Saturday, May 30, 2009

About The Concept Of Opportunity Cost

In this post, I mention that I disagree with George Reisman on the issue of opportunity cost, something which reader Wladimir Kraus challenged me to elaborate upon.

First of all, it should be said that opportunity cost is in many aspects not cost in the same sense as other costs. Which is to say it does not mean a reduction in wealth, unlike other costs. Opportunity cost represents foregone increase in wealth, rather than a reduction in it. However, it is relevant as a factor in human action and therefore also in economic analysis.

This can be illustrated by this conversation between Homer and Marge in the Simpson's episode "Lisa's rival" where Homer had acquired a large amount of sugar and thereafter decided to stop going to his job at the nuclear power plant and instead start a career as a sugar salesman, a choice that Marge expressed strong disapproval of:

"Homer: And you didn't think I'd make any money. I found a dollar while I was waiting for the bus." [Homer triumphantly shows the one dollar bill he found for Marge]
Marge: While you were out earning that dollar, you lost forty dollars
by not going to work. "

So who was right, Homer or Marge? If you reject the concept of opportunity cost, you would have to say that Homer was right in his decision to sell sugar instead of working at the nuclear power plant. He did after all make a dollar.

But really, of course Marge was right. From a pure cash flow perspective, doing a job that earns you a dollar instead of one that makes you forty dollars, is in fact a choice that is associated with a thirty nine dollar cost. While that doesn't mean that Homer had a $39 negative income, it did mean that this choice cost him the additional thirty nine dollars he would have earned if he hadn't substituted his nuclear power plant job for his suger salesman job. Meaning that it was a bad choice unless Homer enjoyed that job task for a value of $39 or more relative to the job task he had at the nuclear power plant.

The concept of opportunity cost also has many important tasks with regards to economic analysis. A good example is the issue of why money demand is negatively correlated with the level of interest rate. Without the concept of opportunity cost there is no reason to expect that. But if you realize that holding cash and accounts that don't pay interest, has a opportunity cost compared to the alternative to investing it in interest bearing accounts, then you realize that because lower interest rates means a reduction in the opportunity cost of holding money, lower interest rates will increase money demand.

Reisman offers the following objection to the concept of opportunity cost: I
magine a person could spend $1 million buying stock A or stock B at $10 a share, and he decides to buy 100,000 shares of A. Next, stock A's price rises to $20 and stock B's to $30. If that person were not informed abou$t opportunity costs, he would think he had made $1 million. But, writes Reisman, "If one believes the opportunity-cost doctrine, this is grounds for leaping from the nearest skyscraper — one has lost a million dollars"

Well, if you still have $2 million I don't think financial problems justify suicide. That consideration doesn't justify rejection of the opportunity cost concept either. Warren Buffet for example lost, not just in the sense of missed opportunities, but in a very strict sense some $25 billion during 2008. But since he still had $37 billion, his financial problems clearly aren't a reason for suicide. Reisman's example really doesn't prove anything.

Clearly though, you would still regret the decision to invest in the stock that rose just 100% instead of the stock that rose 200%, similarly to how Warren Buffet presumably regrets the decisions that caused his $25 billion loss.

So, while opportunity cost may not be a cost in the sense that costs are represented in business accounting, it is a cost in a praxeological sense, which is to say in terms of how it affects human behavior. It is therefore a valid concept in economics.

Friday, May 29, 2009

Euro Area Money Supply Growth Reach New High

M1 growth in the euro area rose sharply in April, from 5.9% to 8.4%, with the 6 month rate being 9.1% and the 3 month rate being 11.9%. In August last year, it was as low as 0.2%, but the sharp interest rate cuts since then have made monetary conditions a lot more inflationary.

On the other hand, the consumer price inflation rate fell back to 0.0%. But that reflects the brief period of price deflation in late 2008, and is therefore as irrelevant as the high 12 month figures in August and September last year were for the short term outlook. The more forward looking commodity price markets are already seeing the effects of inflationary pumping by the ECB and other central banks.

