Monday, March 30, 2009

GM Bankruptcy Is Inevitable

Obama says that he is determined to rescue the U.S. auto industry but that it can't be allowed to become permanent wards of the state.

That sounds nice, but at least as far as GM goes, these two goals are incompatible. It's not that GM is broke. It's not. It's worse than broke.

GM has $86 billion in negative equity. Do note the "negative" in that. Normally, companies of course have a positive equity, and in many countries (Though obviously not the United States) companies with negative equity are automatically considered bankrupt. And it's only going to get worse and worse as long as it continues to operate. GM lost a full $31 billion in 2008, of which $9.6 billion was in the fourth quarter.

A company like that simply can't survive unless it either somehow magically achieve a quick and very dramatic turnaround or it becomes a basically permanent ward of the state.

In order to return to profitability, GM needs both a cyclical recovery and a reduction of labor costs to levels comparable to its Japanese competitors. Neither of these things are likely to happen anytime soon, so in order for GM to avoid bankruptcy it will have to remain a ward of the state for a long time.

It remains to be seen whether the Obama administration will choose to let GM go bankrupt or whether it will in fact become a ward of the state. But it seems very clear that for the foreseeable future, it will have to choose one of these two alternatives. It can't avoid both.

BTW: I explained here why bankruptcy really wouldn't be as bad as many of you probably thinks.

Saturday, March 28, 2009

Irish Economy Adjusting In A Painful Way

Ireland had the biggest boom of all Western European countries (many countries hardly boomed at all), a boom that had both sound and unsound elements. The sound elements included the very low corporate income tax and a favorable demographic structure, while the unsound element of course consisted in massive monetary inflation fueled by the ECB's low interest rate policy.

The sound elements are still there, but these positive factors are now overwhelmed by the cyclical slump caused by the end of the monetary boom and the global economic downturn.

The bad news for Ireland is that it is suffering a very deep slump-much worse than the recession in the rest of the euro area. GDP fell by a full 7.5% in the year to Q4 2008. The alternative GNP measure (used because Ireland's GDP number is strongly influenced by corporate tax planning transactions) fell less, but only slightly so (6.7%).

Looking at the specific components, government consumption was basically flat while consumer spending fell 4.1%. The driving factor behind the slump however was the drop in fixed investments by 31.4%.

On the plus side however, net exports improved dramatically. Indeed, the current account deficit almost disappeared during Q4 2008 and was only €133 million (roughly 0.3% of GNP), down from €2.73 billion in Q4 2007 (roughly 6.5% of GNP).

Preliminary numbers for January trade shows that this trend continues, as exports fell a mere 1% while imports fell 28%. It seems likely that the current account deficit will be turned into a surplus during 2009.

At the same time, price inflation has dropped much faster than in the overall euro area, from 3.5% in the year to February 2008 to 0.1% in the year to February 2009. In the euro area as a whole, the drop was more modest, from 3.3% to 1.2%. Ireland will probably see that number fall below zero in the coming months.

Thus, while conditions are again turning inflationary elsewhere, Ireland is indeed experiencing a deflationary downturn. The downside for Ireland is that this will in the short-term imply a deeper downturn, as the GDP/GNP numbers illustrate. But as the current account numbers illustrate, Ireland is at the same time adjusting much faster than elsewhere. The fact that the previously very large current account deficit (previously as large as America's peak levels relative to the size of the economy) is turning into a surplus is in part the result of improved competitiveness through lower inflation, but mostly a result of the fact that the Irish are no longer borrowing from abroad to finance malinvestments.

Friday, March 27, 2009

Verbal Logic Is Not "Intuition"

One positive effect of the financial crisis is that it appears to have made more and more people skeptical of the flawed mathematical models used in academic economics and both academic finance and by financial firms.

This is of course a result of both the utter failure of these mathematical models to predict the crisis and the role of some of these models in actually causing the crisis.

Columnist Anatole Kaletsky recently published an article where he criticized these models. I don't agree with all of his arguments of formulations, but I certainly agree with his conclusion of the failure of mathematical models.

This article has evoked response from several people, including Paul Krugman, who apparently completely failed to grasp the point of the article, as the claim that Keynes didn't use mathematical was met with a supposed example that Keynes did do mathematical modeling. Krugman apparently didn't notice that the point of the was that this wasn't a good thing.

Krugman however does concede that Keynes' model wasn't particularly advanced in its mathematics. Here is the example that Krugman quotes:

"Let Z be the aggregate supply price of the output from employing N men, the relationship between Z and N being written Z = φ(N), which can be called the aggregate supply function. Similarly, let D be the proceeds which entrepreneurs expect to receive from the employment of N men, the relationship between D and N being written D = f(N), which can be called the aggregate demand function.

Now if for a given value of N the expected proceeds are greater than the aggregate supply price, i.e. if D is greater than Z, there will be an incentive to entrepreneurs to increase employment beyond N and, if necessary, to raise costs by competing with one another for the factors of production, up to the value of N for which Z has become equal to D. Thus the volume of employment is given by the point of intersection between the aggregate demand function and the aggregate supply function; for it is at this point that the entrepreneurs’ expectation of profits will be maximised. The value of D at the point of the aggregate demand function, where it is intersected by the aggregate supply function, will be called the effective demand. Since this is the substance of the General Theory of Employment, which it will be our object to expound, the succeeding chapters will be largely occupied with examining the various factors upon which these two functions depend."

What Keynes is actually saying here in an unnecessarily complicated way is simply that employers will hire workers as long as they think that hiring them will bring in more extra revenues than extra costs. Something which illustrates what I've long said is the best case scenario for mathematical models, namely that it will say the same thing as you could say with verbal logic, something which of course violate the principle of Occam's razor.

Mark Thoma then published an article which would supposedly defend these models.

Yet the best "defense" it comes up with is that non-mathematical theories (which are called "intuition") can be false too, and that this supposedly doesn't prove that mathematical models aren't illegitimate.

