Monday, November 30, 2009

Steve Horwitz' Exaggerated Claim Of Things Getting Better

Steve Horwitz argues that things have become dramatically better since 1973. Indeed, judging by his table real wages have increased as much as 3,5 fold-at least (and Horwitz argues that the real improvement is bigger since it doesn't account for quality improvements).

But he fails to notice that all items that he lists are durable consumer goods. And durable consumer goods have had a big decline in their relative price. Between the first quarter of 1973 and the third quarter of 2009, the price index for durable consumer goods increased just 59% (even less if you exclude cars, which are not included in Horwitz' table). Meanwhile, however, nondurable consumer goods (like food and gasoline) increased 266% in price and the price of services (such as rent and health care services) increased 447% in price, causing the overall Personal Consumption deflator to increase 319%. And the personal consumption deflator has been adjusted for both quality improvements and price substitution (a principle which partly contradicts the former).

Adjusted for that 319% price increase, an increase in nominal wages from $4.12 to $18.72 represents a real wage increase of just 6.6%. Horwitz wage number doesn't entirely correspond to Q1 1973 and Q3 2009 averages, but adjusting for that would only increase the real wage gain to 8%-which is not much for 36 years. So what his table reflects is almost entirely the declining relative price for durable consumer goods (especially if you adjust for quality), not increasing real wages.

While I largely share Horwitz' conclusions of the potentials of human creativity, he is ignoring the negative factors that are holding back progress-such as Fed policy and other government interventions.

Sunday, November 29, 2009

Leftists Uncomfortable With Their Pro-Bailout Positions

Robert Reich (former Clinton Labor Secretary turned Obama supporter) is shocked that Wall Street bankers have used bailout money from the government to enrich themselves.

As if any sane observer expected them to do otherwise....

As for Reich's specific proposals to regain some of that money, well his proposal to let homeowners go to a bankruptcy judge and have them modify the mortgage is too vague too comment on,

As for repealing the repeal of "the Glass-Steagal act ", it should again be noted that no institution that were affected by that repeal had any disproportionate involvement with subprime mortgages. Instead, the institutions that were most involved in the debacle were insurance company AIG, mortgage institutions Fannie Mae and Freddie Mac and pure investment banks Bear Stearns and Lehman Brothers (and for that matter Goldman Sachs).

As for his third proposal of clawing back the $13 billion that Goldman Sachs gained from the government bailout of AIG, that's fine with me. But that would of course increase risk premiums again and undo much of the risk premium reducing effects that the bailouts intended to achieve.

Leftists like Robert Reich and Paul Krugman are obviously uncomfortable knowing that the bailouts they favored benefits rich but incompetent Wall Street bankers that in a pure free market economy would have gone bankrupt. But that hasn't caused them to disavow that pro-bailout position. Instead, they propose symbolic measures which will do little to impoverish rich Wall Street bankers, but will instead undo much of the desired effects of the bailouts and also create other negative effects.

Saturday, November 28, 2009

Ayn Rand-An Investment Genius?

Allen Barra at "the Daily Beast" calls Ayn Rand "a wicked witch" and says that she has given him the creeps since high school (presumably a long time ago).

After that he proceeds with a full-scale ad hominem (personal) attack, trying his best to use every alleged (real or made up)personal flaw of her to make her look as bad as possible. He however advances no real argument against her ideas, except that Alan Greenspan was responsible for the financial crisis, and Alan Greenspan used to be an associate of Rand, so this supposedly means that Rand's ideas caused the financial crisis.

That of course does not follow since Greenspan in practice abandondend Rand's ideas decades ago, and as Fed chairman he in fact implemented policies that were the opposite of the ones he advocated when he was associated with Rand.

Barra is so eager to attack Rand that he doesn't think through his attacks. The example most interesting to most readers is that Rand until her death in 1982 only saved in savings deposits and didn't invest in the stock market, something which according to Barra proved her ignorance. Except that during the last few years of Rand's life, stock markets were in a bear market (the through of the bear market was reached several months after Rand died), while interest rates were relatively high. So putting your money in a savings deposit while not investing anything in the stock market was in fact the smart thing to do. So if we are to judge her ideas on that basis, we would have to laud Rand.

Keynesianism & Asset Price Bubbles

I hinted in the last post that if the budget deficit had been larger in America, then the housing bubble wouldn't have been as big. I now see that the "Stumbling & Mumbling" blog has made a similar argument.

To state the argument in more explicit terms: The housing bubble was the result of too low interest rates, something which encouraged lending to the housing sector which fueled the housing bubble. While some observers have tried to blame Bush's deficit spending policies for the bubble, it may in fact have limited it. The reason for that is that budget deficits, all other things being equal, drives up interest rates, and also bids away resources to the receivers of deficit spending. Both of these mechanisms helped bid away resources from the housing sector and thus limited the bubble.

Now, budget deficits are bad too, so acknowledging this certainly doesn't mean that deficits are always net beneficial even during asset price bubbles. But it does mean that a deficit during a boom create a causal relationship which is countercyclical and limits asset price bubbles, which in turn means that the Keynesian aggregate demand analysis is not correct.

This is quite similar to the problem facing monetary policy. Standard Keynesian analysis says that the currency appreciation caused by higher interest rates will help policy makers contain booms. However which in turn will enable more imports while reducing exports, and so reduce savings and increase borrowing. That in turn will aggravate the imbalances associated with an inflationary boom. This will to a large extent counteract the stabilizing effect of higher interest rates and for really small countries like Iceland this effect could even be bigger. For bigger countries like the U.S. or the U.K., the interest rate effect will by contrast be larger, but even here the exchange rate effect will counteract part of the interest rate effect.

The common theme here is that the Keynesian analysis by focusing on the direct effect on aggregate demand misses the way in which government budget balances and exchange rates affect savings and investments, and that standard Keynesian policies for that reason are less effective or even counter-productive when it comes to stabilizing the business cycle.

Friday, November 27, 2009

Krugman & The Tobin Tax

Paul Krugman today comes out in favor of the Tobin tax. Krugman however wants to expand it beyond currency markets and in to all financial transactions.

He first quotes James Tobin's argument for the proposed tax named after him:

"Tobin argued that currency speculation — money moving internationally to bet on fluctuations in exchange rates — was having a disruptive effect on the world economy. To reduce these disruptions, he called for a small tax on every exchange of currencies.

Such a tax would be a trivial expense for people engaged in foreign trade or long-term investment; but it would be a major disincentive for people trying to make a fast buck (or euro, or yen) by outguessing the markets over the course of a few days or weeks. It would, as Tobin said, “throw some sand in the well-greased wheels” of speculation."

But first of all, while it is often true that currency speculation can be disruptive (that is a reason why the system of freely floating fiat national currencies isn't an ideal situation, despite Krugman's previous assertion to the contrary), that is not necessarily related to the kind of low return transactions that would be hit particularly hard by the Tobin tax. The transactions that would be particularly discouraged by a Tobin tax would be arbitrage type dealings trying to close discrepancies in pricing. Ending arbitrage trade would represent a big reduction economic efficiency.

And furthermore, by reducing trading volumes, slippage (the decrease/increase in price caused by an individual actor's sale/purchase, something which prevents the realization of potential gains through transactions) would increase, something which would produce non-trivial costs for people engaged in foreign trade and long-term investments.

Thus, problems with large exchange rate fluctuations are not the result of “speculation”, but are inherent in the nature of fluctuating currency exchange rates. Given that system however, short-term speculation is a force that reduces, and not aggravates the problem. This applies to short-term speculation in other markets too.

Later, Krugman, who again wants to apply the tax to other markets in addition to the currency markets argues against the objection that the tax wouldn't address the real problems, based on the specific effect it would have on the credit markets ( the below thus doesn't apply to other markets):

"What about the claim that a financial transactions tax doesn’t address the real problem? It’s true that a transactions tax wouldn’t have stopped lenders from making bad loans, or gullible investors from buying toxic waste backed by those loans.

But bad investments aren’t the whole story of the crisis. What turned those bad investments into catastrophe was the financial system’s excessive reliance on short-term money.