Tuesday, May 26, 2009

Short & Long-Term Investing, Peter Schiff & Don Luskin.

Don Luskin quotes, shall we say selectively, from a Times article about his arch-enemy, Peter Schiff. Here is the part that Luskin quoted:

"...[Peter] Schiff's TV bookings are down 75% to 85%, says his younger brother Andrew, who handles p.r. for him. About the only things written about him lately have been negative--the result of financial blogger Michael (Mish) Shedlock's pointing out that Schiff's investment recommendations were money losers in 2008. How could a bear have managed to lose money last year?"

Here are the sentences that followed, that Luskin for some reason ignored:

"Schiff was blindsided when global investors piled into dollars and U.S. government bonds during last fall's panic. But that rush to safety has already abated, and over longer periods, Schiff's decade-old strategy of steering clients out of U.S. securities and into commodities and overseas stocks has been a big winner. His investment record surely can't be the reason for his fall from media grace."

Would anyone interested in being honest and sincere to his readers really have viewed these following sentences as being irrelevant? I think not, confirming again that Luskin is nothing but a con artist.

Schiff was wrong to assume that global stock markets would decouple from the U.S. stock market during the crash. Instead, as always before, other stock markets followed the U.S. stock market when it crashed. Indeed, most of them fell even more than the U.S. stock market. Many investors treat non-U.S. stock markets as high beta assets, meaning that during rallies they will rally more and during crashes they will crash more. So, when the U.S. stock market crashed, most other stock markets crashed even more.

But while his "divest from America" strategy for above mentioned technical reasons proved to be a loss making strategy during 2008 because it ignored these technical factors, it has in fact been a winning strategy during a longer period of time. Because while a high beta asset will fall in value more than other assets during bear markets, they will also rise more in value during bull markets. So, ironically, Schiff's investment strategy was a winner as long as his macroeconomic forecasts were wrong, but it was a loser when his macroeconomic forecasts were right. The reason for that is again that Schiff overlooked technical factors.

The reason why Schiff's strategy over longer periods of time has been better is that market valuations outside the U.S. have been lower.

So while Schiff was wrong about short term market timing (something he never claimed to master anyway) and the short term relationship between U.S. and foreign stock markets, he was nevertheless right about the right long term strategy and about the current economic bust. Which is more than you can say about Don Luskin, who as late as September 14,2008 (the day before the Lehman collapse) dismissed all talks of a recession and recommended buying stocks "with both hands" when the S&P 500 was trading at 1500.

[Note: the editor of this video clip has inserted assertions that it was recorded in June 2008, when in fact it was made in early July 2007, which is even worse for Luskin]

Friday, May 22, 2009

U.S. Treasury Yield Spike-Inflation Or Default Fear?

The U.S. dollar has in recent days depreciated significantly in value against most currencies, while yields on Treasury securities have spiked. The 10 year yield has increased to 3.45%, up from the December 18 2008 low of 2.08%. This has been attributed in the financial media to increased worries about the United States federal government losing its top AAA rating from rating agencies like Standard & Poor's and Moody's. Given the dismal track record of these rating agencies, I see no reason to care about that, but since some other people might care, it can't be ruled out that this could be a factor.

However, it seems that market fears are less about any potential formal default, than it is about increased fear of inflation. While the TIPS-nominal Treasury yield spread is not a perfect indicator of inflation expectations, it still gives you a fairly good picture of changes in inflation expectations most of the times.

In Monday, the nominal 10-year yield was 3.22%, while the 10-year TIPS yield was 1.66%, meaning that the spread was 156 basis points. Since then, the TIPS yield has barely budged, rising to just 1.67% when this is written (since yields constantly change in the markets, it might be slightly different when you read it), but the nominal yield has increased some 23 basis points to 3.45%, meaning that the spread has increased 22 basis points to 1.78%, the by far highest level in 2009.

The fact that the price of gold is again rising also confirms that inflationary expectations are rising.

