The Irrational Reasonings About "Bailouts"

The tragicomical thing about the Greek debt crisis is that for from being impossible to solve , the most rational solution is very easyily achieved. As I wrote before, if only Germany and other countries perceived by the currentlty dysfuctional bond markets as "safe" would engage in mutually beneficical arbitrage, then the crisis would end quickly, enabling Europe's economy to recover.

The most likely scenario at this point is that Greece will in fact receive the necessary financing. Just who will provide it and at what terms is not clear at this point, but it nevertheless seems likely (though not certain) to arrive.

But regardless of whether it will arrive and in what form, what should be clear is that it should arrive.

Opponents in particularly Germany, but also in Holland and other euro area countries, often try to portray it as Germany and other euro area countries paying for Greece's irresponsible ways. If that had been the case, then such a deal would indeed have been unjust. But that is simply not true for several reasons, including the ones I mentioned in my previous post, namely in short:

1) Because Greece still pays a lot higher price than other countries (such as Britain) with similarly irresponsible behavior, it won't create any moral hazard.

2) Because Germany and other lenders in this arbitrage arrangement will receive a higher interest on the money they lend than the money they borrow, they will in fact earn money, meaning that Germans can as a result of such a deal receive tax relief, while avoiding spending cuts or an increased deficit.

Furthermore, if we assume that the alternative to such a deal is a Greek default, then, the "no rescue" alternative looks even worse. The reason for that is that German and other European banks have great stakes in Greece (and also other countries perceived as vulnerable). If Greece and perhaps others get parts of their debts written off in a default, then this will create a need for infusion of capital from German tax payers to avoid a German banking collapse. Some of these capital infusions will probably be recovered, but probably not all (especially if you consider the opportunity cost of that capital), meaning that in the "no-rescue" scenario, German tax payers will in fact be forced to give away money to Greece, or indirectly "bail it out" with the banks as intermediaries.

And with Greece under this scenario getting away with writing off much of the money they irresonsibly borrowed, a real moral hazard problem will arise, as the Greeks will get the impression that it's OK to engage in excessive deficit spending as they won't have to pay back all of it, just like they didn't this time.

Thus, preventing a Greek default through rescue packages is arguably even more in the interest of Germany and others than in the interest of Greece. And the view that it should be opposed because it allegedly "rewards the Greeks and punishes Germans" is in fact as irrational and misguided as any view can get.

Moderate U.S. Growth Continued

The U.S. economy grew at a rate of 2.4% adjusted for terms of trade changes during the first quarter. Rising consumer spending, business investments and increased inventories all contributed to growth, while falling government demand, falling residential investments and a higher trade deficit held back growth.

The fact that government spending fell (Only state & local government spending fell. Federal spending rose moderately) , while private spending rose is arguably the most bullish aspect of the report.

Less positive is that the increase in private growth rested on a big drop in the savings rate and rising inventories. Rising asset prices are causing people to draw down savings, just like during the housing bubble. Between Q2 2009 and Q1 2010, the savings rate dropped from 5.4% to 3.1%. This is still somewhat higher than during the housing bubble, but now the budget deficit is far higher, so the national savings rate is in fact much lower than during the housing bubble.

No Arizona Fries For You

In a move not too dissimilar to the refusal of some to eat "French fries" before the start of the Iraq war (even though these fries weren't produced in France or contain any French input material), some are now boycotting Arizona Iced Tea in response to Arizona's new anti-illegal immigrant law. One boycotter named Travy Nichols calling it "the drink of fascists" and another by the name of Jody Beth writing that "Dear Arizona: If you don't change your immigration policy, I will have to stop drinking your enjoyable brand of iced tea,".

It is not clear why Arizona would care if anyone boycotts that "fascist" drink, however, since it is made in New York State. Nor do these geniuses seem to realize that if you boycott Arizona, you boycott everyone in that state, including immigrants ( and opponents of the new law).

Military Spending Moral Hazard

When analyzing the Liberal Democrat position that thee U.K. doesn't need nuclear weapons, Max Bergmann argues that the criticism from Labour leader Gordon Brown and Conservative leader David Cameron overlooks one factor:

"The notion that the UK needs nuclear weapons because of the dangers of Iran demonstrates an outdated world view that sees Britain as isolated and sees security issues in a vacuum. The fact is that the UK is in NATO – which means under Article 5 an attack on one NATO member is an attack on all. This means that an attack on the UK is an attack on the US and therefore the US nuclear deterrent is effectively a UK nuclear deterrent as well. If the UK’s nukes just magically disappeared there would be no practical change in its ability to deter a nuclear attack."