But while it is certainly true that what he calls "intuitive" reasoning often produces false theories, the point is that mathematical modeling can never give a more accurate description than verbal reasoning. At best, as in the quote from Keynes above, it simply expresses in an unnecessarily complicated way what can be derived from verbal logic. In many cases, though, the translation into mathematics makes correct theories false. One example of this is the focus on equilibrium (a focus necessitated by the fact that the first order condition of a Lagrange multiplier is that the partial derivative is zero, which in this context translated into English means that no further economic gains can be made, or in other words that equilibrium is reached), which in turn means that there are no room for one of the key elements of economic reality, namely entrepreneurship.

The description of verbal theory as "intuition" is also misleading. "Intuition" is usually defined as acquiring knowledge without the use of reason or inference, yet verbal (praxeological) logic is just as based on reason as mathematics. Verbal logic can also be made formal if you want to, in the form of a syllogism as I did here.

Thursday, March 26, 2009

Profits Collapsing-Labor's Share Of National Income Rising

Remember when leftist economists kept talking about how corporate profits kept increasing as a share of income, while labor income kept falling, something which they mainly blamed on Bush, with some also throwing in free trade and some paleoconservatives adding immigration.

Actually, though, as I explained several times here, this was mainly (though perhaps not entirely) a cyclical phenomenon, caused by Alan Greenspan. Labor's share of national income always decrease during cyclical booms while increasing during recessions (usually it starts increasing a few quarters before the recession starts), with corporate profits displaying the opposite trends. The effects of this on inequality is further reinforced by swings in stock market valuation and corporate executive pay.

During this boom, corporate profits peaked during Q3 2006, at 10.8% of gross domestic income (GDI), a big increase from 5.8% of GDI in 2001. At the same time, labor's share of GDI fell from 58.2% in 2001 to 55.5% in Q3 2006. Yet now almost the entire trend has been reversed. Since then (until Q4 2008), labor's share of GDI has jumped to 57.8% and profits have plummeted to 6.2%. It seems almost certain that before this slump ends, labor's share of GDI will exceed the 2001 peak, while the profit share will fall below the 2001 low. And it also seems likely that profits will fall below the 1982 low of 5.4%. It is however less likely that there will be a repeat of the negative profits seen during the Great Depression*.

This crisis is as we all know what helped push Obama and the Democrats in general into power. Yet the crisis has ironically at the same time deprived them of one of their key issues, namely the increase in inequality and the decline in labor income relative to profits. And the irony becomes even greater when these alleged foes of inequality and excess capital gains are proposing schemes, like the Geithner plan, which subsidize rich investors with hundreds of billions of taxpayers' dollars.

*=Note that this definition of profits exclude things like writedowns and goodwill impairment. Including writedowns and goodwill impairment, aggregate profits did turn negative in Q4 2008.

Wednesday, March 25, 2009

Paul Krugman Is Right!

You didn't expect me to ever write that, right? But as it happens, he provides a pretty good explanation of why the Geithner plan represents a big government hand-out to investors participating in it.

A "nonrecourse loan" BTW, is a loan where your risk is limited to losing the asset which the loan was meant for. The creditor cannot demand that you compensate him if the value of that asset is lower than the value of the loan. In this case, this means that since the nonrecourse loan provides 85% of the financing, your potential loss if the return surprised on the downside is only 15%. But in case the return surprises on the upside, your potential gain is unlimited.

Meaning that even though the expected value of the asset is really only $100 from the point of view of the overall economy, the expected value is $130 for investors-and -$30 for the government using Krugman's illustration. The exact expected value would be smaller or greater depending on how big you assume the potential fluctuations are, but the bottom line that the plan represents a subsidy will hold as long as it is assumed to be possible that the asset could decline more than 15% in value. And you'd have to be pretty naive to think that no mortgage vacked security could fall more than 15% in value.

Relative European Inflation Rates+ BoE Might Limit Further Inflating

For February (Source for U.K. number here). These numbers correlate quite nicely with exchange rate movements for countries with floating exchange rates, and with relative economic strength for countries with fixed exchange rates or members of the European Monetary Union, in accordance with the theoretical principles I described here.

Iceland 21.6%
Latvia 9.4%
Lithuania 8.5%
Estonia 3.9%
Poland 3.6%
UK 3.2%
Slovakia 2.4%
Sweden 2.2%
Holland 1.9%
Greece 1.8%
Denmark 1.7%
EU 1.7%
Italy 1.5%
EMU 1.2%
Germany 1.0%
France 1.0%
Spain 0.7%
Portugal 0.1%
Ireland 0.1%
Switzerland -0.1%

The notable exceptions being Latvia and Lithuania, and to a lesser extent also Estonia, who has much higher inflation than you would expect given their economic growth and given the fixed exchange rate they have to the euro. This is in part a result in the two former cases of an increase in the Value Added Tax (VAT) and in part the lagged effect of the previously very high money supply growth rates.

The U.K. number BTW apparently surprised many analysts significantly on the upside, as they didn't think that the extreme weakness of the pound would somehow cause import prices to go up and that this wouldn't also make domestic manufacturers more willing to raise prices (or abstain from cutting them. But no need to worry for British readers as the Keynesians at Telegraph assures you that a lower purchasing power of your earnings is good for you.

However, as a result of the higher inflation rate, Bank of England Governor Mervyn King seems to be getting second thoughts about his plans to inflate even more (at least about implementing it fully), something which caused the pound to rally yesterday.

Saturday, March 21, 2009

The Return Of Inflation

Back in December 2008, I wrote a post called "the coming return of inflation". Since inflation has in fact returned now, I will copy that post's name except for that part about "coming", as it has already come.

This week's news that the Fed will inflate at a much faster rate than previously announced seems to have actually been a statement of an already initiated policy. The Fed balance sheet expanded a full $163.7 billion to $2041.4 billion in the week to March 18, most of it in the form of mortgage backed securities and agency bonds on the asset side. This reverses some of the decline in the size of the balance sheet that we saw earlier in the year.