As Gary Gorton and Andrew Metrick of Yale have shown, by 2007 the United States banking system had become crucially dependent on “repo” transactions, in which financial institutions sell assets to investors while promising to buy them back after a short period — often a single day. Losses in subprime and other assets triggered a banking crisis because they undermined this system — there was a “run on repo.”"

But why would banks want to rely on such short-term financing? Wouldn't they all other things being equal want longer term financing so as to reduce the risk of becoming illiquid or be forced to pay higher interest rates? Yes, of course they would, so why would they want to borrow through repo transactions? The answer is that the Fed has systematically held down short-term rates, making it cheaper to borrow through repos and other form of short-term contracts, than through long term contracts.

And the reason why the Fed did that was that they on the advice of Keynesians like Krugman wanted to encourage borrowing -including subprime borrowing- in order to close a perceived "output gap", which is to say the very thing that Krugman now says he wants to discourage. The problem thus lies in the kind of inflationary Fed policies that Krugman has always recommended. And if the kind of tax that Krugman now argues for was imposed on bond markets it would have a deflationary effect.

Meaning that fiscal and monetary policy makers would given the current Keynesian paradigm of trying to close "output gaps" have to use other policies like even lower interest rates, unorthodox monetary policy measures or higher budget deficits that would produce the exact same kind of mess or some other form of mess (a higher budget deficit instead of a lower cost of capital would have meant a smaller housing bubble, but would have produced problems in the form of a structurally higher government deficit and therefore also a higher level of government debt).

And just like in other markets, such a tax would reduce arbitrage and increase slippage and thus produce even worse results than during the current system.

Thursday, November 26, 2009

Dubai Boom Turns Into Bust

Today when most Americans are busy eating turkeys, global markets was hit with news that Dubai, one of the seven emirates in the United Arab Emirates, now seems to be defaulting on its debt, rattling global markets.

Dubai has invested tens of billions of dollars in construction and other activities in a bid to lessen its dependence on oil exports. That may be an understandable ambition, yet as they are now learning, dependence on construction, finance and tourism financed by inflationary credit is not really any better.

They go through ups and downs just like the oil business, and in this case, the downturn in construction and finance (and to a lesser extent also tourism) came at around the same time as oil prices dropped, providing no meaningful diversification.

It is difficult to say with certainty at this point what the repercussions will be. The most likely scenario is that the damage will be largely limited to the Arab Middle East as most of Dubai's dealings are made according to the principles of Islamic finance (which non-Muslims have limited stakes in) and that the repercussions for the rest of the world will be limited. However, a small risk exists that the problems will spread through indirect mechanisms to the rest of the world.

Inflation Behind Bigger U.K. Contraction

Looking at the latest more detailed third quarter GDP reports from the U.K. and Germany, one can notice one interesting fact. They had nearly the same nominal GDP change in the year to the third quarter, namely -3.2% and -2.9%.

Yet because the domestic demand deflator rose only 0.2% in Germany and 1.8% in the U.K., the difference in the change in the real value of GDP was far greater, -3.1% versus -4.9%, meaning that the U.K. had a more severe recession because of higher inflation.

Wednesday, November 25, 2009

Russia, India Diversifying Away From USD & Euro

Russia's central bank announces that they will try to diversify its foreign currency holdings. Currently, most of it is in U.S. dollars (47%) and euros (41%) with the rest being in pounds (10%) and yen (2%). Apparently, they start including Canadian and Australian dollars. In principle that might be a good idea, although the timing may not be perfect (they would have gotten Canadian and particularly Australian dollars a lot cheaper last year). It is not clear at which currency's expense these new holdings will come, but it will probably mostly be at the expense of the two largest currencies, which is to say the U.S. dollar and the euro.

The Australian central bank will probably not object to this given their past statements, but the Canadian central bank will probably not be happy about this as they have already complained that they think the Canadian dollar is too strong. The question is what, if anything, the Bank of Canada will do to weaken the Canadian dollar.

Meanwhile, gold rose to yet another all time high (at least in U.S. dollar terms), partly as a result of rumors that the Indian central bank will buy even more gold. The price of gold has previously been suppressed by the IMF's planned gold sales, so the willingness of the Bank of India and others to absorb these gold sales with their own purchases is clearly bullish for gold. Bank of India seems to understand that diversifying among paper currencies is not enough, you need real values in the form of gold too as there is always a risk that central banks will inflate away the value of bonds. Being a central bank, that is something they should be and are aware of, though other central banks that don't buy or even sells gold seems to actually believe their own official image of being "inflation fighters".

Tuesday, November 24, 2009

Government Weakens Car Makers To Take Them Over

Henry Payne at the Planet Gore blog points out that federal mileage standards weakens Detroit auto companies relative to their competitors, something which provides an excuse for the government to take over them once government regulation have weakened them sufficiently in the name of the fraudulent "climate change" "science".

The Inexact Number Of 640,329

Caroline Baum notes that Obama, when asked about the dubious quality of the estimates of the number of jobs created or saved by his plan, replied "this is an inexact science".

For once, I agree with Obama. Estimating the exact number of net job gains or losses caused by a particular science is impossible, and involves a very large margin of error even for more rough estimates. But as Baum also notes, Obama's economists do not agree. They claim that exactly 640,329 jobs have been created or saved by the stimulus plan

This estimate of course comes from the same economists who before the stimulus plan was implemented said that without the stimulus, the unemployment rate would be 9% right now, whereas the actual number with the stimulus is 10.2%.

And the Keynesian models used for such estimates usually do not consider the various factors which reduce the effects of increased government spending, such as higher interest rates, higher prices or a higher trade deficit.

Price Inflation Recovering Fast

In July, the inflation rate reached a low of -2.1%. Since then, this number has increased to -0.2% in October as the deflation from July to October 2008 has been removed from the 12 month comparison and as consumer prices rose between July and October 2009. The big increase will however come in the two coming months.

Between October 2008 and December 2008, consumer price fell a seasonally adjusted 2.4% (before seasonal adjustment, the drop was 2.9%). This means that even if consumer prices are flat in seasonally adjusted terms, this would increase the inflation rate to 2.2%. Given a more plausible scenario where they increased 0.7% over two months (something which would require an unadjusted increase of just 0.1% each month), it would rise to 2.9%, above the 2% level that central banks target.

The euro area and most other economies can slso expect significant increases in their inflation rates though the increase will in in most cases be smaller because of the recent dollar weakness.

It could be noted that Mish and his followers have argued that the official CPI understates deflation because it uses "owner's equivalent rent" instead of house prices. I partially agree with that since it is house prices and not "owner's equivalent rent" that determines the cost of housing for home owners. However, Mish's calculations overstated this by first of all using the Case-Schiller index which likely overestimated house price declines as it only covered 20 cities, and not the larger number of smaller cities where the housing boom and bust was smaller and secondly because some of that price drop reflected reduced preference for ownership, something which means that the perceived value of owning dropped which in turn means that a quality adjustment would have reduced some of that drop.

The interesting here is that if you use house prices then the rise in inflation is even more significant (particularly if you ignore the two caveats I mentioned and use Mish's index in unaltered form), because for the fourth straight month in September, house prices have actually risen, causing the yearly drop to decline to the lowest level since late 2007. As the big monthly declines in late 2008 and early 2009 are gradually removed from the base in the 12 month rate of change, the yearly decline will drop fast in the coming months.

By contrast, the annual increase in "owner's equivalent rent" is dropping fast as it has been flat or falling for the last few months. As a result, inflation is recovering even faster using Mish's methodology.

For those of you who wonders how this acceleration in price inflation is consistent with the recent moderation in monetary inflation see here.

Monday, November 23, 2009

Government Fails-So We Need More Government?

Jeffrey Sachs points out that the U.S. government is dysfunctional, while also arguing that this dysfunctional government needs to expand its control over the economy....

Of course, he would presumably says that an ideal government would do this and that which would be so great. But even accepting for the sake of the argument that this ideal government would be so great, this overlooks that you must base your analysis on how things are, not some fictional utopia.

Just like it is invalid for free market advocates to claim that markets always work perfectly (they clearly won't, even in the absence of government interventions) , it is invalid to advocate government action on the basis that the government will act in a perfect and hyper-rational way, when we know that in the real world, government structures and government employees act in a very imperfect way. Calling for more government action will therefore be for more of that dysfunctional and imperfect government action.