The argument here is not that Iran isn't a threat, or that nuclear weapons are immoral, arguments which you may or may not agree with. The argument here is clearly that since the United States will despite the recent disarmament treaty with Russia keep a sizeable nuclear arsenal, and since the United States is bound by the NATO treaty to defend Britain and other NATO members, its nuclear arsenal constitutes a deterrent. This in other words means that because of the NATO treaty, Britain should let American tax payers pay for its nuclear deterrent, because given the current arrangements it can do so.

This highlights how the current American security arrangements create a "moral hazard" where other countries shift over their military spending on America. Another example of this is South Korea , which spends a relatively modest 2.75% of GDP on its military, despite facing one of the most credible military threats (Only Israel's threat situation is arguably more dire) in the world in the form of the loony but well-armed North Korean regime. If not for the American troops in South Korea, and the pledge to send more in case the North attacks, South Korea would have surely spent more.

This factor is arguably also present in for example Taiwan and most Western European countries, as they rely on the promise of American intervention in case they face attacks. This is good for these nations as they don’t have to spend as much on national defense, but it is not quite as good for America who has to spend more on its military to keep this up.

Was The Icelandic Volcano Ash Scare Completely Unmotivated?

Well, I won't pretend to be an expert in this area, but an increasing number of actual experts seems to agree that most (if not all) of the economically damaging air flight bans was unmotivated.

Solving The Credit Ratings Agency Problem

Paul Krugman discusses the problem of rating agencies (Which I have discussed for example here, here and here).

The problem isn't just incompetence, but also the problematic incentives created when issuers of bonds choose between the agencies, meaning that rating agencies often have strong incentives to give higher ratings than they know are proper, since they will otherwise lose the customer. Another problem is that their assessments when "correct" are only "correct" because of the self-fulfilling prophecy mechanism. Two equally sound institutions may end up differently only because one received high ratings and thus had easy access to capital, while another suffered a failed due to liquidity problems created because they received low ratings.

Allowing people to sue rating agencies for ratings which are purposely manipulated and non-objective is a fine principle and should be implemented. However, because rating agencies can likely afford to hire very good lawyers, this will not always be effective.

Krugman's favored solution is for the government to choose rating agencies. But a better solution would be for bond purchasers to choose agencies.

Furthermore, all legal privileges for rating agencies should be abolished. I am here referring to the legal requirement on or encouragement of many financial institutions to use credit rating agencies. If governments didn't require or encourage their use, they would be forced to shape up to attract business.

Ukraine Strikes Gas For Fleet Base Deal

Ukraine has been hit by the global economic crisis a lot harder than almost all other countries. One result of this was the defeat of incumbent anti-Russian president Viktor Yushchenko (who received a humiliating 5.5% in the first round of Ukraine's presidential elections) in favor of the more pro-Russian Viktor Yanukovych.

Now Yanukovych has been able to give Ukraine's battered economy a big relief by agreeing to allow Russia to lease a fleet base in the Crimea peninsula for another 25 years (the lease was about to expire in 2017) in exchange for a 30% discount on natural gas delivered to Ukraine from Russia. The deal will save about $3.7 billion per year, or about 3% of Ukraine's GDP, and also likely improve prospects of additional loans from the IMF.

Domestic and foreign opponents of the deal argue that this deal compromises Ukraine's independence. Yet with the Ukrainian government being bankrupt and in need of foreign financing anyway, it is difficult to see how it could have been truly independent anyway. Moreover, renting land for a foreign military base is hardly something that destroys your independence. Germany and Japan and many others allow America to keep military bases on their soil, and yet no one argues that this compromises their independence. Even Cuba leases land for military bases to the U.S. government, but that hardly makes the Cuban government a U.S. marionette.

The VAT Issue: Will A VAT Increase Size Of Government

Most countries today have a Value Added Tax (VAT), with the United States and Hong Kong being the most notable examples (Unlike Hong Kong which have no local governments, most states in the United States and in some cases cities, have sales taxes).

Since the current level of budget deficits in the United States is in the long run unsustainable, the discussion has begun of how to close the deficit. Imposing a federal VAT is one possible way to close it. I will in a number of posts (this being the first one) analyze the effects of a VAT.

The key counter-argument against it among advocates of limited government is that it will prove to be a "money machine" for the government that will expand the size of government. Is this argument true?

In short: Yes.
One reason for this is that a VAT is "efficient" in the sense that it will be effective in raising revenue. The fact that retailers can deduct VAT paid by its suppliers reduces the incentive for tax evasion compared to sales taxes. Another reason is that it is more politically easy to have several taxes (income taxes, payroll taxes and consumption taxes like the VAT) each having moderate rates than a single tax with a high rate, as each tax seems less burdensome even if the total burden is the same. A third reason is that "hidden taxes" like payroll taxes and consumption taxes are perceived as less real than direct taxes like the income tax.