At the same time, money supply continues to expand rapidly. M2 expanded $39.8 billion to $8343.1 billion in the week to March 9, and is up 10.1% compared to 52 weeks earlier. Most of this increase came in the latest 26 weeks, with the annualized gain during that period being 17.8%. MZM meanwhile expanded $58.7 billion to $9505 billion during the same week. It is up 12% in the latest 52 weeks and up an annualized 17.8% in the latest 26 weeks.

This rapid increase in money supply is now finally starting to show up in prices, with the PPI being up 0.9% in the first two months of the year and the CPI 0.7%.

Different commodity price indexes show somewhat different increases, but they are all up several percent since their lows late last year. The Reuters Continuous Commodity index is for example up 11% from its November low, while the CRB spot index is up 4%. Oil, which briefly traded as low as $30 per barrel in December, closed at $52, an increase of more than 70%. Gold is up 32% from its October low of $720 per ounce.

The evidence is clear then that the significant monetary inflation is beginning to revive price inflation. And as monetary inflation continues, so will likely price inflation.

Thursday, March 19, 2009

Treasury Yields & Inflation Issue Revisited

Yves Smith at the Naked Capitalism blog writes this regarding the market effects of the "Shock and Awe" inflationary shock from the Fed yesterday:

"As readers no doubt know, stocks took off, bonds rallied big, as did gold (note the last two are contradictory)"

Smith doesn't elaborate upon why she thinks it is contradictory with a rally in bonds and a rally in gold, but presumably this assertion is based on a belief that a rally in bonds indicates falling inflationary expectations, while a rally in gold indicates rising inflationary expectations. This illustrates the confusion that exists on this issue. Smith, like previously Mike Shedlock, analyses Treasury yields only from an inflationary expectations basis.

Yet as I pointed out in my analysis of Shedlock's previous similar assertions, there are many factors that could move bond yields, and inflationary expectations is just one of them. There are other factors that are neutral from the point of view of inflation, and there is one way in which more inflation will lower Treasury yields: namely if the central banks starts to flood bond markets with liquidity by buying Treasuries and other bonds. Thus, far from being "contradictory" to a gold price rally, a bond rally (and the decline in yields this implies) could be very consistent with it.

Indeed, yesterday's dramatic price movements illustrate just how wrong Smith and Shedlock are in arguing that falling Treasury yields necessarily indicates a more deflationary (less inflationary) environment. No one in their right mind could possible believe that the news that the Fed will increase their planned asset purchases from $600 billion to $1.75 trillion and pay for those purchases by "printing money" could mean less inflation. Instead, it will of course mean more inflation. And so, if movements in Treasury yields primarily or even entirely reflected movements in inflationary expectations, then Treasury yields should have fallen yesterday. Instead, the 10-year yield plummeted from 3.02% to 2.52%, one of the biggest one day drops ever. This illustrates that the yield reducing effect from a greater money supply is very real, and often (including in this case) far more significant than the yield increasing effects of higher inflationary expectations.

This is not to say that it is irrelevant. While the yield gap between regular securities and inflation-protected securities is an imperfect measure of inflationary expectations (because the former are more liquid), its movements still gives you a hint of inflationary expectations. Tuesday March 17, the nominal 10-year yield was 3.02% and the inflation-protected 10-year yield was 1.90%. When this is written (the numbers may have changed slightly when you read this), the nominal 10-year yield was 2.52% and the inflation-protected yield was 1.21%. While the nominal yield thus dropped 50 basis points, the inflation-protected yield fell as much as 69 basis points, meaning that the yield gap thus rose 19 basis points.

The increase in inflationary expectations thus limited the decline in yields somewhat. But the expectations of massive money supply increases still overwhelmed that effect, as the 50 basis point decline in 10-year yields illustrated.

Wednesday, March 18, 2009

Fed Pledges To Inflate More

Even as the consumer price index increased for a second month in a row (for a total of 0.7%, or 4.2% at an annual rate), the Fed now says it will accelerate inflation. The FOMC Statement specifically pledges to:

"The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and anticipates that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period. To provide greater support to mortgage lending and housing markets, the Committee decided today to increase the size of the Federal Reserve’s balance sheet further by purchasing up to an additional $750 billion of agency mortgage-backed securities, bringing its total purchases of these securities to up to $1.25 trillion this year, and to increase its purchases of agency debt this year by up to $100 billion to a total of up to $200 billion. Moreover, to help improve conditions in private credit markets, the Committee decided to purchase up to $300 billion of longer-term Treasury securities over the next six months."

$1.25 trillion + $200 billion + $300 billion. That adds up to $1.75 trillion in Fed asset purchases.

Financial markets reacted immediately, with stocks, Treasuries, foreign currencies ,gold and commodities in general all soaring in value. $300 billion of purchases won't really make that much difference considering that the deficit this year will be well over $1.5 trillion. However, combined with the massive purchases of mortgage-backed securities and agency debt, and the possibility that they might later decide to purchase even more, the massive increase in liquidity will certainly result in Treasury yields dropping significantly, which is what we saw today.

However, considering the inflation that this will unleash, Treasuries are not the place to be right now. The only safe place is in real assets, such as gold.

Monday, March 16, 2009

Crisis Reduces Financial Globalization

For a long time, cross-border financial integration kept increasing along with trade integration. In most countries, there were significant net sales of domestic equities and bonds to foreigners, while domestic investors were net buyers of foreign equities and bonds. This was in many cases motivated by a wish for diversification based on the theory that if your investments in your domestic stock market went sour, that could be compensated by gains in your foreign holdings.

That theory has seemingly been refuted in the current crisis. Whenever for example the U.S. stock markets have a sell-off, so will the Asian and European markets the next day. That correlation have held almost always except for when news published after the U.S. close support a different movement, but that usually means that the U.S. stock market will also move in that direction.

In a longer-term perspective, there will be significant decoupling between different markets, and diversification can thus reduce risk for long-term investors. But in the short- to medium term perspective, global equity markets will usually move in the same direction. And as many or even most investors have a short to medium term perspective, this means that they now likely find diversification less worthwhile.

