevent excessive Wall Street pay.

And as these irrational corporate hiring practices persists because of the bailouts, this means that the usual case for tolerating higher pay (that higher pay will mean more competent employees) is no longer applicable. And that is the key fallacy of some libertarian critics of Wall Street executive pay limits such as David Kramer and Robert Wenzel makes. They don't realize that the competence argument for high pay levels isn't applicable here. Limiting executive pay in a sector dependent on government aid is really no different from limiting the amount paid out in welfare.

While we can presumably all agree that the key problem is the existence of the bailouts, it is simply not the case that government supported companies can be analyzed from the same perspective as market based companies.

Consistency Is A Vice?

Menzie Chinn attacks Rush Limbaugh and others for always pushing for tax cuts, whether it is a boom or a bust.

The attack resembles one from Paul Krugman a little more than 2 months ago wrote:

"The answer is, eliminate the capital gains tax. Now, what was the question?"

First of all, Chinn and Krugman, exaggerates. I don't think Limbaugh or anyone else really think it is the answer to literally every question. It is however what they always think will boost economic growth. And Krugman's example to suggest an even wider faith, how some Republicans wanted to push through tax cuts after the 9/11 attacks weren't about thinking the tax cuts would stop al-Qaeda, it was about boosting the economy after the negative shock that the attacks constituted (His misleading description of this made the title of his post "Caricature economics" quite appropriate).

And secondly, Krugman and other Democrats have been quite consistent in pushing for increased government spending on for example health care during both the housing bubble and during the current slump. So if consistency is really a vice, then they are guilty too.

And thirdly, at other points, Krugman have attacked "right-wingers" for supposedly being inconsistent. Krugman once quipped "Just as there are no atheists in foxholes, there are no libertarians in a financial crisis." , referring to how some (but certainly not all, including me and even Limbaugh) of those that generally claim to support free markets supported bailouts of financial institutions, something which supposedly refuted the validity of free market principles.

And fourthly, and most importantly, it shouldn't be considered a vice to be consistent. Chinn and Krugman may disagree with that all they want, but if you really believe that tax cuts will boost structural growth why not consistently favor it both during booms and slumps? If anything, that should make your belief in it more credible.

How Terrible Wouldn't That Be?

Oppenheimer analyst Meredith Whitney defends the extremely high pay levels on Wall Street by saying:

"The failure to pay employees well may drive away “the best and the brightest. If you can’t compensate your employees, they’re going to go somewhere else You’re going to get a different variety of folks who are going to come in."

Two obvious questions:
Just where are these "best and brightest" people supposed to go? Are there any companies out there eager to hire people who have just wrecked their companies?

And what's the worst thing that could happen if "a different variety of folks" came in? Could this result in financial companies not making hundreds of billions of dollars of losses?

Last Silver Lining For Detroit Lost

January U.S. car sales were really ugly:

Chrysler: -55%
General Motors: -49%
Ford: -40%
Toyota: -32%
Nissan: -30%
Honda: -28%

As a result of this, overall sales may have fallen below 10 million at an annual rate for the first time in several decades. Korean car maker Hyundai was the only one gaining. And while overall car sales appears to be falling as fast as in recent months, Detroit has lost its one silver lining, that their loss of market share was halted. Now it appears that they're losing market share in a rapidly contracting market, which is really bad.

The Super Weak New Zealand Dollar

The New Zealand dollar yesterday fell below 50 U.S. cents (Which in inverted terms means it costs more than 2 New Zealand dollars to buy 1 U.S. dollar). While that is not a record low against the U.S. dollar as it was briefly trading below 40 U.S. cents back in September 2001, it's nevertheless the lowest since December 2002. And moreover, the low value back in 2001-2002 reflected to a large extent the extreme strength of the U.S. dollar at the time, and if we look at the exchange rate versus the euro and the yen, it is in fact record low. Back in 2001, the New Zealand dollar traded at 48 Euro cents and 49 yen. Now it is trading at 39 euro cents and 45 yen.

After the 2001 lows, the New Zealand dollar had several years of bull market, as it rose in 2007 to highs above 80 U.S. cents, above 60 Euro cents and nearly 100 yen. The collapse against the yen since then is particularly dramatic, losing more than half of its value in the latest 19 months. Although it took some beating in the year after that, most of the decline has come since the global financial turmoil became more dramatic in September 2008, with the New Zealand dollar dropping 45% in just 5 months against the yen.

The reason why the New Zealand dollar has taken such a beating against other currencies in general and the yen in particular is of course that New Zealand went into the slump with higher interest rates than others, meaning that its interest rates had more room to fall, putting downward pressure on the currency. The New Zealand dollar has in other words depreciated in value because of the same mechanism that has caused the yen to rally .

Where will it go from here then? At this point, it clearly looks undervalued, but as long as the global slump continues it will nevertheless be difficult for it to recover as people will expect the Reserve bank of New Zealand to cut interest rates further to counteract the slump.

Because New Zealand more or less appears to have structurally higher interest rates, that however means that once there is an economic recovery, it will probably again rally significantly, just like it did between 2001 and 2007.

Half Empty Or Half Full Manufacturing Surveys?