On an anecdotal note, I have personally in discussions heard many Swedes say that they pay only 30% in taxes. 30% was the income tax rate applied at the time for them, meaning that they thought that they didn't pay any payroll taxes or consumption taxes.

Casey Mulligan however argue that the hidden nature don't matter, using a scatter plot which seemingly show no relationship between public pension payments and the amount of payroll taxes which are hidden. But his comparison is highly problematic for a number of reasons, not least the fact that this is linked to a defined benefit, which is probably more politically popular than general funding for government, which is what VAT would be about.

Tino Sanandaji has a more relevant comparison, namely between the proportion of all taxes that are visible and the total tax burden. He finds that there is a positive relationship. The relationship isn't perfect, but since there are always other factors involved, no causal relationships have a "perfect" empirical relationship between causal factor and aggregate phenomenon it contributes to.

In a previous post, Sanandaji found a link between the level of VAT and the level of total taxation.

In conclusion, based on the theoretical and empirical evidence, accepting a VAT will all other things being equal contribute to an expansion of the size of government, though the effect might not be dramatic.

How To Solve The Greek Crisis

Despite the fact that Greece has already implemented radical austerity measures and despite the €45 billion secured from the EU and the IMF, the bond markets have continued to decent into insanity. The current 10-year yield spread between German and Greek 10-year bonds imply a 100% certainty of a 44% default (bond holders will get only 56% of the nominal value) assuming 0% risk of a German default. Anyone who studies historical defaults, not to mention the adverse consequences to Greece if it defaults should recognize that this is irrational.

But it appears that the bond markets are driven by speculators determined to implement a self-fulfilling prophecy, i.e. by short-selling they hope to drive up yields, something which they know will raise the assumed probability of default, and thus help raise yields further in a self-reinforcing vicious spiral.

How can this be solved? Since euro area exit and default are closed, and since further austerity measures would -at least alone- likely have no significant effect given current market sentiment, only one solution will be effective: namely for Germany and others to extend the 5% loan offer to indefinite amounts, coupled of course with tough demands to implement deficit reduction measures.

This would eliminate the risk of default, and would ultimately mean that Greek bond yields would fall to levels below 5%, thereby eliminating the need for the facility. Bond markets may not respond this way in the short term given the current irrationality, but it really wouldn't matter since Greece wouldn't have to borrow from them anyway. And since people in time would realize that this will be a obvious losing bet, yields would ultimately adjust.

But wouldn't this be unfair to tax payers in Germany and elsewhere who has to "bail out" Greece? The answer to this is an emphatic no, because it wouldn't really be a bailout since "bailout" traditionally means that the entity that bails out loses economically from it. But in this case it won't. If Germany borrows €25 billion from the bond markets at 3% and lends that money to Greece, the German tax payers will gain 500 million euros per year. If the amount is €50 billion, the gain will be €1 billion per year, if the amount is €100 billion, the gain will be €2 billion per year, and so on. The German government (and other governments) will engage in arbitrage, not a bail out.

Since the mutual gain to both will be greater the greater the arbitraged sum, there is nothing unsustainable about this, regardless of how great the transactions will be.

Another key argument against this is that it might encourage other European governments to be fiscally reckless, because they expect to receive a similar deal.

This argument completely overlooks first of all that these loans comes associated with exactly the kind of fiscal austerity measures that the loans are allegedly discouraging and secondly that even with this help, Greece will pay a much heavier price than other countries with similar fiscal situations. At 5%, the real cost of borrowing will be much higher than for governments with similar deficits both inside and outside the euro zone. Greece is being more than sufficiently punished for its fiscal sins.

If EU leaders adopted this plan, the crisis would quickly fade away, relieving Europe's economic problems. If they don't, then anything could happen, and then ashes from Icelandic volcanoes might not be the only thing darkening the future economic picture in Europe.

U.S. Federal Debt Exceeds National Income

Since Obama became president on January 20, 2009, federal debt in America has increased by $2.25 trillion, from $10.62 trillion to $12.87 trillion on April 20. When Bush became president 8 years earlier, federal debt was $5.73 trillion.

As a result, federal debt now almost certainly exceeds national income for the first time since the years following World War II. While second, or even first, quarter numbers for national income is not yet available, the fourth quarter 2009 number was $12.47 trillion. While possible, it is highly unlikely that it has risen to $12.87 trillion or more since then.

With the increase being $544 billion the latest 3 months alone, federal debt will soon become not just slightly larger than national income, but a lot larger.