Meanwhile, bond investors have discovered that because of the dramatic exchange rate fluctuations, investments in foreign bonds are something which will increase risk in your portfolio. Domestic bonds (particularly government bonds) will not fluctuate very much in value, but foreign bonds could fluctuate quite dramatically in value in terms of your own currency, meaning that this diversification will actually increase risk in your portfolio, something which the increased exchange rate volatility has illustrated.

And while that increased risk in the past was compensated for with higher interest rates, the big drop in interest rate differentials has reduced that advantage with cross-border bond investments.

Likely as a result of all of this, we can now see that financial integration is being partially reversed. Evidence for this was provided in the latest Treasury International Capital Data. In the year to January 2008, foreigners (as in non-Americans) made net purchases of $191 billion of American equities and $764 billion of American equities. But in the October 2008 to January 2009 period, they net bought just $3.5 billion of American equities while they net sold $93 billion of American bonds.

Similarly, in the year to January 2008, Americans net bought $85 billion of foreign equities and $153 billion of foreign bonds. But in the October 2008 to January 2009 period, they net sold $47 billion of foreign equities and $12 billion of foreign bonds.

How Low Oil Price Is Setting The Stage For Higher Future Oil Price

Like other commodities, price movements in oil and natural gas work with a significant time lag. Because it takes a lot of time to find new wells, not to mention how long it takes to extract them, supply only responds with a significant time lag. Similarly, demand also responds largely with a time lag, as it takes some time for people to for example switch the kind of vehicles they use. This means that the short-term price elasticity (responsiveness to price changes) is very low, but it is a lot higher in the medium to long-term.

The flip side to low price elasticity is that a large change in prices is required to accommodate even small changes in demand or supply. A good example is the big drop in the price of oil between June and November 2008 in response to the drop in demand caused by the big drop in global economic activity (or for that matter. the big run-up in prices before June 2008).

Right now, we are seeing the first signs of a response to that big drop in demand, as gasoline demand is rising and drilling activity is collapsing. This has so far only resulted in energy prices being stable for the last few months, and not rising, as the continuing deterioration in economic activity in the U.S. and Europe is reducing demand. But once the global economy recovers, so will the price of oil, and likely very fast.

Sunday, March 15, 2009

Trading Tip

I have recently received questions from several readers’ concerning technical advice on the best and cheapest way to trade financial markets, based on your best judgment after having read my constantly updated analysis.

A general reply that I now want to give is: I'm an economist, not a broker, so if you want the best possible advice in that aspect, then I'm not the one you should ask. But that doesn't mean that you can't find such information on my blog. If you are interested in that kind of information, look at the google-ads, you'll see that some of them do contain that kind of information. Similarly, the ad appearing in every post contains relevant information for everyone serious about learning how to actually trade the markets.

Saturday, March 14, 2009

Dollar Rally Hurting U.S. Corporate Profits

I warned about this already last year, and now Marketwatch also reports that the overvalued U.S. dollar is inflicting great damage to U.S. corporate profits.

This negative effect occurs because this will force U.S. exporters to lose market share or reduce their margins (or a combination of the two) and also because the dollar value of the profits of foreign subsidiaries of U.S. companies will go down if the value of foreign currencies go down versus the U.S. dollar. Some of this negative effect will be counteracted by lower cost of input for U.S.-based firms, but the overall net effect is still clearly negative.

The negative effect on the dollar value of profits of foreign subsidiaries was also confirmed in the flow of funds report that I discussed in the previous report. There it was reported that net profit from abroad fell from $421 billion to $287 billion (though some of that decline likely reflected economic weakness in other countries). As the dollar has strengthened further since then and as there is always a time lag due to the use of futures contracts, this effect will be even greater in the coming quarters.

This factor is yet another reason for believing that this week's rally is simply another bear market rally (or suckers rally), not the beginning of a new bull market.

Friday, March 13, 2009

Flow Of Funds Report Contains Mostly Bearish News

Remember when various so-called supply-side economists such as David Malpass argued that the low savings rate and increasing debt level wasn't a problem because asset values kept going up?

Some of us pointed out at the time that in the long run, asset prices couldn't keep going up like that and that therefore it was not a sustainable substitute to real savings, and that these asset values could and most likely would turn down again, creating problems as the value of debt won't go down in the same way.

Yesterday's flow of funds report
confirmed (and expressed in more specific numbers) what we all knew-namely that asset values fell sharply during the fourth quarter of 2008, and that net worth thus fell back sharply. More specifically, it fell to $51.5 trillion, down $5.1 trillion in that quarter, and down a total of $12.9 trillion since the peak in the second quarter of 2007. It is now lower than in 2004 even in nominal terms, and if you adjust for inflation and population growth, the numbers are far lower than then.

Moreover, leverage, as defined by liabilities as percentage to assets, rose to a new all time high of 21.7%, up from 20.5% in the previous quarter, 18.6% a year earlier and 17.5% in 2004. That may not sound so high, but remember that this is an aggregate numbers that includes Bill Gates, Warren Buffett and all other billionaires and multi-millionaires that have hugh assets but little or no debt. The number of people with negative net worth is likely increasing fast as the value of their only asset, their homes, drop, while their debts stay unchanged. This is illustrated in how mortgage debt as a percent of home values, rose to 57%, up from 55.2% in the previous quarter and 42.1% in 2004.

And it should also be mentioned that home values in the Flow of Funds are based on the OFHEO house price index, which has dropped a lot less than the competing Case-Schiller house price index. While the Case-Schiller index probably exaggerates the house price decline, OFHEO likely underestimates them, meaning that the drop in home values and therefore also home equity (and overall household net worth and leverage) is underestimated.

The one positive item was that household debt has finally started to fall, while savings is up. This is a necessary first step to restoring sound household balance sheets. Just as asset values won't rise all the time, they are unlikely to fall forever (espeacially not at this rapid rate) and once they stabilize, this means that net worth can start rising again. However, there is still a long way to go before we've seen the end of this process.