Bank of Israel Raises Interest Rates Again

The Bank of Israel was the first to raise interest rates and is now the second (after the Reserve Bank of Australia) to raise it a second time.

Most analysts hadn't expected it, but given the relatively (compared to other countries) high Israeli growth rate and the increase in inflation the move is far from shocking. The Israeli economy will next year receive an additional boost from the Netanyahu governments planned personal and corporate income tax cuts.

With both inflation and growth accelerating and with short term interest rates still being only 1%, more interest rate increases from the Bank of Israel can be expected.

U.S. Activity Index At A Recessionary Level

The Chicago Fed national activity index fell to -1.08, its weakest level since June. The 3 month moving average also weakened, to -0.91.

According to the Chicago Fed, a 3 month moving average above -0.70 indicated the end of a recession. And while it did briefly rise slightly above that level in September (-0.67), it is now again at a recessionary level.

Foreign Ownership Increases Labor Productivity?

The Dutch statistics bureau reports that foreign owned companies (especially North American owned companies) in Holland has a lot higher labor productivity than Dutch owned companies. Does that mean that foreign ownership is what caused the higher productivity?

Well, the foreign ownership per se probably doesn't raise productivity unless you can find some reason why foreign capitalists are better than Dutch ones. However, the fact that these foreign companies that invests in Holland are (almost by definition) multi-national and usually large can explain it.

Larger companies with large factories benefit from economies of scale, something which helps increase efficiency. Many companies use Holland, which is part of the euro area and located in the center of Western Europe, as production center for the entire European market. This furthermore enables vertical specialization, something which also enhances efficiency.

Holland has some domestic owned companies of that sort of course, but most Dutch owned companies are small and focused on the domestic market, while most foreign owned companies are large multinational companies.

Sunday, November 22, 2009

George Will On Peak Oil

George Will provides an interesting perspective on the "peak oil" theory (though he doesn't use that term), pointing out that as early as 1914, imminent depletion of resources was predicted, something which has been repeated again and again after that, only to be followed by increased production and reserves. And as the cost of extraction falls, production capacity can continue to expand.

That however of course assumes that politicians won't interfere and prevent this increased production based on the shall we say increasingly shaky "global warming/climate change" theory" (See more on "climate gate" at the Save Capitalism blog). But that would not really be a case of "peak oil" but "peak politics".

More interesting reading on oil can be found here.

Saturday, November 21, 2009

What A Real Recovery Looks Like

The latest U.S. recovery has been a really strange on. Except for stock prices and the headline GDP and industrial production numbers, almost no numbers have indicated recovery. Real wages, employment, real disposable income, tax revenues and (probably, first numbers for that are released next week) real national income are all falling.

It would be instructive then to outline what a real recovery would look like. The 1983-84 recovery provides a real good example. Like the current recovery it was preceded by a deep recession, but the recovery had a very different character. Between the fourth quarter of 1982 and the fourth quarter of 1984 we saw the following:

The GDP volume rose by 13.7% (6.6% at an annual rate)
terms of trade adjusted GDP rose by 14.5% (7% at an annual rate and real disposable income excluding transfer payments rose by 12.5% (6.1% at an annual rate).

Real national income rose by 16.2% (7.8% at an annual rate) reflecting a gain in real corporate profits by 49.3% (22.2% at annual rate), and an increase real labor income (aka "compensation of employees") by 11.6% (5.7% at an annual rate)

The latest number reflected both an increase in the number of jobs by 7.3 million or 8.3% (which given the size of the current labor force would be more than 10 million new jobs in just 2 years) and an increase in real average weekly earnings by 2.6%. Note that almost all of these new jobs were in the private sector and that private sector employment rose as much as 10% in 2 years. As result, the unemployment rate dropped from 10.8% in December 1982 to 7.3% in December 1984 despite a significant increase in the size of the labor force.

And despite the fact that there were net tax cuts, real federal tax revenues rose by 5.9%.

(As a technical note, I deflated all the above numbers except volume GDP and of course the employment and unemployment numbers with the gross domestic purchases deflator to make the real numbers comparable)

Now that's a real recovery. Before we can start talking about a recovery worth mentioning we should see numbers which are, if not quite as strong as during the extremely robust 1983-84 boom (matching that is pretty tough), but at least as consistently showing positive growth.

Friday, November 20, 2009

Clarification On Carry Trade

In my theoretical reasoning regarding why carry trade is in fact profitable, I argued for it from the perspective of the text book scenario on why uncovered carry trade can't be profitable. Namely, because traders knowing about the interest rate differential will trade up the value of the currency with higher interest rates to such a high level that it can be expected that the currency will depreciate in the future enough to make the difference in exchange rate adjusted return disappear.

Since that is the scenario usually presented in international economics textbooks and classes, I still think it was right of me to focus on that. However, in hindsight I think I should have also clarified that the incompatibility of the purchasing power parity theory and the uncovered interest parity theory in a world where real interest rates differ does not depend on the initial adjustment taking place.

Assuming that the initial adjustment process, where the exchange rate of the high interest rate currency initially becomes overvalued from a goods market perspective, initiates, then the increased demand for goods from low interest rate countries will also increase the demand for their currencies, thus preventing the full initial appreciation of high interest rate currencies needed to create the expectation of future depreciation of high interest rate currencies needed to equalize return.

Suppose however, that no initial adjustment takes place, can the incompatibility of the purchasing power parity theory and the uncovered interest parity theory still be relevant? Yes, because in order for return to be equal, countries with higher real interest rates must still see their currencies depreciate in real terms. If the high interest rate currency wasn't overvalued to begin with, this means that it will become more and more undervalued as the years pass by. As a result, demand for goods in high interest rate countries will increase as the years pass by, which also means that demand for that currency gradually increases. That in turn will prevent or at least limit the gradual depreciation needed to equalize return.

This clarification has little theoretical importance except in one aspect, namely that it doesn't necessarily mean that high interest rate countries will empirically see net exports decline (see trade deficit increase or trade surplus drop). If the initial adjustment does not take place, it could in fact mean that net exports increases.

Thursday, November 19, 2009

New Zealand To Propose Fiscal Austerity To Reduce Trade Deficit?

A reader asked me to comment on this article in the New Zealand Herald. Some economists at the Treasury in New Zealand argues that if New Zealand would tighten fiscal policy this would lower interest rates, something which in turn would weaken the exchange rate something which in turn would reduce the trade deficit in New Zealand.

They are right insofar that fiscal austerity will indeed reduce interest rates and also reduce the trade deficit in New Zealand. The reduction in the trade deficit will be lower than the reduction in the budget deficit (it is not so to speak any "identical twin deficit relationship"), but it will clearly reduce the trade deficit.

That reduction will because of New Zealand's floating exchange rate system in part be the result of the lower exchange rate of the New Zealand dollar caused by lower interest rates. "Autonomous" shifts in interest rates will have a more ambigous effect on the trade deficit, but a reduction caused by higher government savings will unambigously reduce the deficit.

However, while their theoretical predictions are basically correct, the terms used indicate that they probably exaggerate the net value of these effects for New Zealand.

The reader indicated that he wanted to know the investment implications of this. Well, such a move will likely reduce real interest rates something which as I explained in the previous post makes investments in New Zealand dollar denominated securities somewhat less attractive. However, New Zealand has had higher interest rates before even during times of budget surpluses and they will likely continue to have structurally higher real interest rates, even if the proposed strategy is implemented.

Why Carry Trade Is Profitable In The Long Term

I have hinted or mentioned explicitly several times before (for example here, here and here), high interest rate currencies tend to give a higher return than low interest rate currencies. I will now elaborate on this issue.

In my own compilation of returns for investors (based on 3-month interest rate data from the OECD web site and exchange rate data from the Federal Reserve web site) in the 25 year period between 1984 and 2008 (more strictly between December 31, 1983 and December 31, 2008), investors in the three highest yielding developed countries, New Zealand, the U.K. and Australia got a cumulative return of 885% (9.6% per year), 525% (7.6% per year) and 488% (7.3% per year). By contrast, investments in the three lowest yielding developed countries, Japan, Switzerland and the United States gave the far more lackluster cumulative returns of 371% (6.4% per year), 376% (6.4% per year) and 264% (5.3% per year).