British Employment Numbers Were Weak, Not Strong

The pound strengthened today after employment numbers that were supposedly stronger than expected.

Yet what seems to have evaded the markets was that while jobless benefit claims did indeed dip, the more relevant broad unemployment numbers increased. Furthermore, employment continued to drop and fell as much as it did during previous months.

The fact that government employment rose and that private employment therefore fell even more than the overall number makes the whole thing look even worse.

Nominal wage increases picked up a bit, but so did price inflation, so real wages continued to fall.

The weather factor may have been depressed the numbers somewhat, but clearly no recovery can be seen in these numbers.

2-Year European Inflation Rates

British inflation numbers were released today, showing a 3.4% increase. Together with the European numbers released last Friday this means that we can now summarize 2 year inflation rates, which is to say the cumulative 2 year change in consumer prices. I selected below inflation numbers for various European countries based on which countries had the most significant changes and those that were biggest (if you're interested in those that I omitted see here).
Iceland 36.4%
Romania 11.2%
Hungary 8.7%
Poland 7.0%
Lithuania 7.0%
Britain 6.4%
Greece 5.5%
Sweden 4.4%
Estonia 3.9%
Latvia 3.6%
Italy 2.5%
France 2.1%
Czech Rep. 2.1%
Euro area 2.0%
Germany 1.6%
Spain 1.4%
Switzerland 0.7%
Portugal 0.0%
Ireland -3.1%

The following things can be noted:

-The two countries that was most different from the rest was the two island nations of Iceland and Ireland. Iceland had with its cumulative 2-year increase of 36.4% the by far biggest increase, while Ireland was the only country with a 2-year decline in consumer prices. However, Portugal came very close to register a 2-year drop (given the statistical margin of error that exists, it is possible that they did) and Romania and Hungary also had extraordinarily big price increases.

-Switzerland was the only non-Euro area European country with an inflation rate below the Euro area average, though the Czech Republic also came close. The recent rally in the Swiss franc means that the relative Swiss inflation rate will likely fall further in the near future.

-Greece had the by far biggest consumer price increases within the Euro area, while Lithuania had the biggest increases inside the Euro bloc (which also include countries with fixed exchange rates. However, Lithuaniaäs number reflects entirely a big 2009 increase, and in the latest year consumer prices have dropped somewhat. Similarly, the Latvian number conceals that in the year to March 2009, consumer prices rose 7.0%, only to fall by 4.0% the latest year.

About The Icelandic Volcano Eruption

The European continent seems to be struck by bad luck recently. First was the great cold snap during particularly late December and January. Barely had Europe recovered from this when a volcano in Iceland erupted. This volcano eruption seems to have been particularly powerful, because not only was the areas in Iceland close to the volcano affected negatively, but in addition to that the ashes it emitted has spread throughout Europe, ending air traffic in most of Europe.-

The media has focused on the plight of travelers being stuck at places they were supposed to leave for various reasons (including business purposes), or compelling them to travel by the much more expensive and/or time consuming means of train, bus or taxi. That is really bad enough, but a lot of goods traded are transported using air planes, meaning that the stop on air traffic will hurt trade too.

There is thus little doubt that this factor will hurt the European economies, and distort second quarter GDP numbers negatively in almost all European countries. Just how big the effect will be is uncertain at this point, not least because we don't know how long the problem will persist.

I should perhaps also comment on the fact that many airlines have criticized the decision to close air traffic.

I am not an expert on the scientific assessments of the affects of volcano ash on air traffic, but from what I've read about tests made by those who are experts, it seems that really great quantities of volcano ash could down a plane, but that at the far lower quantities spread throughout most of Europe, it is possible to fly a plane safely.

It seems very clear that European governments so far have been determined to err on the side of safety. And that they have most likely indeed erred on the side of safety. While we should do everything we can to minimize the risk of air traffic deaths given a certain level of air traffic and other relevant considerations, we should recognice that traffic is the life blood of modern economies.

Without traffic, no trade (not even intra-national trade) can be made, and the world would be condemned to local economic autarky, something which would not only mean the deaths of many people, but also make the lives of the survivors much worse. Meaning that we can't assume that stopping air traffic is costless, and that just as is the case with car traffic we shouldn't hold it to a standard where there is zero risk of any deaths (We rightly allow car traffic to precede, even though car traffic causes some 40,000 deaths in the EU alone each year).

We should of course continue to monitor the ash clouds, and stop traffic whenever the risk of crashes is high. But the standards for allowing air traffic so far have been far too strict, and needs to be changed. And this will certainly be a factor when to be considered when analyzing second quarter economic data.