Thursday, May 21, 2009

Arnold Should Have Sticked To Acting

Commenting on Obama's new proposal to prohibit Americans from buying the kind of cars they want, and instead only allow them to buy "greener" cars with less comfort and less safety (thousands of people more will likely die in traffic accidents each year as a result of these regulations), Arnold Schwarzenegger said:

"All of a sudden, the car manufacturers needed . . . the taxpayers' money, So in order to get that help, I'm sure that President Obama said: 'OK . . . here's what you need to do"

There are two comments which can be made about that. First, in what way does it make sense to increase costs further for companies that are already in trouble? Indeed, part of the reason for their problems is the costs that previous mileage standards imposed by the government have created.

And if receiving government money and being in financial troubles justifies being told what to do, doesn't that mean that California, who despite receiving huge hand-outs from the federal government is in a deep financial crisis, should be put under outside control?

But then again, the problem is that the federal government is now under control by people who wants to implement the same kind of high government spending and strict "green" regulation policies that have made California such an economic basket case. So federal control over California would likely mean no policy change. Meanwhile, Obama's copying of California's policies will make the rest of the country's economy just as messed up as California's.

Sunday, May 17, 2009

Latvia & The Issue Of Devaluation

Given the deep problems experienced by Latvia (and only to a slightly lower extent also Estonia), should it perhaps change course, drop the peg to the euro and/or reset the peg at a much lower exchange rate (which is to say, devalue)?

The short answer is that devaluation would probably reduce the short-term severity of the slump-but not by much and it would prolong the adjustment process.

To understand why that is so, we should first analyze the usual trade off between adjustment through devaluation and deflation for a country facing an economic downturn, and then also add the particular elements relevant for Latvia.

During an economic slump caused by a previous period of malinvestments, a need exists to adjust to more sound and sustainable patterns of spending. That can be achieved by a higher real interest rate (higher interest rates lowers demand for investment goods by increasing the cost of funding) and a lower real exchange rate (which makes investment goods more expensive).

A country which is part of a monetary union (or has a fixed exchange rate) will see its relative price inflation rate fall, something which given the equality of nominal interest rates and the unchanged nominal exchange rate will cause its real interest rates to increase and its real exchange rate to decline. Both of these effects makes it more profitable to reduce domestic investment spending and to instead invest money abroad.

By contrast, if a country has a floating exchange rate and the domestic central bank responds to the recession by cutting interest rates, this will lower the nominal exchange rate. The lower nominal exchange rate will in turn likely raise price inflation, but the real exchange rate will still likely fall significantly. Indeed, it will likely lower the real exchange rate a lot faster than through the deflationary way that the real exchange rate is reduced in a monetary union or under a fixed exchange rate policy. But while that price mechanism will adjust faster under a floating exchange rate policy, the interest rate adjustment will be prevented and counteract the adjustment. Instead of encouraging a shift from investment goods industries through higher real interest rates, the reduced real interest rates caused by both lower nominal interest rates and higher price inflation will discourage that adjustment.

With the exchange rate adjustment going faster with floating exchange rate but with the interest rate adjustment being prevented, does that mean that the overall result will be theoretically ambiguous? Yes, in terms of the effect on the symptom of the current account balance. But not in terms of the underlying adjustment to more sound structure of production.

The lower real interest rates and lower real exchange rate under a floating exchange rate system will mean that inefficient lines of production will be preserved to a greater extent, something which will mean a milder short term contraction (however, the reduced domestic purchasing power caused by the lower exchange rate will reduce the size of that relief). But this also means that the desired adjustment from sectors that depend on various forms of indirect subsidies (artificially lowered interest rates and exchange rates) to sectors that reflect people's preferences is counteracted, something which in the long term will lower real output.

Because the undervalued exchange rate will hit some foreign producers, it should be noted that some of the negative effects of the floating exchange rate system will hit foreigners, instead of the country with the undervalued exchange rate. That may mean that even if the undervalued exchange rate hasn't increased domestic growth, it may appear to do so because of the damage done to others, which in relative terms makes domestic growth look better. For example, even if the weak pound weakens the U.K. economy in absolute terms, it might still appear as if it is strengthening it if the weak pound inflicts even greater damage to Ireland and other euro area countries.