The carry trade strategy of investing in high interest rates countries while not investing (or even borrowing) in low interest rates countries yielded even better results if portfolios shifted each years depending on which countries had high interest rates that year (United States for example had relatively high interest rates in the late 1990s, but had low interest rates after the Internet stock bubble ended). In that case, the average return of the high interest rate countries was a cumulative 795% (9.2% per year) while the average return of the low interest rate countries was just 285 %( 5.5% per year).

Since the currencies of the two countries with highest interest rates among developed countries right now, Australia and New Zealand, has appreciated dramatically this year, the results will probably be even clearer when data from this year is included.

According to the uncovered interest rate parity model taught by universities in international economics classes, these differentials shouldn't exist. But they do, meaning that the model is at least partially false.

The reason for why it is not true is that as I pointed out here, it is not consistent with the purchasing power parity model in a world where real interest rates differ. Remember, exchange rates are determined based both on goods market transactions (which the purchasing power parity model deals with) and asset market transaction (which the uncovered interest rate parity model deals with), and if high interest rate currencies become initially overvalued in goods market terms in accordance with the scenario necessary for the uncovered interest rate, then demand for goods produced there will fall, preventing the currency from rising sufficiently in value for uncovered interest rate parity to hold.

Today's international economics classes fails to integrate theories related to goods markets and capital markets, even though both are involved in determining exchange rates in the real world.

To illustrate these abstract theories with a specific example, assume for example that Australia and Japan have nominal interest rates of 6% and 2% respectively, and assume that inflation in Australia is 2% and 0% in Japan. In order for interest parity to hold, the Australian dollar must on average depreciate by nearly 4% per year against the yen. Since there is a 2% inflation differential, the real depreciation of the Australian dollar has to be 2% per year. To create the expectation of such depreciation, the Australian dollar must now become at least 22% overvalued in terms of the goods market equilibrium. But if the Australian dollar started to become that overvalued then demand for Australian goods, and the Australian dollars needed to buy them, would drop, preventing the necessary Australian dollar appreciation. The initial shift in capital market demand for Australian dollars needed to create the conditions that would make the uncovered interest rate parity theory true will then to some extent be counteracted by goods market actions. As a result, the long term return for investors in countries with high (real) interest rates will be higher than in countries with low (real) interest rates.

Note however that in case high interest rates simply reflects high inflation, then it will not give you a high return, as people who invested in securities denominated in for example Icelandic krona and Zimbabwean dollar are painfully aware of.

And also note that the strategy is not entirely risk free in the short term. Some years, like in 2008, the carry trade strategy will inflict losses on those who follow it. But other years (like likely 2009) the return will be extraordinarily good, and if you have a more long term perspective it will generate higher returns for you.

Coincident Indicators Drop Again

While this is near universally ignored by the financial media who only look at the leading indicator index, the coincident indicator index dropped again, albeit only slightly, for the second month in a row.

The coincident index is made up of nonfarm payrolls, real disposable income excluding transfer payments, real business sales and industrial production. When determining how the economy doing right now, the coincident index is the one to look at. And with the coincident indicator index dropping, the strength of the so-called recovery can again be called into question.

Note however that the Conference Board who compiled the index probably understimated the declie. Only nonfarm payrolls and industrial production are yet known, so they have to impute the values for real disposable income excluding transfer payments and real business sales, something they do with an "autoregressive" model. That model has however severe limitations as it doesn't uses common sense analysis of data which can indicate that value (such as CPI and the employment report), but instead analyses past values to estimate current values. As such it often fails, like it did last month when the model predicted an increase in real disposable income excluding transfer payments, while in reality it decreased. Now it again predicts an increase (even with that estimate the overall index still dropped because of the big decrease in nonfarm payrolls), even though labor market data indicates another decrease.

Wednesday, November 18, 2009

Paul Krugman On Chinese Currency Policy

Before I continue, I should immediately say (to pre-empt misunderstandings) that I think China should make the yuan stronger. Not however, for the reasons most pundits argue but rather because China needs to rein in the obvious inflationary excesses of their current boom, and currency appreciation would be one way of achieving that.

And furthermore, yuan appreciation would reduce the political pressure for barriers against Chinese imports.

However, the arguments used by many pundits to argue for Chinese currency appreciation are very misleading and dangerous. Case in point is Paul Krugman's latest column. Almost all of his columns and blog posts contain errors, and I don't have the time or will to try to correct them all. But the latest one was unusually misleading even for being Krugman.

First he writes:

"Some background: Most of the world’s major currencies “float” against one another. That is, their relative values move up or down depending on market forces. That doesn’t necessarily mean that governments pursue pure hands-off policies: countries sometimes limit capital outflows when there’s a run on their currency (as Iceland did last year) or take steps to discourage hot-money inflows when they fear that speculators love their economies not wisely but too well (which is what Brazil is doing right now). But these days most nations try to keep the value of their currency in line with long-term economic fundamentals.

China is the great exception."

First of all, while it is true that today, most major currencies float against each other, quite a lot of countries throughout the world pegs their currency against other currencies (Usually the U.S. dollar or the euro), including for example Hong Kong, Saudi Arabia and a lot of European countries. And during many periods in world history, for example during the classical gold standard or during the Bretton-Woods system, fixed exchange rates have been the rule. Fixed exchange rates are in other words definitely not something the Chinese just came up with, it was the standard system for most of the time since start of the Industrial Revolution.

And since exchange rates aren't affected by just direct measures to affect the exchange rates, but also by for example interest rate policy, floating exchange rates aren't really market based. Only a pure gold (or other commodity) based currency can be entirely market based.

Nor are they ruled by "economic fundamentals" (whatever that is supposed to mean), as is evident by for example the fact that weak economic reports in America usually leads to a stronger dollar (and that stronger reports usually leads to a weaker dollar).

Furthermore, while the yuan may be pegged to the U.S. dollar, it has in fact been floating against all other currencies (well, except others that are pegged to the USD) in the exact same way as the USD. The yuan appreciated dramatically late last year and early this year against most currencies, and has since depreciated against most currencies.

Moving on to the next paragraph:

"And in recent months China has carried out what amounts to a beggar-thy-neighbor devaluation, keeping the yuan-dollar exchange rate fixed even as the dollar has fallen sharply against other major currencies. This has given Chinese exporters a growing competitive advantage over their rivals, especially producers in other developing countries.

What makes China’s currency policy especially problematic is the depressed state of the world economy. Cheap money and fiscal stimulus seem to have averted a second Great Depression. But policy makers haven’t been able to generate enough spending, public or private, to make progress against mass unemployment. And China’s weak-currency policy exacerbates the problem, in effect siphoning much-needed demand away from the rest of the world into the pockets of artificially competitive Chinese exporters."

What Krugman overlooks is first of all that the dollar, and also the yuan, is still generally stronger than when China ended the yuan's appreciation against the dollar, meaning that compared to the beginning of that policy shift, the yuan has appreciated against most currencies.

And secondly, and more importantly, because the dollar and the yuan have moved up and down in the same way, any accusation against China holds for the United States as well. If China has pursued a "beggar-thy-neighbor devaluation" policy then so has the United States.

Krugman later discusses the recent increase in the trade deficit:

" Looking forward, we can expect to see both China’s trade surplus and America’s trade deficit surge.

That, at any rate, is the argument made in a new paper by Richard Baldwin and Daria Taglioni of the Graduate Institute, Geneva. As they note, trade imbalances, both China’s surplus and America’s deficit, have recently been much smaller than they were a few years ago. But, they argue, “these global imbalance improvements are mostly illusory — the transitory side effect of the greatest trade collapse the world has ever seen.”

Indeed, the 2008-9 plunge in world trade was one for the record books. What it mainly reflected was the fact that modern trade is dominated by sales of durable manufactured goods — and in the face of severe financial crisis and its attendant uncertainty, both consumers and corporations postponed purchases of anything that wasn’t needed immediately. How did this reduce the U.S. trade deficit? Imports of goods like automobiles collapsed; so did some U.S. exports; but because we came into the crisis importing much more than we exported, the net effect was a smaller trade gap.

But with the financial crisis abating, this process is going into reverse. Last week’s U.S. trade report showed a sharp increase in the trade deficit between August and September. And there will be many more reports along those lines."