Also, while household debt is down and savings is up, overall debt growth remains strong and net national savings is negative (though it did improve from the previous quarter). The primary reason for this is of course that the federal budget deficit reached record levels, something which also contributed to increasing growth in the federal debt. Also, while corporate debt growth has slowed significantly, it is still positive. And corporate savings, as defined by retained profits reached a new low of just $244 billion at an annual rate, down from $459 billion in the previous quarter and $703 billion in 2006. This is a result of the fact that while corporate profits have plunged, dividends have only recently started to drop and even now only moderately. And do note that this measure of corporate profits excludes writedowns. Had they been included, the numbers would have been even worse.

Overall, a quite bearish report in other words.

Switzerland Intervenes To Weaken The Franc

The Swiss franc yesterday depreciated some 3% in value against the euro. Normally, the euro/franc exchange rate rarely move more than 1% in a day.

The reason for this unusual move was that the Swiss National Bank not only cut short-term interest rates to 0.25%, but also announced that it will actively intervene to weaken the franc.

The franc is the only European currency to have actually gone up in value against the euro. Other have either been stable (because their central banks pursue a fixed exchange rate policy) or have fallen in value against the euro, often dramatically.

The Swiss National Bank is no longer the relative hard money central bank that it used to be, which is why I recently stopped being bullish on the franc. Yesterday's announcement makes the case even stronger for a bearish view.

One good thing about this is that it could reduce the problems that many Austrian and other Western European banks have in Eastern Europe. One source of the problems was that many in Eastern Europe borrowed in terms of francs, and so when it rose sharply against the Eastern European currencies, the debt burden for the borrowers soared. The franc had already fallen some 5% from its highs against the Polish zloty, and today it then fell another 3%, reducing the debt burden for Poles that borrowed in francs by 3% at the same time.

Thursday, March 12, 2009

Crisis Causes Inequality To Go Down

The number of millionaires in America is dropping fast, from 9.2 million at the end of 2007 to 6.7 million at the end of 2008, as is the number of "affluent households" (with a net worth between $500,000 and $1million), from 15.7 million to 11.3 million. Those were year-end numbers, and as the stock market has dropped significantly since then, these numbers have likely dropped further too.

In a related news item, the number of billionaires globally is also declining fast, from 1,125 to 793, and those that still are billionaires have in most cases seen their net worth drop significantly. For example, Bill Gates net worth has dropped $18 billion, while Warren Buffet has lost $25 billion. The collective net worth of billionaires dropped from $4.4 trillion to $2.4 trillion, both as a result of the lower numbers of billionaires and the lower average net worth among billionaires.

This illustrates a rarely noted phenomenon: economic downturns tend to be associated with falling inequality, while booms are associated with rising inequality. Inequality reached the highest level ever in U.S. history in 1928, only to shrink dramatically during the Depression. It then reached new highs in 1999, and then later (after having briefly declined in 2001-02) in 2006. In other words, inequality tends to peak during financial bubbles, and then decline after those bubbles burst.

That is hardly a coincidence. Asset owners tend to be wealthier than others, almost by definition, and when asset prices rises relative to goods prices, this will inevitably mean that the rich will become relatively richer. Moreover, during cyclical peaks profits in general and financial sector profits in particular tends to peak as well, something which will enable executives and financial sector employees to receive really fat bonuses, thus increasing inequality in labor income as well.

The background to these cyclical tendencies is of course monetary policy.

The bad news for the majority of non-wealthy people is that the decline in inequality that we are now seeing will entirely be a result of the rich becoming less rich. It won't mean that the poor and the middle class will become richer (indeed, they are likely to suffer too, only less so than the rich).

This decline in inequality is also bad for Obama's official "soaking the rich" budget strategy. If you make government financing dependent on soaking the rich, that means that government finances will depend on a high level of inequality. If inequality goes down, there won't be enough rich people to soak to minimize the deficit to a sustainable level. This in turn means that there will be a need to either restrain spending or to raise taxes on the poor and the middle class.

Greenspan's "New" Denial

Sigh. Greenspan again tries to deny his guilt in the housing bubble. He doesn't use any new arguments, and instead repeats the old argument about global savings glut, so I'll just quote my own article on Greenspan's guilt. Here is an excerpt with the parts relevant for this argument:

"This explanation really doesn't explain why the bubble started to inflate in 2001 and ended in 2006-07. Did the savings glut start in 2001 and then end in 2006? To the contrary, the external surplus of both China and oil-exporting nations fell in 2001, while they rose quickly in 2006-07. And, as explained below, given how the central bank sets interest rates, those flows will mainly affect money supply instead of interest rates.

Greenspan himself makes this argument by pointing to how long-term interest rates did not rise after the rate increases in 2004-2005. This is dishonest for more than one reason. First of all, the housing bubble started already in 2001, when he pushed through rate cuts of an unprecedented magnitude, from 6.5% to 1.75% in a mere year. Secondly, because of the increased popularity of adjustable-rate mortgages, short-term interest rates were just as important as long-term interest rates. Thirdly, movements in market interest rates always tend to precede movements in the federal-funds rate as market interest rates are really the future average federal-funds rate during the duration of the bond.

If really long-term interest rates were determined only by global liquidity, then were long-term interest rates about 1.5% in Japan and 6.5% in Australia until only recently? This is all the more telling given the fact that Japan has a very high budget deficit and a huge public debt, while Australia had a budget surplus and a very small public debt. And to further illustrate the point, after the Reserve Bank of Australia unexpectedly reversed its previous rate-hike policy and started to aggressively lower short-term interest rates, the 10-year yield has fallen some two percentage points, while the Japanese yield has stayed unchanged.

And long-term interest rates did in fact rise from 3.3% in June 2003, when the deflation scare made everyone believe interest rates would stay low for long, to 4.7% in June 2004 when the Fed had already signaled the start of a series of rate increases. That long-term interest rates didn't rise further after that merely reflected that the series of rate increases after that was factored in by the markets."