Generally speaking though, the choice is between the lower short term under floating exchange rates and the better long term outcome under fixed exchange rates.

For Latvia however, even the short term boost is not as clear as it is for Sweden, because of the high burden of euro denominated debt. If Latvia devalues, or "floats" (which is to say enabling it to sink)its currency, this will mean that the domestic currency value of that debt will soar, creating big problems for those Latvian households and companies that took those loans.

New York Times' Misleading Article On Norway's Oil Fund

New York Times has an extremely misleading article on Norway's soon to be ousted (the centre-right opposition parties leads big in the polls for the parliamentary elections in September this year) socialist government. Norway has since 2005 been led by a left-wing coalition of the Centre Party, the Labor Party and the Socialist Left Party. The Finance Minister is Kristin Halvorsen, leader of the Socialist Left Party.

The article contains many errors, but the perhaps most blatant one is the part about the Norwegian oil fund. One of the decisions Halvorsen made was to increase the equity stake in Norway's oil fund from 40% to 60%. In the New York Times article, this is presented as a smart move given the stock market rally of the last two months.

What is not mentioned is however is that this strategy was implemented already in early 2008, before the dramatic sell-off in global stock markets during late 2008 and early 2009. Stock prices are therefore even now far lower than when Halvorsen decided to invest more in stocks.

As a result, the Norwegian oil fund lost 23.3% of its value last year, or NOK 633 billion (roughly USD 100 billion). The decline in value is even greater if you only look at the equity part of the portfolio. Among the stock picks of the Norwegian oil fund were IndyMac ( NOK 2.3 billion lost), Lehman Brothers ( NOK 514 million lost), Bear Stearns ( NOK 200 million lost) and Washington Mutual ( NOK 168 million lost). Note that this 23.3% figure only refers to 2008, and that all of the gains since March were cancelled out by the losses from January to early March.

Since the oil fund has some equity positions to begin with, the oil fund would have lost a lot of money even without the policy change. But since the policy change increased equity holdings by 50%, a conservative estimate of the loss resulting from Halvorsen's decision would be NOK 211 billion. It's probably even higher given the opportunity cost from foregone bond interest earnings.

Yet despite these massive losses resulting from Halvorsen's decision, the New York Times tries to depict her as a smart investment strategist! It is difficult to get more misleading than that.

Saturday, May 16, 2009

Mining Activity Declines Dramatically

One largely unnoticed detail of Friday's industrial production report was that mining activity is now decreasing dramatically. "Industrial production" of course leads most people to think of manufacturing, but that is only one component (albeit the most important one). But in fact, "industrial production" also consists of mining and utilities (power production).

Of these 3 components, utilities have so far fared the best. Until a few months ago, mining also performed a lot better than manufacturing. But since November 2008, mining has declined by 9.1%, even more than the 7.8% drop in manufacturing. During the latest 3 months, the difference is even greater, 3.6% for manufacturing and 6.9% for mining.

This is of course a lagged effect of great commodity price sell-off in late 2008. While for example Copper is up more than 60% since its late 2008 low of $1.25 per pound, it is still about 50% lower than the peak of more than $4 per pound level that we saw a year ago. This means that the incentive for extracting copper and most other commodities is much smaller than a year ago. And for that reason, commodity producers are investing a lot less in new capacity, and in increasingly many cases, they don't even find it profitable to utilize all existing capacity.

That will have a distinctive stagflationary effect-it will lower growth while at the same time contributing to higher future price inflation.

Government As The Great Deflation Fighter

While the overall U.S. CPI stayed unchanged due to zealous use of seasonal adjustment (unadjusted it rose 0.2%), the so-called core index which some like rose 0.3%. No need to worry about inflation though, because fans of the core index at that point always come up with some "core core" index. What other item should be excluded so as to create a "core core" index varies of course depending on just what sub-item increases particularly much that particular month.