Krugman tries to imply that the great drop in the trade deficit was simply a matter of falling trade volumes, but that is not true. Between May 2008 and May 2009 (the month with the lowest trade deficit) exports dropped 21% and imports 31%. The truth is that the drop in the trade deficit reflected the sharp drop in domestic demand.

And similarly, the increase in the trade deficit since then reflects largely the effect of the so-called "stimulus package". While Krugman's Keynesian models won't recognize that fiscal stimulus will reduce net exports (meaning increase trade deficits in the case of America), that is what happens in the real world, reducing the so-called "fiscal multipliers" significantly below the fantasy levels indicated by Keynesian models. And in case you wonder, trade barriers wouldn't really improve thse "fiscal multipliers" because while it would reduce the trade deficit increasing effect, it would on the other hand increase the price increasing effect.

So, while a stronger yuan would be in China's best interest because it would contain domestic inflation and foreign protectionism, it wouldn't help improve the American economy or job market.

Housing Starts, Real Wages Drops

Two data was published today that confirmed that the U.S. economic recovery is anything but robust.

First, housing starts and to a lesser extent building permits dropped sharply in October, indicating that the big increase in residential construction in the third quarter was only temporary.

Secondly, the seasonally adjusted consumer price index increased more than 0.3% in October. As a result, real wages dropped slightly. Combined with the drop in employment, this means that aggregate real labor income (and therefore probably also the key coincident indicator real disposable income excluding transfer payments) fell in October.

Considering that rents fell slightly again (probably because of the mechanism discussed here), a 0.3% increase in the CPI is incidentally particularly significant and indicates a stagflationary trend.

Tuesday, November 17, 2009

How "Stimulus" Increases Unemployment

Alan Reynolds explains it here. Note how Obama economic advisor Larry Summer's previous writings are used against the policies of the Obama administration, just as in the issue of whether a health insurance mandate should be considered a tax [increase].

U.S. Industrial Capacity Drops

U.S. Industrial production rose 0.1% in October, far less than most economists had expected, following 3 months of more solid gains. Manufacturing alone declined, as did mining, but that was more than compensated by gains in utilities (electricity) production).

One detail that no one, as far as I know, in the financial press has discussed is that in recent months industrial capacity has dropped. The drop is biggest in manufacturing but can also be seen in mining (utilities capacity is still growing, but at a slower rate than last year) As a result, capacity utilization has increased faster than production.

In October 2008, manufacturing capacity was up by 1.8% while mining capacity was up 0.7%. In recent months however, these numbers have turned negative, and in October 2009, manufacturing capacity had dropped 1% while mining capacity was down 0.6%.

These annual declines will likely be even greater in coming months since first of all the level of business investment is low and secondly because much of the current capacity reflects previous malinvestments and can only produce products which people don't demand any more. As that capacity is written off, official industrial capacity will decline further.

Falling industrial capacity will have a stagflationary effect on the economy as it will both limit production and increase the willingness of remaining producers to raise prices as potential supply and therefore also potential competition is reduced.

European Rebalancing Continues

The Euro area trade surplus was €3.7 billion in September 2009, compared to a €6.0 billion deficit in September 2008.

This happened despite the fact that Germany saw its surplus drop to €10.6 billion in September 2009, down from €15.3 billion in September 2008.

This means that the deficit for the rest of the Euro area dropped from €21.3 billion in September 2008 to just €6.9 billion in September 2009. As other surplus nations like Holland, Austria and Finland also saw their surpluses drop, this reflects a really big reduction in the trade deficits of countries like France, Italy, Spain, Portugal and Greece.

Monday, November 16, 2009

Not So Strong Japanese Recovery

The Japanese Cabinet Office today reported higher than expected quarterly real GDP growth of 4.8% at an annual rate in Japan, something which contributed to the global stock rally today.

Yet they also reported that nominal GDP growth was -0.3% at annual rate, meaning that the 4.8% real growth number assumed deflation as high as 5.1% at an annual rate. While the general price level arguably is falling in Japan, it is not plausible that it dropped that much between the second and third quarter. Indeed, the domestic demand deflator reported only 1.3% deflation, meaning that terms of trade adjusted GDP rose just 1% at an annual rate. This number is roughly in line with the 0.8% reported increase in gross domestic income.

In previous quarters, the terms of trade factor caused the decline in GDP to be exaggerated, and that is in fact also true for the four quarter (one year) change. But while output in Japan never dropped as much as headline GDP numbers suggested, the current recovery is also a lot weaker than the headline GDP number suggest.

Irish CPI Lower Than 2 Years Ago

October inflation data for all EU countries except the UK was released today by Eurostat. Some of the information had already been released or hinted by national statistics offices (such as the dramatic Baltic disinflation), but some interesting information still came out.

One such fact was that Ireland now has lower consumer prices than 2 years ago. In October 2008, its inflation rate was 2.7% while in October 2009 it was -2.8%, meaning that Ireland is the only European country (and except for maybe Japan (whose October numbers aren't yet available), the only country anywhere) to have lower consumer prices than 2 years ago. By contrast, the average inflation for the EU was 3.7% in October 2008 and 0.5% in October 2009, and for the Euro area the numbers were 3.2% and -0.1%, meaning that consumer prices rose 4.2% over 2 years in the EU and 3.1% in the euro area.

Bush Warns Of Policies He Implemented

George W. Bush warns of the danger posed by increased government intervention. A bit too late for that insight, given the increases in government spending he presided over, and given how the TARP programme he created is what has allowed Obama to take over much of the financial sector and auto industry. In the latter case, Bush gave GM and Chrysler money from TARP so that they could avoid bankruptcy until Obama became president, despite strong opposition from Congressional Republicans and the fact that TARP was never intended for auto companies. Ultimately GM and Chrysler went bankrupt anyway, but instead of the normal bankruptcy (which would have meant a reconstruction, not a liquidation) they would have gotten if they went bankrupt before Obama's presidency they came under the control of Obama and the unions. Bush is thus partly responsible for large parts of Obama’s destructive agenda.

Sunday, November 15, 2009

Paul Krugman-Master In Disparate Activities

Steve Landsburg summarizes Paul Krugman's achievements in the following way:

"It’s always impressive to see one person excel in two widely disparate activities: a first-rate mathematician who’s also a world class mountaineer, or a titan of industry who conducts symphony orchestras on the side. But sometimes I think Paul Krugman is out to top them all, by excelling in two activities that are not just disparate but diametrically opposed: economics (for which he was awarded a well-deserved Nobel Prize) and obliviousness to the lessons of economics (for which he’s been awarded a column at the New York Times)."

Saturday, November 14, 2009

Exchange Rates & Trade Balances

The U.S. trade deficit rose sharply in September, and for the third quarter as a while. Because the deficit was higher than the Bureau of Economic Analysis had assumed in its first estimate, third quarter GDP will likely be revised down from the unrealistically high first estimate.

One interesting pattern is that the trade deficit climbs after a period of dollar weakness, and furthermore that the big drop in the deficit late last year and earlier this year came after a dollar rally. How could this be true?

Jim Jelter at Marketwatch explains it with oil, and that would indeed explain a lot since the drop in the deficit followed a drop in oil prices and the increase in the deficit.

However, the non-petroleum deficit also fell sharply late last year and early this year (from $37 billion in September 2008 to $20 billion in June 2009) and has since then increased again (to $26 billion in September 2009). So it is not simply oil.

There are in fact three explanations for this. One is the J curve effect. In the long run, a lower real exchange rate will, other things being equal, increase net exports, which in the case of the United States mean a smaller trade deficit. However, in the short run, it could actually lower net exports (the initial downward slope of J). The reason for that is that a weaker dollar will raise import price, and usually raise them more than export prices while at the same time much of the contracts have already been signed, meaning that volumes will in the short term not be affected very much. And as the price of imported goods rise while volumes in the short run is basically unchanged, this means that in the short run the cost of imports will rise, increasing the trade deficit. In the long run, when volumes have adjusted to the price changes, the deficit will fall, but in the short run it could actually increase.

Oil is one example of this, as the dollar price of oil is very sensitive to dollar movements, but it is not the only one.

Another explanation is that things need not be equal. And things like the "cash for clunkers scheme" and other parts of the stimulus package have helped increase the deficit.