Wednesday, March 11, 2009

Chinese Exports Fall-Domestic Demand Rise

Some make a big deal of the big decline in the Chinese trade surplus in February. But looking at monthly numbers in isolation is potentially misleading for January and February in China because of the Chinese New Year. More meaningful is to look at the combined figure for January and February.

If you do that, you can see that the surplus rose compared to last year despite a significant decline in exports, as the cost of imports fell even more. The drop in imports is likely mostly caused by falling prices for oil and other imported commodities.

One interesting fact is that despite reduced foreign trade, domestic demand in China appears to be holding up well. Fixed investments rose 26.5% in January-February compared to the previous year and car sales also rose, though only 2.7%. However, compared to the 39% drop in the U.S. and similar declines in many other countries, that is very good.

A number of indicators, including power consumption and bank lending suggests that the Chinese economy continues to grow (though at a low rate of growth by Chinese standards) as a growing domestic market and lower commodity prices more than offsets the negative impact from falling exports.

Tuesday, March 10, 2009

Treasuries No Longer Considered Risk Free

Marketwatch reports that the cost of credit default swaps for U.S. Treasuries is rising. The significance of this is that Treasuries are no longer considered to be 100% risk free. Usually, in finance classes, they use the yield of government securities as the risk free reference rate in for example the CAPM formula. But this presupposes that everyone perceives these securities as being risk free, something which is evidently no longer the case.

Personally, I don't think there is any risk of default for a government that issues debts in its own currency and has a fiat currency with a floating exchange rate, as it can always print whatever money it needs to pay. That might lead to a de facto default, as the real value that investors get back is lower, but it won't be the kind of formal default that credit default swaps protects you from. So the people buying these swaps are wasting their money for nothing. But that's their problem, and the point remains that Treasury yields thus contain a risk premium, and cannot be used as the risk free reference rate.

Stocks Still Well Above Levels Typical For Deep Slumps

Bloomberg news has a story which makes a point that I have made several times before (for example here), namely that while stock valuation (by the measure of 10-year moving average of profits) at this point in time has finally fallen below the historical average, that doesn't mean that stocks can't fall further, because during really deep slumps like the Great Depression and the deep recessions of 1973-75 and 1981-82, valuation levels have been a lot lower than now.

Indeed, the reporters Alexis Xydias and Michael Tsang, underestimates just how much stocks will have to continue to fall to reach levels typical of deep economic downturns. At one point in the article, they say its 27% and at another point they claim it is 21%. The real number is much higher. If you look at the actual data from Robert Schiller, you can see that the current 10-year P/E ratio is 12.03. During the Great Depression, it was as low as 5.57, during the 1973-75 recession it fell to 8.29 and during the 1981-82 recession it fell to 6.64. Thus, even if you use the most favorable reference point, the 1973-75 recession, stocks have to fall another 31%. If you use the number from the 1981-82, stocks have to fall nearly 45% more and if you use the number from the Great Depression, stocks will have to fall another 54%.

While this slump will probably not be as deep as the Great Depression (though that can't be ruled out), it will definitely be worse than both the 1973-75 and the 1981-82 recessions. Compared to those periods, stocks are still far too expensive.
That is why I don't think we've seen the end of this bear market. While it is possible and even likely with some kind of short-term rally soon, that will only be a temporary one, and stocks will after that fall to even lower levels than today.

Does China Need A Blizzard?

Or does China at least a new round of blue ear disease among pigs? What kind of absurd question is that you may think? But it is not absurd if you are an adherent of the non-Austrian view on price deflation, which are always considered bad, indeed not just bad, but it is the worst possible calamity, something which should make us "abandon all hope" according to one well-known columnist.

In 2008 China had a temporary spike in price inflation, related not just to high money supply growth and the global commodity price boom, but also negative supply shocks like a severe blizzard and blue ear disease among pigs. That latter factor had a greater impact on the Chinese consumer price index than it would have had in other countries, because pork is something of a staple food in China.

This year, there have no outbreaks of blue ear disease among pigs, and while there have been blizzards, none have been as severe as the one China suffered from last year. The result is that the Chinese consumer price index fell 1.6% in the year to February, led by a 18.9% decline in the price of pork.

Since we don't want the Chinese to "abandon all hope", then any good Keynesian would at this point hope for a new severe blizzard or outbreak of blue ear disease among pigs, so that prices can again start to rise.

The Chinese however doesn't seem to agree with the Keynesians, as car sales started to boom during the period when consumer prices fell, in sharp contrast to the big declines in most countries where the CPI rose during this period. That hardly indicates that they have abandoned all hope.

So who should we believe? The Keynesians or the Chinese? I am personally more inclined to believe the Chinese.....

Sunday, March 08, 2009

Cap & Trade-The Worst Kind Of Carbon Tax

Obama will now implement various measures to fight what he believes is the threat of "climate change". Among those are his "Cap and trade scheme" that he for example explicitly mentioned in is remarks to the joint session of Congress.

An alternative approach to "cap and trade" is a straightforward carbon tax. As I've already pointed out, "cap and trade" is simply a euphemism for an alternative form of carbon tax. What is then the real difference between "cap and trade" and a straightforward carbon tax? The difference lies in what element is fixed and what is variable (what will fluctuate).

It is a basic truth within macroeconomics that monetary policy makers can only fix one target at the time. If they try to fix exchange rates, then they'll have to let consumer price inflation and money supply growth fluctuate. If they try to target consumer price inflation, they'll have to let money supply growth and the exchange rate fluctuate. If they target money supply growth, they'll have to let the exchange rate and consumer price inflation fluctuate.

This conflict also exists for politicians that try to reduce carbon dioxide emissions through economic incentives (taxation). Either they'll have to fix the amount that emissions will be reduced and let the incentive fluctuate. Or they'll have to fix the incentive abnd let the emission reduction fluctuate.