Was the global manufacturing surveys good news or bad news? That seems to be something of a "Do you believe the glass is half full or half empty"-question. In almost all countries, the index was higher in January than in December. But in all countries, it remained well below the 50 threshold for growth versus contraction.

As it happens, both interpretations were right-though the "half empty" crowd slightly more so. The reason for that is that we know this means for certain (assuming the surveys are correct. But if they're not correct, then that diminishes the "half-full" interpretation just as much) continued significant contraction.

The case for the "half full" interpretation lies in that this could (with emphasis on could) be the first step towards a recovery. Rarely, if ever, do these indexes go from say 35 to 55 in a month. Instead, during shifts from expansion to contraction and vice versa, they move gradually a few points up or down. So this moderate uptick is exactly what we would expect to see if this was the beginning of the end of the slump. And that is what the case for the "half full" interpretation lies in. The problem is that while we know a index value of 35 implies contraction, we don't know for certain whether an index movement from 32 to 35 is the beginning of a recovery, or a false signal that will be followed by a decline back down to 32 again. Thus while a recovery will almost necessarily be reflected in a moderate uptick, it is not equally certain that a moderate uptick really reflects a recovery. We'll have to wait for coming reports to see this.

Protectionist Stimulus

The planned U.S. stimulus bill is not done yet, as the Senate's version may differ from that passed in the House of representatives, but it appears that both the House bill and the bill most likely to be passed in the Senate will contain so-called "Buy American" provisions. And that means that the stimulus money can only be used to buy American products.

To some, such provisions may appear sensible since it is American production that is meant to be stimulated. However, this overlooks two key points. First of all, since American products are often more expensive, that means that there will be less money for other projects. And secondly and more importantly, if the U.S. government says it will only buy Americans, this means that others will buy less American. That is both a result of them being poorer and because they will be more hostile to America and feel that if they can be discriminated against by America, then they can discriminate against America.

"Buy American"-provisions violate NAFTA and WTO agreements. And while neither of these bodies have any power to stop this, other countries will see the American move as a green light to do the same.

The latter factor is a reason why several large American companies, like General Electric and Caterpillar, have opposed the "Buy American" provisions.

Flat Earth Economics

A few hundred years ago, it was widely believed that the Earth was flat and that the Sun revolved around Earth (Geocentrism). Now we all (?) know that the Earth is round and revolving around the Sun, but we could perhaps find it understandable that people actually believed in those things with their more limited level of knowledge. I mean, after all, when we look around, this planet doesn't appear to be round, it appears to be flat. Or well, not exactly flat, there are mountains, hills, and valleys, but on average it appears to be flat. Similarly, we do in fact seemingly see the sun move, rising in the East in the morning and setting in the West in the evening. And if it was Earth that was moving shouldn't we feel that we were moving, just like we felt that we were moving when we were riding on a horse?

Similarly deceptive appearances exist in Economics. When for example (almost) all companies report that sales are declining, it seemingly appears as if Keynesians are right when they say that the crisis is caused by "insufficient aggregate demand". If it were true as Austrians and some other non-Keynesians say, that the crisis was caused sector specific overinvestment, then surely we should see some sectors boom while others contracted. But as all sectors suffer, the Keynesian aggregate demand explanation appears more plausible.

What the Keynesian theory overlook is of course while "aggregate demand" in a statistical sense may indeed fall, the explanation that this is the root cause of problems assume that the reason why people demand less goods is that they simply don't want more of it, which is not true, if anything people are less content with their level of spending during slumps. The cause is instead that they can't afford these things any more because a large part of the nation's productive capacity has turned out to be malinvestments, and so cannot generate income for the people who worked and/or invested in that sector. Or in other words, as the malinvestments means that these workers/investors can't supply any goods, they can't demand goods from other sectors. The supply shock that the revelation of malinvestments implies will thus later result in what later appears to be a decline in aggregate demand, but the root cause remain the sector specific malinvestments.

Similarly, how could increases in the money supply possibly be responsible for higher prices, when it is often the case that immediately following a money supply increase, no significant price increases can be seen. And how could money supply increases be responsible for price increases when the time lag between the two usually vary? And how could it be responsible for price increases when some prices increase dramatically while others fall? Surely, if money supply was responsible for price increases, then all money prices should rise equally? As prices behave differently, surely there must be more specific explanations for each price movements (greedy price gouging capitalists, droughts, terrorist attacks or whatever).

This fallacy is complicated that it is often true that non-monetary factors move specific goods up or down and that for various reasons the exact time lag between money supply changes and price changes vary. But the money supply increase means that prices that rise for non-monetary reasons as well will move up more than otherwise, and that other prices will rise even though they would have been flat or even falling without the increase in money supply.

But while the theories that aggregate demand is responsible for the business cycle and that price movements are unrelated to money supply movements are of course as false as the Flat Earth theory or the Geocentric theory. But they are also as seemingly plausible at first glance, which is why it is easy for people to get deceived by these theories.

But while natural scientists today of course reject the Flat Earth theory and the Geocentric theory, most economists instead argue for the false theories created by false appearances. Frederic Bastiat once wrote that what separates good economists from bad is that the former when evaluating certain actions looks beyond the immediate effects for some and also looks at the effects for others and the long term effects for all. What also separates good economists from bad is that the former when explaining certain things look beyond the appearance created by the visible symptoms, and looks at the more complex root causes.