And the third explanation is that while an "autonomous" (caused by other factors than the trade deficit) weakening of the dollar will at least in the long run cause the deficit to decline, an "autonomous" (caused by other factors than the dollar) increase in the trade deficit will cause the dollar to drop. If for American due to "cash for clunkers" demand more Japanese and Korean cars, this will increase demand for foreign currencies and therefore lower the dollar's exchange rate.

Because of the latest factor, there is actually no necessary empirical correlation between the dollar's exchange rate and the trade deficit. The positive causal relationship that the dollar's exchange rate has on the trade deficit is counteracted by the negative causal relationship that the trade deficit has on the dollar's exchange rate. In some cases the former will have a greater influence than the latter and in other cases the latter will have a greater influence than the former, but none of them will always have a greater influence. Which will have greater influence depends on the circumstances. And usually (including now) they will to some extent cancel each other out, limiting the empirical net effect.

Friday, November 13, 2009

Krugman On World War II multipliers

As a follow-up to this post, Paul Krugman has as stated earlier repeatedly argued that the experience of World War II proves the benefits of massive government spending. Not necessarily on the military, but spending of any kind.

However, while reported GDP did rise significantly, the fact is that private sector spending fell sharply during that period-following a period when it grew fast (And the official numbers probably gave a too rosy picture since price con. The drop in private spending has led for example Robert Barro to argue that the fiscal policy multiplier* is less than 1.

Krugman here argues against this in the following way:

"Well, the chart below, drawn from Millennial Historical Statistics, shows spending on new homes and cars before, during, and after the war years. Both basically collapsed. Why?

The answer is that (1) There were draconian building restrictions in effect — in fact, the end of those restrictions helped set off the postwar housing boom, and (2) new cars weren’t being produced, because the factories were making tanks instead (and if you did manage to acquire a car somehow, gasoline was rationed)."

But regarding 2), the use of factories to produce tanks instead of cars is in fact a perfect example of the "crowding out" that Krugman denies. And the rationing of gasoline wasn't something the government implemented just for fun. They implemented it because they needed it for the U.S. war machine, again a perfect example of "crowding out".

And as for building restrictions, why were they implemented? Again, hardly for fun. Instead the purpose was clearly to ensure that home builders didn't bid up the price of and so divert the raw materials needed to build houses, and that was also needed in the U.S. war effort. The building restriction were in fact a form of rationing of the resources that could be used for both purposes. That too is a good example of "crowding out" in action.

Krugman would perhaps respond to this by arguing that if the government had simply increased spending and not rationed certain goods, then the crowding out wouldn't have occurred. That is however not true as the example of car production illustrates. The reason for that is that then the market's "rationing system", prices, would have kicked in, and either crowded out private spending or limited the ability of the government to use the resources in its war effort.

This doesn't necessarily mean that fiscal stimulus can never increase GDP. Under the right circumstances and done in the right way, it can do so in the short run and sometimes even in the long run. However, in almost all cases (especially when it doesn't involve reduction of marginal tax rates) it will in fact crowd out other spending, as was clearly the case during World War II. And sometimes the stimulus can crowd out so much private activity that it causes GDP to fall.

*=For those of you who didn't know it, the fiscal policy multiplier is sort of the Keynesian version of the Laffer Curve. It is the increase in GDP caused by fiscal expansion divided by the amount of fiscal expansion. If the multiplier is less than 1 this means that some crowding out of other activities occur.

Thursday, November 12, 2009

Australian Job Growth Continues

Australian employment growth continued in October, with the number of new jobs being 24,500, the equivalent of roughly 340,000 in the U.S. Together with last months gains, this means that the slight loss in jobs in earlier months has been fully recovered and that overall employment reached a new record high of 10.83 million.

Unemployment still increased slightly, but that was due to a big increase in the work force. Australia has an unusually high rate of population growth (2% per year) so employment must grow by about 18,000 per month just to accomodate the growing population, and this month the participation rate also increased.

This report increases the probability that the Reserve Bank of Australia (RBA) will again increase interest rates. The 32% appreciation of the Australian dollar relative to the U.S. dollar this year will on the other hand make the RBA more reluctant to hike interest rates.

Israeli Exports Rise

Israel was the first country to raise interest rates after the financial crisis, and it now appears to be the first to register positive annual export growth. Exports rose 5.4% in the year to October while imports fell 25%, resulting in the first Israeli trade surplus in recorded history. The drop in the cost of imports was largely the result of cheaper oil.

The Israeli economy was one of the few that had positive growth in the second quarter, and judging by these trade numbers and other numbers, growth has probably increased even more since then.

Leftist Claims Government Spending Reduces Growth

Leftists tend to have big contradictions in their world views. They think taxes on carbon emissions and tobacco are good, because they think we should reduce carbon emissions and smoking, but fail to notice that by this logic taxes on investments and work efforts reduce productive activities.

Now Dean Baker argues that military spending will reduce economic growth, a theory which contradicts fellow leftist Paul Krugman's view that military spending during World War II is what took us out of the Depression. This is how Baker explains his theory:

"defense spending means that the government is pulling away resources from the uses determined by the market and instead using them to buy weapons and supplies and to pay for soldiers and other military personnel. In standard economic models, defense spending is a direct drain on the economy, reducing efficiency, slowing growth and costing jobs."

I have no objections to what he says here, but it is interesting that he fails to notice that this logic applies to all forms of government spending, not just the military. And yet Baker has been a consistent advocate of increased government spending in all other areas.

Wednesday, November 11, 2009

Paul Krugman & Scott Sumner Should Favor Ron Paul Bill

There has recently been a spat between Paul Krugman and Scott Sumner over the effectiveness of monetary policy under current conditions (Krugman never mentions Sumner's name, but it is likely that he in his posts on the subject is referring to him). Both agree on the need for more inflation, but they disagree on how to achieve it. While arguing that Fed policy should be as inflationary as possible, Krugman believes that because of the zero bound for interest rates ("the liquidity trap" in Keynesian) there's really not much more the Fed could do to inflate more, meaning that fiscal measures are needed.

Sumner disagrees. He seems to think that the Fed can and should target inflation, or more accurately nominal GDP (NGDP) growth. I really don't think that is possible, at least not with any precision since first of all monetary actions are forward looking and since we can't know for sure what NGDP growth will be in the absence of action, meaning that monetary policy actions can just as well push NGDP growth further from the target as pushing it closer. And secondly it is not possible to know with any precision exactly how great effect monetary policy actions will have on NGDP growth. A reduction in interest rates or asset purchases could have great effect during optimistic periods, but little effect during pessimistic periods.

Also, I don't think one of Sumner's proposed actions for creating inflation and therefore by extension higher NGDP growth, namely raising inflationary expectations, will really be that effective. Almost all market participants already know that the Fed wants inflation to return (specifically to about 2%), and are doing what they believe will be effective to create it. Announcing that target formally won't make any difference.

However, Sumner is right that the Fed could do more to achieve inflation, most notably stop paying interest on bank reserves and instead charge negative interest rates on reserves to make banks more eager to lend.

And, if we are to believe Professors Anil Kashyap and Frederic Mishkin (the latter of whom is a former Fed governor), Krugman and Sumner should also favor the "audit the Fed" bill initiated by Ron Paul. The reason for that is that according to Kashyap and Mishkin, that bill would raise inflationary expectations after it is revealed to the world whom the Fed deals with and in what way. I don't believe in it, but presumably Krugman & Sumner has a higher faith in the assertions of their fellow professors than I do.

China To Resume Yuan Appreciation?

The latest Chinese economic data showed continued acceleration in the pace of economic growth in China, with retail sales, industrial production and exports all strengthening.

Probably as a result of this, China is now hinting that they might soon return to the old "currency basket" system.

Literally the shift for a call from a dollar peg to a currency basket change would only imply an appreciation against the dollar if the dollar depreciates against other currencies. If the dollar would appreciate, then this shift in policy would in fact imply a weaker yuan than under current policy. But during the 3 years (from the summer of 2005 to the summer of 2008) when China officially followed a currency basket, the yuan's movements against the dollar did not have the inverted movements against the dollar's movements against other currencies, so in practice the "currency basket" system is just a code word for gradual appreciation.