In a "cap and trade" scheme the emission reduction is fixed, so fluctuations in demand for emissions will result in fluctuations in the tax on emissions. In a straightforward carbon tax, the tax rate will be fixed so fluctuations in demand for emissions will result in fluctuations in actual emissions.

Which scheme is preferable, or which scheme is the lesser evil? "Cap and trade" is the worst of the two because they create an unnecessary (artificial) economic cost. Leaving aside the issue of whether really emission reductions are a worthwhile goal, we have to ask which scheme produces the greatest economic cost. While uncertainty about prices is necessary in many cases in order to avoid excess surpluses or shortages of goods and services, it is nevertheless always a bad thing in itself, which is why artificial uncertainty (that do not fill any function) is a bad thing, period.

"Cap and trade" creates such an artificial uncertainty for market participants. Remember, the difference between "cap and trade" and straightforward carbon taxes lies in what is uncertain, the price (tax) or the amount of emission reductions. While short-term fluctuations in emissions shouldn't be a problem for the politicians, short-term fluctuations in price is an example of the kind of artificial uncertainty that produces an economic cost as companies can't be sure of how much the tax will cost them, and they will therefore refrain from investments which will likely but not certainly be profitable.

So, while "cap and trade" and a straightforward carbon tax will not (need not) create any difference in the level of emissions, "cap and trade" will for any given level of average emissions impose a greater economic cost.

But if "cap and trade" produces a greater economic cost, why do Obama and many other politicians push for it? The most likely explanation is that "cap and trade" sounds better from a political point of view. Obama frequently claims that he will not raise taxes for anyone with a family income of less than $250,000 a year, an assertion that is false for several reasons, including his planned "cap and trade" scheme". But since "cap and trade" doesn't sound like a tax, Obama thinks he can get away with that lie, while he knows that anyone would recognize a straightforward carbon tax as a tax.

But make no mistake-"cap and trade" is a tax that you will all have to pay, and it is a tax that will damage the economy even more than most other taxes.

Saturday, March 07, 2009

Bull/Bear Markets Explained

I have for years known what the terms "bull market"/"bullish" and "bear market"/"bearish" means, yet it now seems that until just recently I might have misunderstood the origin of the terms. When I explained these terms to you, I retold an explanation that I had heard that the terms originated from the different attack styles of the animals ("When a bull attacks it strikes UP with it's horns - when a bear attacks it strikes DOWN with it's paws")

The worlds sexiest linguist, hotforwords aka Marina Orlova (whom I discussed previously here) however here argues these terms have another origin.

Obama & The Stock Market Crash

While stocks barely managed to stay positive for the day after having been down as much as 2%, they (as measured by the S&P 500 index) are still down nearly a third since the November 4 close of 1005.75. As you may remember, November 4 was the last trading day before Obama won the Presidential election.

Many Republican commentators blame this crash entirely on Obama, something which upsets certain Obama apologists, including Robert Reich and Barry Ritholtz.

The correct answer to this question is similar to the answer to the question of whether Herbert Hoover's policies caused the Great Depression. They weren't the main cause of the Depression (the most important cause was instead monetary factors). But they did make the Depression even worse than what would have been the case if monetary factors alone had been at work.

Similarly, Obama is not entirely responsible for the crash, but he is not completely innocent either. The truth is that the main reason for this meltdown is the lagged effects of the housing bubble. So, even if John McCain (or even Ron Paul) had won the Presidential election, the S&P 500 would probably have been trading well below 1005.75 right now. But it would probably have been trading significantly higher than 683. The reason for this is that Obama has proposed an unprecedented increase in the budget deficit, which will reduce future growth, while he at the same time wants to increase taxation of corporations. Both of these factors reduce the present value of future net profits, and so also reduce the fundamental value of stocks.

U.S. Jobs Report Confirm Weakening Economy

You know the U.S. employment report was bad when bulls use really pathetic arguments to spin it as good.

For example, we have Paul Ashworth, arguing that because the preliminary job loss number in February was slightly lower than the revised number in January and December, this means that job destruction may have reached its peak. But even setting aside that 651,000 is not that much lower than the January number of 655,000 and the December number of 681,000, those numbers were reported last month as 598,000 and 577,000 respectively. In other words, the preliminary loss for February was greater than the preliminary losses for January and December. Given how job losses have been consistently revised up for the last year, it seems pretty safe to assume that this preliminary number will be revised up as well.

Then there is Robert Stein, who chooses to focus on the smaller job loss ("only" 351,000) in the household survey, and points to how much of the increase in the unemployment rate was driven by a higher participation rate. But that overlooks how the household survey's monthly changes are notoriously volatile and that one shouldn't make too much of that. In January by contrast, the household survey job loss was 1,239,000, and the 2 month loss is even higher, and the 12 month loss roughly the same as in the payroll survey.

But apart from the smaller decline in the erratic household survey, there was really nothing bullish about the job report. Indeed, even the one thing used to be a silver lining, the increase in average hourly earnings, is getting worse, increasing only 3 cents or 0.16% on the month, much less than in previous months. That could to a large extent reflect a purely statistical effect from which workers are losing their jobs, rather than an actual reduction in wage increases for any actual worker, but it could also mean that the weak demand for labor is finally pushing down wage increases. However, regardless of the extent to which these explanations are true, the implication of that is that aggregate nominal labor income is declining even faster than before.

Thursday, March 05, 2009

Bank Of England Starts Quantitative Easing

As expected, the Bank of England reduced short-term interest rates to 0.5% today, leaving them with little room to cut further. But no need to worry (in case you did worry about it inflating too little), the Bank of England will now start what is called "quantitative easing", which is to say purchasing assets and paying for them with money created "out of thin air".

Unlike the Fed, the Bank of England will focus on government securities (though some private assets might be bought as well), buying £75 billion of them in a first step and an additional £75 billion later.

Similar moves in America by the Fed have had some success in boosting the money supply, but no success at all in reviving economic growth. There is little reason to believe the Bank of England's moves will work better.