This month it was tobacco prices, which rose sharply, largely due to the federal tax increase implemented by Obama and his fellow Democrats, as well as some additional tax increases in some states (though actually the price rose even more than the average amount of the tax increases).

But since deflation is supposedly the big worry, and since the tax increase was so successful in raising tobacco prices, that means that some economists now see a new solution to deflation: raise taxes! Quote from the Wall Street Journal:

"Indeed, if deflation threats eventually do become more apparent, the Fed may have a solution on its hands. “Thank you Washington — along with postage, subway fares etc. — the government is a significant source of inflationary pressures,” said John Ryding and Conrad DeQuadros at RDQ Economics"

Indeed, government has long found ways to raise prices, in addition to the traditional method of printing money. From taxes to regulation to slaughtering cows to reduce milk production. That all of this means reduced consumer purchasing power is apparently irrelevant.

Friday, May 15, 2009

The Yuan As New Global Reserve Currency

Nouriel Roubini argues that in the future, the Chinese yuan (aka the renminbi) will be the new "reserve currency of the world". I made that prediction 4 years ago, and I still believe in it.

However, it will be several more years before we start seeing oil quoted in yuans instead of U.S. dollars. First of all, the Chinese must make the yuan fully convertible. Something they will likely do eventually, but it will probably not happen during the next few years. And secondly, China must overtake America in economic size, something which will take at least another decade.

But some time (not too many years) after 2020, China will establish itself as the dominant economic power. And by that time, the yuan/renminbi will probably be fully convertible- and then it will overtake the U.S. dollar as the "reserve currency of the world", just like the U.S. dollar once overtook the U.K. pound.

Thursday, May 14, 2009

Is Paul Krugman Saying He Is Evil?

OK, let's rewind the tape: left-wing Keynesian Paul Krugman calls right-wing Keynesian Greg Mankiw evil for doubting the Obama administration's shall we say optimistic growth forecast. Mankiw responded to the accusation of evil by challenging Krugman for a public bet, so as to enable Krugman to benefit from Mankiw's alleged wickedness. Krugman did not respond to that challenge.

Krugman is probably happy now that he didn't take that bet, since he now too says that growth will be slow. Given his own previous assertion that forecasts of a weak economy represents evil, doesn't this mean that Krugman has in effect declared himself evil?

Wednesday, May 13, 2009

Inventory Correction Far From Over

Because inventories made a large negative contribution to U.S. first quarter GDP, it is widely assumed that businesses will need to rebuild them, something which will supposedly create a recovery later in the year. The problem with this theory is that while inventories have been reduced, sales have fallen even more, causing the inventory to sales ratio to rise far above previous levels.

Because the contribution to GDP from inventiories reduction is counted in terms of the change the latest quarter compared to the change in the previous quarter ( the contribution is so to speak the second derivative (the change of the change), and not the first derivative(the actual change)) it is unlikely that inventories will continue to lower GDP as much as in the first quarter, and it is even possible that it will make a positive net contribution later this year. But given how high the current level of inventories is, further inventory reductions should be expected, meaning that there will not be a particularly large contribution to growth from inventories even later this year.

Tuesday, May 12, 2009

Latvia's Great Depression

And you thought that the Latvian GDP number (-10.5%) for Q4 2008 was bad. Well, that's nothing compared to the 18% decline in Q1 2009. There's a great risk that the Q2 number will be at least as bad.

The main reason for this depression is the sudden shift from a real money supply growth of about 30% during the boom years, to a contraction in real money supply of more than 20% in the year to March 2009. That reflects both a 17.8% nominal money supply contraction and a price inflation rate of 8.2%. Latvia's depression is thus a extreme but clear real life illustration of the Austrian business cycle theory

The price inflation rate fell back significantly in April, but it is still far too high at 6.2%. Latvia has adjusted more slowly than neighboring Estonia, which is why its depression will probably be both longer and deeper than Estonia's.