Tuesday, November 10, 2009

The Deregulation Myth

A popular myth among leftists is that the financial crisis was caused by "deregulation". Of course, when pressed on exactly what deregulation was involved, they usually can't give an answer, revealing a blind faith that whatever the problem it had to involve lack of regulation.

Among the minority of leftists that can give a more specific description of what regulation was lacking, the 1999 repeal of the Glass-Steagal act (which prohibited companies from pursuing both commercial banking and investment banking) is the most common reply. Yet there is no evidence whatsoever of that having any negative role. The companies that contributed the most to the bubble and subsequently suffered the most were companies that were either pure mortgage institutions like Freddie Mac and Fannie Mae, pure investment banks like Bear Stearns and Lehman Brothers or an insurance company (AIG which invested heavily in Credit Default Swaps that insured dodgy mortgages). None of those companies had been affected by the repeal of Glass-Steagal.

Veronique de Rugy has another interesting perspective on this myth by pointing out that spending on regulatory agencies has sky-rocketed in recent decades, even in inflation-adjusted terms. If there really was so much deregulation, then one should really expect such spending to fall or at least stagnate in real terms, not increase dramatically.

Falling Tax Revenues Shows That The U.S. Economy Remains Weak

Preliminary numbers for October shows that federal tax revenues fell by 18%, following a decline of 7% between October 2007 and October 2008.

Part of the decline this year reflected the revenue reducing provisions in the stimulus package, but the main cause is the weak economy. Illustrating this is the fact that state tax revenues are down by nearly 10%. And states haven't reduced taxes, in some states like California and New York they have in fact been raised.

The perhaps most interesting point here is that this confirms my belief that GDP statistics provide a far too rosy picture of the state of the U.S. economy. If those numbers had been true, then we would have seen a much smaller drop in federal and state tax revenue.

However, it is not likely that overall economic activity fell as much as 10%. Since income taxes are to varying degree progressive, it could and probably did also partly reflect a reduction in economic inequality.

Local government tax revenues have held up better, but this reflects the fact that local governments rely largely on property taxes, the amount of which do not fluctuate according to the level of economic activity.

Monday, November 09, 2009

20 Years Since Berlin Wall Was Torn Down

Here's a classical clip related to today's 20th anniversary of the tearing down of the Berlin wall:

What Reagan could have added when he mentioned Khrushchev's "We will bury you"-prediction was that if communism was so more attractive, then the wall wouldn't be needed since no one in East Germany or other communist country would want to leave. If anything, West Germans should try to flee the "capitalist exploation" they suffered from according to communist ideology.

Latvia Has First Case Of Price Deflation

For the first time since Latvia became independent from the Soviet Union in 1991, Latvia saw consumer prices fall in the year to October. It should be noted that this would have probably come earlier if they hadn't increased the VAT and other consumption taxes in January. The rate of deflation will probably accelerate further in coming months.

Similarly, Estonia saw its rate of deflation increase and Lithuania saw its rate of inflation drop sharply, even as the euro area and most other countries saw their inflation rate move in the other direction.

Sunday, November 08, 2009

Illustrating The Failure Of Econometric Models

From Greg Mankiw's blog:

What does that say? A tempting interpretation is that it proves that the policies implemented by the Obama administration have failed. That could be the case, and on theoretical grounds there are reasons to believe that it is at least part of the explanation, but the chart itself doesn't prove that it is the case. It could also mean that the underlying economy was far worse than predicted.

What we can say for certain is that shows that the standard models used by the Obama administration to predict the future fail in their task. And while no one can predict the future perfectly even using correct theories, the standard models fails more than others. And the reason for that is that they are based on false theories for the purpose of making it more purely mathematical, something which in turn is ironically motivated by a desire to make theories more "operational" (more able to predict future data). Something which means that these econometric models are simply useless.

Saturday, November 07, 2009

Obama Administration Claims That America Has No Taxes

When Bill "depends on what the meaning of "is" is" Clinton was revealed to have had sexual relations with "that woman, Miss Lewinsky", he claimed that he hadn't lied when he said he didn't have sexual relations with her, because he had his own private definition of what a sexual relationship is.

Now Obama is trying to do a similar trick when it comes to taxes. It has been clear for some time that if someone had yelled "you lie!" to Obama when he claimed that he didn't want to raise taxes for anyone with a household income below $250,000, then that person would have spoken the truth.

For example, the tax increase on cigarettes that Obama signed will not only hit a lot of people earning less than that, but it would actually tend to hit them to an even higher extent than people earning more than that. The same thing goes for the health insurance mandate, which for all practical purposes is a tax increase, something which even Obama's top economic advisor Larry Summers have pointed out.

Now I see that Obama's press secretary Robert Gibbs in response to a reporter that had pointed out that the tax on cigarettes had been raised, claimed that the tax is not really a tax because "people make a decision to smoke". And similarly White House spokesman Linda Douglass argued with regard to the health insurance mandate that "a fee would only be imposed on those few who could afford to purchase insurance but refuse to do so".

So, according to Obama administration officials taxes aren't really taxes unless if people can avoid it by changing their behavior.

That definition not only contradicts the definition of taxes used by everyone outside the Obama administration, it would in fact imply that only a pure poll tax (also known as head tax), could be considered a tax. And since America as far as I know doesn't have such a tax, that would imply that America have no taxes according to the Obama administration!

Mises In WSJ

Ludwig von Mises' business cycle theory is presented in the Wall Street Journal.Saying that he predicted the current recession is a bit misleading. It would be more accurate to say that he provide the theoretical framework to explain it. Also, he took his cue from more than Hume and Ricardo, for example Böhm-Bawerk, But otherwise, the article was relatively good.

Friday, November 06, 2009

Employment Report Slightly Less Weak-But Still Weak

The U.S. employment report indicated that the U.S. labor market was slightly less weak in October than in September-but still weak.

The main improvement was that unlike the previous month, average hourly earnings rose and the average work week did not drop, As a result average weekly earnings rose in nominal terms after having declined the previous month. However, it remains to be seen how much, if any, of that nominal increase in average weekly earnings will translate into a real increase as I suspected that consumer prices rose faster in October.

On the other hand, the number of people that had a job continued to fall and the unemployment rate rose to 10.2%-the highest since 1983. It should be noted that the widely quoted payroll employment could underestimate the number of lost jobs. Payroll survey employment fell by 5.5 million in the latest 12 months while household survey employment fell 6.6 million. Basically the entire discrepancy has come in the latest 3 months, when the payroll survey indicated just 600,000 lost jobs while the household survey indicated 1.8 million lost jobs. In the latest month, the drop in payroll survey employment was 190,000 while the drop in household survey employment was 589,000.

Since these two surveys are supposed to measure the same real world phenomenon they should give the same results. When they don't you can be sure that at least one of them is wrong, but usually the truth lies somewhere in between. Most economists, including me, believe that the payroll survey is more reliable particularly when it comes to monthly fluctuations. However, while the truth is probably closer to the payroll survey number, the consistently much larger loss in household survey employment indicates that the payroll survey probably underestimate job losses.

Tom Palmer's Strange Critique Of ABCT

Tom Palmer has a strange critique of Tom Woods' book Meltdown and the Austrian Business Cycle Theory presented there:

"In fact, what we saw was a bubble in housing, which is not a “long-term project” that will “bear fruit only in the distant future,” but a speculative investment in a durable consumer good, with an additional twist: the low refinancing rates and the inducements to refinance led many to treat their homes as ATM machines and withdraw cash to finance, not “long-term projects,” but consumption. But Mises and Hayek explained a previous boom-and-bust cycle in terms of a lengthening of the capital structure, so we must believe — we must, a priori! — that all boom-and-bust cycles must — they must! — follow the same process."

But as I've explained here, housing and other durable consumer goods (such as cars) are partly capital investments- or "long-term projects" if you will. Most houses will last decades, or even centuries in extreme cases, While maintenance will obviously be needed after a while, the fact remains that buying a house is a long term investment (Indeed, many capital equipment purchases by business will last a shorter period of time), and the logic of the Austrian business cycle theory therefore applies.