Chart Of The Day

Australian trade balance:

Previous deficit country Australia is now having consistent surpluses. The expiration of beneficial commodity price contracts could lower export revenues and therefore the trade surplus, but on the other hand, the lagged effect of the dramatic weakening of the Aussie dollar will likely act to increase the surplus.

Wednesday, March 04, 2009

"Evil" Or Realistic Bears?

Conservative Keynesian Greg Mankiw draws the wrath of left-liberal Keynesians Brad DeLong and Paul Krugman for being pessimistic about future growth, with Krugman this time being the one to engage in name-calling and refers to Mankiw as "evil" for doubting Obama's projections of high growth.

The DeLong-Krugman argument rests on historical experience that shows that growth tends to be rapid after deep slumps, as there are a lot of unemployed workers that can be employed quickly and so produce high growth. What is noteworthy in this context is that if you look at Mankiw's original post, he doesn't even deny that, and says explicitly "when recovery comes, it will probably be a robust one.". Yet DeLong and Krugman pretends in their posts that Mankiw denies this.

But Mankiw's point is that we don't know when the slump will end and so we can't say that growth from now until a certain year, say 2011 or 2012 to be high. Even though that is the main argument discussed in his post, DeLong and Krugman fails to mention or discuss that argument. Mankiw is BTW right about this. To illustrate this point, assume that someone in late 1930 had concluded that because GDP had fallen 8.6% that year, there must be robust growth, say 8% per year in the coming 3 years (1931 to 1933). That person would have been dead wrong, as GDP fell another 6.4% in 1931, 13% in 1932 and 1.3% in 1933. To illustrate the point further, let's assume that he had projected 8% per year growth in the coming 6 years instead. That would include 3 years (1934-36) where output expanded. How would that proto-Krugman-DeLong forecaster have performed? Not so good.

While there was indeed a very robust recovery during the 3 years of growth, with output in 1936 being 36.3% higher than in 1933, that followed 3 years of contraction of 19.6% (And that doesn't even include the 1930 contraction). GDP in 1936 was therefore only 9.5% higher than in 1930 (and it was unchanged compared to 1929), which is an annual average growth of only about 1.5%.

Thus, even assuming that the recovery will be robust once it starts this time as well, that doesn't mean that we can say that average growth will be high from this point in time to a specified future year because we don't know how long this slump will persist (and right now, the slump seems to be accelerating in pace) and also, we do not know if there could be future slumps. Japan during the 1990s had some brief periods of high growth, but they were fairly quickly cut short by new slumps (And during the 1930s, there was a new slump in 1937-38).

The reason why there tends to be persistent damage to long-term economic growth is that so much of all investments go lost as they are revealed to be malinvestments, meaning that available capital declines, something which reduces not just short-term but also long-term output. Furthermore, the fact that politicians like Herbert Hoover and Barack Obama tends to respond to slumps with political actions that damage long-term growth, such as higher marginal tax rates and higher spending, compounds this effect.

Tuesday, March 03, 2009

Car Sales Numbers Confirms That U.S. Contraction Is Accelerating

Year over year car sales gains in the U.S. were even worse in February than in January for all except Chrysler. Here is the February yearly change with the January number in parenthesis:

GM: -53% (-49%)
Ford: -48% (-40%)
Chrysler: -44% (-55%)
Toyota: -40% (-32%)
Honda: -38% (-28%)
Nissan: -37% (-30%)

German auto makers and Korean Hyundai continues to take market share from the U.S. and Japanese auto makers with BMW sales declining 35%, Daimler (Mercedes)sales declining 21% and Volkswagen sales declining 19% and Hyundai sales declining just 1.5%.

While the fact that February 2009 had one day fewer than February 2008 caused a slight downward bias in these numbers, this still confirms the view that the U.S. contraction is accelerating in pace.

You Know Things Are Bad When....

...the formerly extremely profitable (but now loss-making) Toyota is applying for government loans in Japan.

...When a 17.1% export decline in South Korea is being hailed as good news.

...When President Obama changed his slogan to "Spare change you can believe in"! (Or actually he didn't of course, that was a Jay Leno joke-:)

Monday, March 02, 2009

Deficit Based Personal Income Gain

Today's economic news were seemingly mixed-construction spending fell sharply, and this now includes nonresidential construction as well as residential, with nonresidential construction falling 4.3% versus 3% for residential construction. These numbers are worse than they look since we're talking about monthly changes. To calculate annualized changes you have to raise them by the power of twelve, which in case you wonder means -41% for nonresidential construction and -30.6% for residential construction. That number is certainly consistent with the extremely weak numbers from last week.

The ISM manufacturing index rose slightly, but that marginal increase was so small that it is within the statistical margin of error and it still shows significant contraction.

Seemingly contradicting this trend was the personal income number, with disposable real income rising as much as 1.5% from the previous month, and with real consumer spending rising as much as 0.4%. However, the consumer spending number is to a large extent based on retail sales numbers, and as I've previously pointed out, there are reasons to believe that the apparent gain reflected seasonal adjustment problems.

But what about the income number? Well, if you look at the specifics you can see that the $187 billion nominal gain in disposable personal income was entirely driven by an increase in the government deficit. Market based income fell in nominal terms and even more so in real terms as the price index rose 0.2%.

-For example, private wage and salary disbursments fell $12.9 billion, yet government wage and salary disbursments rose $10.2 billion.

-Personal transfer payment receipts jumped as much as $66.6 billion.

-Personal tax payments meanwhile fell $138.3 billion. Even excluding $5.1 billion increase in "contributions for government social insurance" (which strangely is treated as something different than taxes), that adds up to a net increase of $133.2 billion.

So, we have a increase in government wage and salary disbursments of $10.2 billion plus a $66.6 billion increase in transfer payments plus a $133.2 billion reduction in tax payments, for a total of $210 billion. Excluding that, disposable personal income fell by $23 billion in nominal terms, and roughly twice that in real terms.

Even that is less dramatic than many of the other numbers we've seen, but it is only normal for personal income to fall less than national income during slumps, as retained corporate earnings fall dramatically.