Another Aspect Of Goldman Sachs Suit

I don't know much about what was actually done by Goldman Sachs, but if the SEC's version of the story is correct, then it is certainly fair to say that they were guilty of fraud.

One aspect that has been mostly forgotten by most is mentioned in Jonathan Weil's latest column:

"While those clients may have been seeking exposure to subprime mortgages, and may even have been unconscionably stupid for doing so, they surely weren’t seeking exposure to the other side of a cherry-picked trade created for the exclusive benefit of one of the world’s largest hedge funds. They probably aren’t happy, either, with Moody’s or Standard & Poor’s, which, you guessed it, slapped AAA ratings on the CDOs’ highest rungs."

Yet Again, the question arises, why would would anyone want to pay attention to what rating agencies say?

Liberal Democrats Could Be Even Worse Than Labour

After Liberal Democratic leader Nick Clegg clearly outperformed his rivals Gordon Brown and David Cameron in a debate, the Liberal Democrats have surged in the polls and are in some polls ahead of Labour and very close to the Conservatives.

That is worrisome, because even apart from the fact that this increases the risk of a "hung parliament", the Liberal Democrats aren't a good alternative to Labour. Their "liberalism" is in the modern American-British sense (which is to say essentially social democratic), as opposed to the classical sense (which is to say moderate libertarian) still used in continental Europe and Australia.

Their deficit reduction plan can be summarized as a kind of Underpants Gnomes-style scheme:

Phase 1: Increase government spending and cut taxes for people with low income.
Phase 2: ????
Phase 3: Deficit is reduced.

Perhaps some would argue that my phase 2-characterization is unfair, as they do propose "closing loopholes that unfairly benefit the wealthy and polluters". But apart from the fact that they don't specify what "loopholes" they are referring to, not much more money can be raised by further increases in taxes on high income and carbon emissions (which I assume is what they mean by "pollution"). Further increases in the top marginal income tax rate (currently 50%, after having been recently raised from 40%) would help drive even more businesses from London and encourage increased tax evasion. Similarly, carbon taxes are already so high that it is driving manufacturing away from Britain, and further significant increases would destroy even more of Britain's dwindling manufacturing sector.

If one takes into account the negative effect on the tax base, the proposed Liberal Democratic tax increases would at best help fund their tax cuts and spending increases-and even that is probably too optimistic. The Liberal Democrats would thus likely send Britain further down the destructive path of higher government spending and higher deficits that it has experienced under Gordon Brown.

Good & Bad Inequality

Greg Mankiw points out that to the extent tax cuts for high income earners increase their work efforts and/or reduce tax evasion, this will lead to increased inequality not just in after tax terms but also in pre-tax terms.

To the extent this is true, increased inequality is nothing that the non-rich should be unhappy about. This is to the contrary good for the non-rich.

There are other sources of inequality that are bad, but to the extent it is the effect of increased productive activities by the rich caused by for example tax cuts, it is good not just for the rich, but for others as well.

Chinese Boom Update

Confirming again what I've written about how the global recovery is stronger in Asia than elsewhere, China posted strong numbers today. GDP rose 11.9% in the first quarter compared to a year earlier, while both industrial production and retail sales rose 18% in March.

Chinese money supply growth meanwhile dropped to 22.5% in March (down from 25.5% in February, and nearly 30% in late 2009), indicating that the Chinese central bank is having some success in tightening monetary conditions. If this downward trend in money supply growth continues then economic growth could slow down in the near future, but since growth would be sounder with less malinvestments, that would in fact be a good thing.

Singapore GDP Soars-Revalues Modestly

According to preliminary figures, Singapore's GDP increased as much as 13.1% compared to a year earlier in the first quarter of 2010. Compared to the previous quarter, the gain was an even more impressive 7.2%, or 32.1% at an annualized rate. This however follows an annualized 2.8% contraction in the fourth quarter, so the 6 month increase was only 13.3%, or roughly the same as the 12 month gain.

This confirms what I have previously reported about, how the global recovery is stronger in Asia than in other parts of the world.

Presumably partly as a result of these strong numbers, Singapore's monetary authority today decided to allow a modest 1.2% revaluation of the Singapore dollar, and indicated that it will allow it to gradually rise in the Singapore dollar. Singapore has a "managed float" exchange rate system, which could be seen as something of a compromise between the pure fixed exchange rate systems of for example China and Hong Kong, and the pure floating exchange rate system of for example Japan.

The exchange rate can fluctuate, but the monetary authority significantly limits and largely controls these fluctuations. After having allowed no general increase in value for a while, apparently they now feel that a gradual increase in the value of the Singapore dollar is appropriate.