Saturday, May 09, 2009

P/E Ratio Now Higher Than A Year Ago

Here it is asserted that the decline in S&P 500 earnings by 36.3% is really good news, because it was supposedly higher than official analyst expectations, overlooking that the only reason for this was that these official expectations had been dramatically lowered just in time before the reports.

One way of looking at this is that because of the decline in earnings and the recent stock price rally, the P/E ratio is actually higher than a year ago. Yesterday, the S&P 500 closed at 929, while the close on May 9 2008 was 1388, a 33.1% decline. Which is to say, relative earnings, stocks are about 5% more expensive than a year ago. And earnings for Q1 2008 wern't exactly very impressive, nor were valuations low at that time.

Valuation levels look a lot more attractive if you look at the Graham P/E, which is calculated using the average level of profits during the latest 10 years, unlike the regular P/E which is only based on current earnings. As the "E" in the Graham P/E moves up and down a lot slower than the "E" in the regular P/E, stocks look less expensive using that method. The Graham P/E is currently at 16, roughly equal to the historical average, but way above the levels typically seen during deep cyclical slumps.

Estonian Inflation Falls Below Euro Area Average

Back in April 2008, the 12 month inflation rate in Estonia was as high as 11.6%, more than eight percentage points above the euro area average of 3.3%. Given the fact that Estonia pursued (and still pursues) a fixed exchange rate policy versus the euro, that was a very big difference.

Since then, the euro area average has gone down 2.7 percentage points to 0.6%, while Estonia has seen its inflation rate drop a full 11.3 percentage points to 0.3%in April 2009, so that for the first time its inflation rate is below the euro area average. It would have been even lower if it hadn't been for an 18.9% increase in alcohol and tobacco prices, something which is presumably due to a tax increase.

While the euro area inflation rate will probably not fall by much more (base effects means that it might fall some more, but the recent commodity price rally will limit this effect) before it starts rising again later this year, Estonia will probably see this trend continue until the inflation rate is well below zero.

The reason for this is that while money supply growth in the euro area remains firm, money supply growth in Estonia has been negative for some time now, and stood at -12.4% in March.

Thursday, May 07, 2009

American Consumers Haven't Become More Frugal

Via LRC I found this article by someone called Carol McMullen, which is very sloppy with facts, and therefore reaches very misleading conclusions.

Interestingly, it starts by quoting the one of the more relevant indicators of frugality, namely consumer spending as a share of GDP, but gets the numbers all wrong and then drops it.

"U.S. consumer spending rose from historical rates of about 65 percent of U.S. Gross Domestic Product (GDP – the total of goods and services produced annually in the U.S.) to 75 percent of GDP."

Actually, the post-World War II peak for consumer spending relative to GDP was 70.9% (reached in Q2 2008), a number way to low to be rounded up to 75%. The preliminary number for Q1 2009 is only marginally lower, 70.7%.

Not much of a shift in frugality, especially considering that direct government spending at the same time rose from 20.1% to 20.4%. Taking that into account, savings fell.

Later into the article, shares of GDP aren't mentioned, and instead the discussion shifts to discussing the household savings rate. Aside from getting even that number slightly wrong, that number is misleading for reasons I discussed here.

In the article, it is also asserted that "discretionary consumer spending" in America has been reduced by 30%. Since it is not specified what that is supposed to mean it is difficult to analyze it, but assuming she means car sales and certain other durable consumer goods, she may be right in one sense, but even more wrong with regard to the point she is trying to validate.

Cars and other durable consumer goods differ from other consumer goods (and consumer services) in that purchases of them do not represent only consumption. Since a car will last years, and to a very limited extent even decades (assuming you spend some money on repairing it), car purchases should arguably partially be seen as investments. And so, if purchases of cars and other durable consumer goods fall relative to purchases of non durable consumer goods and consumer services, then this means that savings are falling given a certain level of consumer spending to GDP.

Thus, just as was the case with Japan, the decline in U.S. consumption hasn't represented increased frugality, but declining income.