It is true that in the writings of Mises and Hayek (and Rothbard) ABCT was illustrated almost exclusively with the example of entrepreneurs buying capital equipment, but that doesn't change the fact that the logic of ABCT also applies to housing and other consumer durables. And Palmer's critique looks even more irrational as a critique of Tom Wood's book. While I haven't read the book yet, it seems that he was trying to use a broader range of examples more relevant to this business cycle, by also correctly applying ABCT to housing.

Thursday, November 05, 2009

Productivity Numbers From Fantasy Land

The U.S. Department of Labor claimed today that quarterly productivity rose 2.3% (9.5% at an annual rate) from the previous quarter while it rose 4.3% compared to a year ago. Since this number was based on the supposedly strong GDP number and the supposedly super weak employment numbers we've seen, this was not very surprising. This supposedly meant that unit labor costs dropped 3.6% compared to a year ago while sales prices rose 0.8%.

Since labor costs constitute the bulk of business costs, this would imply that profits must have risen, especially since many other costs (like net interest and capital consumption) have dropped too. Yet in the real world it is reported that profits fell nearly 20% while corporate income tax revenue fell by nearly half.

If neither workers, capitalists, creditors or governments are seeing any gains, just where does this all these alleged productivity gains go? It is true that a large part of the drop in corporate income tax revenues is the result of tax law changes, and that part of the drop in profits reflect a decline in earnings from foreign subsidiaries of U.S. companies. But even then, the numbers simply doesn't add up (especially since lower tax payments should boost reported net income).

Either for example the labor market is stronger than the employment reports say (either in the form of higher employment, longer working hours or higher wages), or the GDP number greatly exaggerates real growth-or both. I personally think that it is both, but mainly that the GDP number exaggerates growth.

ECB, Bank of England To Trim QE

The ECB and the Bank of England today both signalled that they will trim, but not yet end, their quantitative easing (or "emergency liquidity measures" as the ECB calls them).

Both the Euro area and the U.K. is likely to see inflation rise in coming months. The increase will be less dramatic in the U.K., but the U.K. had a lot higher inflation to begin with.

Central bank officials will likely dissmiss this as "temporary" as they are worried that any significant tightening will end recoveries that are fragile at best. Still, they will likely try to gradually withdraw their inflationist schemes, guided by the same belief that Alan Greenspan had in America in 2004-06 that tightening wouldn't weaken the economy if only it was made gradually......

Wednesday, November 04, 2009

Globalization Helps Decouple U.S. Stock Market From U.S. Economy

While there are other reasons (including over optimistic expectations about the future) for the stock market rally, Daniel Gross points to how globalization creates a decoupling between the U.S. economy and the U.S. stock market. I discussed this factor previously here.

His example of GM sales in America and China is interesting for other reasons, but misleading with regard to the U.S. stock market considering that GM went bankrupt a few months ago. GM stockholders will for that reason not be able to enjoy any profits in GM's Chinese subsidiary.

Tuesday, November 03, 2009

Bailouts -And Bonuses- Continues In Britain

The U.K. government will step in with an additional £31.2 billion to troubled banks Royal Bank of Scotland and Lloyd's in a sign that the problems for the British banking sector isn't over.

A condition for this extra cash infusion is that no bonuses will be paid out for anyone earning more than £39,000 per year. However, the chief executive of Royal Bank of Scotland says:

"That does mean we will be making extensive use of deferred payments and payments in shares.

We are aware that we need public support, given our position. However, the surest way for the taxpayer to see value for its support is if RBS is able to have very good people and compete in its markets. We must be competitive or we will not return value to the taxpayer."

Translation: we will make exploit loopholes in the no bonus provision so as to make it meaningless in practice, because we believe it is so important to keep the geniuses that were responsible for the losses that made government support necessary.

This illustrates again the problem with using regulations as a substitute for market mechanisms. If the Royal Bank of Scotland hadn't been bailed out, no bonuses would have been paid of course because the company wouldn't be around to pay them. The attempt to achieve the same effect through regulation fails because regulations in this case, as in most other cases, have loopholes.

Al Gore's Company Gets Half A Billion Dollars From Government

Being a climate crusader is apparently profitable, as a company partly owned by Al Gore gets $560 million from the U.S. federal government-a federal government controlled by his buddies in the Democratic party and whose decision to give away $560 million to Gore's company was guided by the teachings of Al Gore on the issue of "climate change".

Second RBA Rate Hike

The Reserve Bank of Australia today became the first central bank since the beginning of the financial crisis to raise short-term rates twice. The central banks in Israel and Norway have each done it once, but the RBA is the only central bank that has done it two times. Short term rates in Australia now stands at 3.5%, still historically low for Australia but much higher than in most other countries.

Australia's economy is a lot stronger than most other economies, with increasing employment and rising house prices. The recovery in Asia has helped increase the prices of Australia's commodity exports.

Ironically, the dramatic 29% appreciation of the Australian dollar against the U.S. dollar this year has been partly based on expectations of these and more rate hikes, yet at the same time the currency appreciation is reducing the odds of such hikes, as lower import and export prices will reduce consumer price inflation, something which will reduce the RBA's willingness to raise rates. The more rate hikes the markets expect and price in, the less rate hikes will there actually be, in what one could call a self-preventing prophecy.

Monday, November 02, 2009

The U.S. Dollar & Stock Markets

I have noted in the past several times that there has been a strong correlation between the U.S. dollar's exchange rate against all currencies except the yen and stock markets.

It should be noted that as far as the U.S. stock market is concerned, this causation goes both ways. The main reason for this causal connection is that investors treat the U.S. dollar as a "negative beta" asset-one that should fall in value whenever stock markets rise in value and vice versa. Investors reduce their demand for U.S. dollars whenever stock markets rally-and they increase their demand for U.S. dollars whenever stock markets sell off. In part this reaction reflects something of a self-fulfilling prophecy: Investors sell dollars in response to stock market rallies because they believe it should do so, causing it to happen. Another factor is the theory that I described here with regard to the yen (the other main "negative beta"-currency) and stock markets and that also applies to the U.S. dollar.

However, it is not only the case that stock market movements causes the U.S. dollar to move in the other direction, it is also the case that dollar movements causes at least the U.S. stock market to go in the other direction. While not all U.S. companies benefit from a weaker dollar, most do. Either because they export goods or services from America and/or because they have foreign subsidiaries whose earnings in dollar terms increase whenever the dollar weakens. In both cases (but particularly in the former) this means that their profits in nominal U.S. dollar terms increases whenever the dollar weakens-and that they decrease when the dollar strengthens.

For other stock markets however (Except those in countries with currencies pegged to the U.S. dollar of course), movements in the U.S. dollar will have a positive causal effect (meaning that it will cause them to move in the same direction, not necessarily go up as a weaker dollar lower profits for most companies outside the U.S.), somewhat counteracting empirically the similar negative causal effect that stock market movements have on foreign stock markets.

Because most investors care more about market momentum than about underlying fundamentals, the causal link is probably stronger in the short term in terms of the effect of stock markets on the dollar than in terms of the effect of the dollar on the U.S. stock markets. However, in the medium long term, any "permanent" shift in the U.S. dollar's (real) exchange rate will result in U.S. stock prices moving in the opposite direction, while causing other stock markets to move in the same direction.

The negative causal connection between the strength of a currency and the local currency value of the stock market really applies to all countries. By contrast, the negative causal connection between the stock market and the value of the currency only applies to the U.S. dollar (and currencies pegged to it) and the yen and to a lesser extent the Swiss franc. For many other currencies, particularly the dollars of Australia and New Zealand, a stronger stock market will have a positive causal effect.

Sunday, November 01, 2009

The Incidence Of Taxation

New York Times features a story based on calculations of how much different groups earned on the Bush tax cuts. Not surprisingly given the fact that they pay the most in federal income taxes, the calculations show that high income earners gained the most.

The problem with this is however that it assumes that the incidence of taxation falls entirely on the people from whom taxes are collected. That in turn assumes that taxation has no behavioral effects, which is far from plausible. The evidence instead show that the Bush tax cuts did in fact boost overall economic growth, meaning that more people than those with very high income gained from the tax cuts.

Furthermore, in addition to the boost to real economic activities, lower taxes will other things being equal also reduce tax evasion, meaning that revenue losses will not be nearly as great as a static analysis (one assuming zero behavioral effects) would suggest.