Singapore's 2009 current account surplus of 49 billion Singapore dollars was nearly 20% of GDP, far more than in for example China and Germany.

When China abandons its peg, they will more likely adopt a Singapore-style managed float-system than a pure float. That was after all the system they had between the summer of 2005 and the summer of 2008, when they temporarily abandoned their pure peg. As Singapore's current account surplus shows, that may not have much of an effect on its surplus.

Banks Are Again Making Profits

Duly rewarded, of course, for the extremely sophisticated and socially useful task of borrowing short from one government agency (the Fed) and lending long to another (The U.S. Treasury department).....

(From Paul Kedrosky's blog)

Why Focus On Greece?

On the Free Exchange blog and Scott Sumner's blog it is asked why there is so much focus on Greece despite the fact that the Greek economy is relatively small.

There are several explanations for this, but I think the most important explanation is actually simply that the developments have been so spectacular, and this always attracts attention.

This is illustrated by how previously Iceland and Latvia attracted so much attention, even though they are both far smaller than Greece.

Another key explanation is of course the fear of contagion to much larger nations such as Spain and Italy.

About The Chinese Trade Deficit

China reported its first monthly trade deficit since 2004, coming in at $7.2 billion. This deficit will likely to prove temporary as the numbers aren't seasonally adjusted and as China's exports (and trade surplus)is highest in the second half of the year, when Chinese manufacturers delivers toys and other Christmas-related goods. Even so, the trend is clearly for the Chinese surplus to fall, contrary to the predictions of some so-called trade experts. This will likely ease the attacks on the Chinese currency peg.

I should in this context comment on the fact that some people have argued that this deficit is too convenient to be true and that the Chinese statistical authorities are "cooking the books" on this issue to ease foreign attack on the currency peg.

While it can't be ruled out that Chinese authorities have manipulated the numbers slightly, the larger picture is highly unlikely to be false. Why? Well, because trade numbers are reported by both the export nation and the import nation. If China were to report a $7.2 billion deficit even though in reality they had a surplus, we would see a big discrepancy relative to numbers reported by China's trading partners. For this reason, it is much more difficult to get away with manipulating trade statistics than other statistics.

Knowing this, Chinese statistical authorities will in order to ensure their credibility refrain from any significant manipulation. Meaning that the reported trade numbers are likely to be basically correct, with at most only minor deviations from the real numbers (or at least minor intentional deviations).

Greek Financing Fixed

The EU (or more correctly EU member states) has now agreed to borrow to Greece up to €30 billion at a 5% interest rate, if Greece wants to. The IMF will be ready to contribute another €15 billion. Since this means that Greece will get a lower borrowing cost, while Germany, Holland and other lenders will earn a interest premium (as their borrowing cost is a lot lower than 5%), this agreement will be mutually beneficial. It remains to be seen how the increasingly erratic and irrational bond markets will respond, but it will most likely lower bond yields.

Irish CPI Down By 3% In 2 Years

In March 2009, the Irish inflation rate fell below zero for the first time in decades. It was -0.7%, compared to 0.1% in February 2009. Given this, one would have expected the inflation rate to pick up (or perhaps more accurately deflation rate to drop) now because of base effects. The increase in the overall euro area inflation rate from 0.9% to a preliminary 1.5% reflected this. But it held firm at -2.4%.

The gap to the euro area average thus widened to a record high 3.9 percentage points. During the last two years, consumer prices are down a cumulative 3.1% in Ireland, compared to a cumulative 2.1% increase in the overall euro area (While the U.K. number is not yet available, it was almost certainly a lot higher than the euro area, probably around 6%).

Ireland is thus further down the path of a painful but healthy deflationary restructuring of its economy than other crisis hit European economies.

More On Massachusetts Failure

James Capretta has an interesting column on the failure of Mitt Romney's health care scheme in Massachusetts (which is nearly identical to Obama's scheme, except that Obama's is on a federal level). The subsidies it provides has -surprise, surprise- led to increased demand, which in turn has caused health care costs to increase even faster. This has created big fiscal problems for the Massachusetts state government, which is now responding by price controls on insurers to limit cost increases. The insurers in turn respond by restricting access. Meaning that Massachusetts is rapidly moving towards the kind of "cost control by government rationing of health care" that the health care systems in Europe and Canada have used. And since Obamacare will create similar problems once it is implemented on a federal level, so will the rest of the United States later.

A Few Short Economic Data Observations

-Estonia posts its first monthly goods trade surplus since 1993, as exports increase 24% and imports only 9%. Estonia has had a surplus in its overall current account balance during most of the latest year, but until now that was entirely a result of surpluses in service trade and unilateral transfers. Latvia and Lithuania both continued to have deficits in goods trade, but both have surpluses in their overall current account balances, and in the case of Latvia it is much smaller than before (Lithuania by contrast saw a small increase).