Business Cost Pressures Increasing

Though certain central banks acting today appears to have missed this, evidence is mounting that the temporary period of price deflation we saw late last year was indeed just temporary, as the prices of all forms of business inputs are increasing.

First of all, commodity price indexes have increased some 10-20% (depending on which index you look at) since their lows late last year, with key commodities like oil and copper leading the way with increases of more than 50%.

Secondly, unit labor costs (wages, salaries and other benefits adjusted for productivity) increases fast, up at an annual rate of 4.5% in the latest 6 months.

Now, businesses may perhaps choose to lower their margins further rather than raise consumer prices. But considering how margins have already been squeezed big time, there is little room for that. With margins already low, the probability increases that businesses will decide it is more profitable to raise prices than to reduce margins further.

Monday, May 04, 2009

Obama Tax Proposal Will Lower Stock Prices

Obama now pushes to end the possibility of U.S. based multinational companies to defer taxation of their foreign earnings, something which he claims is a "tax break for companies that shifts jobs overseas". An assertion which is not true, unless you define "tax break" as absence of double taxation. The earnings he refer to are already taxed in the countries where the operations are performed, but now Obama wants to tax them in the U.S. as well. As I wrote before:

"This kind of practice [The tax rules that Obama wants to do away with] exist almost everywhere as it otherwise would put a country's multinational companies at a great disadvantage, having to first pay corporate tax in the country it operates in, and then in the country where it is headquartered. This practice means first of all that foreign profits aren't taxed until it is repatriated to the country where the company is headquartered and secondly that a company can deduct taxes it has paid offshore so as to avoid double taxation. If that is what he means by "tax breaks that shift jobs overseas", then doing away with that would greatly damage American multinational corporations, and so also lower stock prices. This together with a proposed "tax credits" for companies that increase domestic operations relative to foreign might perhaps increase the willingness of American companies to move foreign production to America, but the main effect would be to simply damage the competitiveness of these companies as they are forced to choose production alternatives which are less competitive. And as they in effect amount to tariffs on products produced outside America by American companies, they will damage the global economy as a whole and the rest of the world."

And, as this Business Week story points out, a major effect of this will be to make many companies move their headquarters from other countries, where they won't face double taxation.

Most companies will however probably not move their headquarters, but as that will mean that they will have to pay a lot higher taxes or use less cost efficient solutions, this will mean that their net profits will fall, something which in turn will lower the fundamental value of stocks. And once the U.S. stock market experiences another Wile E. Coyote moment and realizes this, stock prices will fall.

Saturday, May 02, 2009

Scott Sumner On Nominal GDP & Austrian Theory

A reader has asked me to comment on the writings of a certain Scott Sumner. His writings are generally focused on making nominal GDP (NGDP), rather than some price index the target of monetary policy. Now, that is actually an improvement compared to inflation targeting, mainly for two reasons:

1) First, it recognizes that positive supply shocks do not reduce the ability of borrowers to repay debt, and vice versa for negative supply shocks, despite the fact that they create price deflation/inflation.

2) It suggests that positive supply shocks should not be met by more monetary inflation, and vice versa that negative supply shocks.

Related to these two facts is that in the long run, nominal GDP growth is likely to be more or less the same as money supply growth. So, while not being an Austrian, Sumner is actually closer to the Austrian analysis than the inflation targeting crowd.

But while being closer, he is not close enough to be an Austrian, or even a semi-Austrian, as should be apparent in this post where he poses 7 questions for Austrians:

"1. Why did NGDP collapse late last year?"

Well, that's a complex story, but mainly because money supply growth collapsed. Money supply grew rapidly after the Fed's initial series of rate cuts from September 2007 to March 2008. Then it fell first to and then below zero during the coming six months.

Another reason was that trouble began to surface elsewhere, for example in the U.K. and Spain, which prompted other central banks to lower interest rates, something which in turn caused the dollar to rally against most other currencies.

BTW: NGDP hasn't "collapsed", it has fallen only marginally ( 2.35% assuming we can the current estimates of Q3 2008 and Q1 2009 are correct). NGDP growth has however "collapsed" into negative territory, though it is likely to turn positive again soon.