-After a drop in January, the German current account surplus increased in February due to higher exports.

German industrial production meanwhile posted its first annual gain (5.6%) in February. However, this improvement has in recent months been a pure base effect, as industrial production is slightly lower than in October.

-Signs of a Canadian housing bubble continues to strengthen.

-The tightening measures adopted by the Chinese authorities appears to have had only a limited effect on the Chinese economy so far, as car sales soar by 63% in March.

-Australian employment growth continued in March, with a gain of 19,600 jobs, equivalent of 270,000 in the U.S. Because of Australia's high population growth however, the unemployment rate still remained unchanged and the participation rate fell slightly.

Greenspan The Delusional

For the umpteenth (I lost count) time, Greenspan tries to deny that he was at fault for the U.S. housing bubble. Since he doesn't advance any new arguments, and since I've already refuted the old arguments he now repeats, I'll simply link to that refutation. See also Caroline Baum's recent column on the subject. Most embarrasing to Greenspan is arguably his failure to understand (or his claim to not understand it) the link between short-term and long-term rates. As Baum puts it:

"Surely one of the hundreds of economists on the Fed staff could have explained to him that the long rate is the sum of the current and expected future short-term rates. If long-term rates are too low, jack up short-term rates more aggressively rather than in quarter-point increments. He can’t plead not-guilty."

This point should have been obvious to even casual observers. Why else would long-term Australian interest rates have been around 6% and Japanese interest rates around 1%, despite much bigger deficits and government debts in Japan? Clearly none of the global factors that Greenspan harps about can explain this, since both Australia and Japan are on this planet and both have free capital movements.

Krugman On ABCT

I hate to discuss Krugman for a second day in a row, but I can't help myself after seeing this post attacking the Austrian Business Cycle Theory (ABCT). After referencing an article by Martin Wolf that mentions Austrian theory, yet contains no real arguments, he himself advances arguments against Austrian theory:

"My view is that the fatal flaw in Austrian economics is that it can’t explain unemployment — or, worse, that it thinks that it can explain unemployment, but is deluding itself. The Austrian view is that unemployment in a slump results from the difficulty of “adaptation of the structure of production” — workers are unemployed as resources are painfully transferred out of an overblown investment-goods sector back into production of consumption goods.

But this immediately raises the question, why isn’t there similar unemployment during the boom, as workers are transferred into investment goods production?"

The answer to that is of course that during the boom phase no businessman is suffering from lack of demand, and so no one needs to lay off workers, quite to the contrary, those in the investment sectors are seeing increased demand.

The problem is that this new source of demand is unsustainable, which means that these new businesses will eventually see a shortfall in demand, something which will cause them to lay off workers.

Krugman continues:

"I’ve asked this question repeatedly over the years, and all I get is one of two things: gobbledygook, or “but during the phase of rising investment, the economy is booming!”, which is of course circular. In practice, Austrians seem to be Keynesians during booms without knowing it; they realize that high demand produces a boom, but don’t realize that this contradicts their own theory of slumps."

What Krugman seems to think that anyone who even mentions demand in any way is a Keynesian-and furthermore that if you mention demand you must think it is the only factor. Both assertions are wrong, of course.

Yes, if some businesses are seeing increased demand while others don't, then this will produce booms. There is nothing necessarily Keynesian about recognizing that. He furthermore fails to mention how this is supposed to contradict the theory of slumps, which is that the end of this unsustainable source of demand is causing the slump. It seems perfectly consistent to me.

Perhaps Krugman believes that this contradicts the theory because the end of this source of demand supposedly means that there is a drop in "aggregate demand", and Austrians supposedly can't believe in declines in "aggregate demand". If you define aggregate demand as simply the quantitative sum of all purchases, then Austrians can believe in it since it is an accounting identity at that point. But the question is just how meaningful that accounting identity is.

The reason why Austrians don't think that the accounting identity "aggregate demand" is what we should focus on is because it misses the key causal factors at work. Since "aggregate demand" is equal to "aggregate supply" which in turn is equal to output, saying that slumps are associated with falling aggregate demand is really like saying that slumps are caused by slumps, meaning that it is in fact Keynesians which use a circular explanation of the boom and bust.

While Austrian theory agrees with Keynesian theory that some form of demand is driving the boom and that the destruction of that demand is driving the slump, what Austrian theory correctly describes unlike Keynesian theory is that 1) The boom is driven not just any form of demand, but by an unsustainable source of demand in the form of newly created money and by demand for capital goods industries (including the construction and consumer durable goods sectors) and that 2) When that demand disappears, the factors of production can move to other sectors only slowly or not at all, causing a decline in real output.