"2. Could a suitably expansionary monetary policy have stopped NGDP from collapsing?"

Suitable is kind of a normative term, but if we reformulate that to sufficiently, and by that include also really radical moves (including for example if all else fails legalizing counterfeiting), then I suppose that it is true

"3. Wouldn’t Hayek have favored enough monetary expansion to keep NGDP from collapsing?"

I'm not a Hayek scholar, so I can't say for certain that he never anywhere in his writings endorsed that idea, but let's just say that until now, I've never heard anyone say that he did, and I can't remember that Hayek wrote that in any of the books and articles I've read.

"4. Hayek originally thought that the Depression was a needed corrective for the excesses and misallocations of the late 1920s. He later changed his mind and argued that the Fed should not have allowed NGDP to collapse. Was he right to change his mind?"

See below, but if he did change his mind, that is not important for me unless good arguments for it were presented from him (I don't believe in "arguments from authority").

"5. If monetary policy could not have prevented an NGDP collapse, what is your story? Is it the Keynesian liquidity trap? (I assume the answer is no.)"

This is basically a variant of question number two, and I there answered that with sufficiently radical moves, this probably could have been done. Though it couldn't have been done with any normal monetary policy action.

"6. If a suitably expansionary monetary policy could have prevented an NGDP collapse, should the Fed have tried to do this?"

No, since this would have prevented the necessary adjustments and would have required really radical moves.

"7. If the answer is no, why not? Wouldn’t that have prevented the collapse in manufacturing in Asia late last year? What is the structural imbalance corrected by having 10s of millions of Chinese lose jobs making stuff like shoes? (Presumably there was no shoe bubble.) Are Austrians worried about the U.S. trade deficit?"

Since the steep downturn in demand was unexpected by most manufacturers, and since adjustment takes time, this has of course created some short term pain. But ultimately, the status quo was not really sound for either Asia or America.

And for example China has already seen significant signs of a speedy adjustment of production for selling to the domestic market. Other Asian countries have not been so successful, but they probably will soon, and at any rate they will benefit from China's stronger economy.

He also asks:

"Do you agree with my view that the 1% (short term) interest rates of 2003 were a totally meaningless indicator of the stance of monetary policy?"

Actually no. This is kind of a complex subject, but in short, I agree that low nominal interest rates doesn't necessarily mean that monetary policy is inflationary, just as high nominal interest rates doesn't necessarily mean that monetary policy is not inflationary. Low nominal interest rates could instead indicate low inflationary expectations or a low time preference.

However, in this case it clearly did indicate that, as it was upheld by increases in money supply and foreign central bank purchases of U.S. securities., with the role of the former rising throughout the bubble. Some would perhaps argue that the former reflected the policy of foreign central banks as opposed to the Fed's. But while that is partially true, it overlooks that given the commitment by these foreign central banks to hold their exchange rate steady, the low interest rate imposed by the Fed provoked them into making these purchases (if interest rates had been higher, they wouldn't have had to purchase these U.S. securities to prevent their exchange rates from appreciating versus the USD).

U.S. Car Sales Near New Low

While the 12 month rate of decline is receding somewhat for GM and Ford car sales, that is mostly a base effect. Which is to say, April and March sales in 2008 were much weaker than January and February 2008, so the primary reason why sales are now falling at a 12 month rate of "only" about 30% (as compared to 40% in February) is that they are compared with a lower base. Meanwhile, for Chrysler and the Japanese car makers (except for Honda), not even the 12-month rates are improving. Toyota saw in fact its 12 month rate deteriorate further, to -42.3%. As a form of update to this post, Prius sales fell the most, a full 61.5%.

The total annualized rate of U.S. car salesfell to 9.32 million in April. While that is slightly higher than the 9.12 million in February, it is lower than the 9.86 million in March, and much lower than the 14.52 million in April 2008. Not to mention how much lower it is compared to the 16.8 million average level in the previous decade.