Keynesian Monetary Policy Needs Bubbles To "Work"

If someone told you that he planned to buy a lot of fat food because he thinks they taste so good and he wants to experience those positive taste sensations, yet he wasn't going to actually eat them because he wants to avoid the weight gains associated with it, wouldn't you believe that he was delusional?

Yet an equivalent delusion can be found in Paul Krugman's writings about monetary policy and asset bubbles. In his latest post, he comments on his old call for bubbles. Let's start by reiterating what Krugman wrote then.

"The basic point is that the recession of 2001 wasn't a typical postwar slump, brought on when an inflation-fighting Fed raises interest rates and easily ended by a snapback in housing and consumer spending when the Fed brings rates back down again. This was a prewar-style recession, a morning after brought on by irrational exuberance. To fight this recession the Fed needs more than a snapback; it needs soaring household spending to offset moribund business investment. And to do that, as Paul McCulley of Pimco put it, Alan Greenspan needs to create a housing bubble to replace the Nasdaq bubble."

Krugman now claims that he wasn't advocating a bubble, he was simply neutrally stating the alleged fact that in order to end the recession, a new bubble was needed.

"If you read it in context, you’ll see that I wasn’t calling for a bubble — I was talking about the limits to the Fed’s powers, saying that the only way Greenspan could achieve recovery would be if he were able to create a new bubble, which is NOT the same thing as saying that this was a good idea. Of course, I know that this explanation won’t keep the haters from pulling up the same quote out of context, over and over."

I have read that whole article repeatedly, yet I can't find anything in the rest of it (you can try to find it yourself here )which provides a different context from what is in the above 2002 paragraph. Still, his explanation might have been plausible if Krugman had been a well-known "liquidationist" Austrian. But of course, we all know he isn't, and we all know that he instead advocates the use of government actions to close the "output gap" as soon as possible, at basically all costs. Indeed, in the next paragraph in his latest post, he writes this:

"But did I call for low interest rates? Yes. In my view, that’s not what the Fed did wrong. We needed better regulation to curb the bubble — not a policy that sacrificed output and employment in order to limit irrational exuberance. You can disagree if you like, but that doesn’t make me someone who deliberately sought a bubble."

So let's restate what Krugman argued:

1) He argued that the only way to end the recession or in other words to "not sacrifice output and employment" was to create a bubble.
2) He argues that he believed and still believe that it would be wrong to "not sacrifice output and employment".
3) Yet he still claims that he didn't endorse a bubble.

You simply can't believe in all of these things at once. You can believe in 1) and 3) at the same time if you at the same time didn't believe in 2), and you can believe in 1) and 2) at the same time as long as you don't endorse 3) and you can believe in 2) and 3) at the same time as long as you don't endorse 1). But you simply can't believe that in the absence of a bubble we would "sacrifice output and employment", argue that it is wrong to "sacrifice output and employment" and still argue that you're not for a bubble.

But aside from Krugman specifically wrote about bubbles in 2002, his current argument that you can use interest rate policy to revive an economy without creating bubbles reveal a lack of understanding (or perhaps honesty) about how a Keynesian monetary policy temporarily boosts an economy.

By lowering interest rates, a Keynesian central banker wants people to borrow money and start spending. If they don't do that for whatever reason, then monetary policy will have no effect on the economy. Thus, a necessary (but not sufficient) condition for Keynesian monetary policy to work is if it causes credit expansion (or possibly lower savings). Yet an expansion based on central bank inflation is an expansion based on an unsustainable factor, meaning in short that it is creating a bubble in the parts of the economy where the newly created money is spent. Thus, in order to work Keynesian monetary policy needs bubbles (not necessarily big ones, but it needs to be some form of bubble(s)).

Suppose then however, we got Krugman's current stated wish of "better regulation to curb bubbles". Assuming they were effective, this means that monetary policy would also become less effective, meaning that the regulations would "sacrifice output and employment".

There is really no escape: either you get a bubble type boom with a temporary boost to some forms of output and employment-or you don't get it. If you get it, it might shorten a recession but create a bubble which will create future problems. If you don't get it you will avoid bubbles, but you won't get the temporary boom in some sectors that Keynesian monetary policy is aimed at achieving. The view of Krugman and other Keynesian that we need Keynesian monetary policy to create a temporary boom and regulation to prevent bubbles is as confused like the view of the guy that bought fat food to enjoy the taste sensations they create while refusing to actually eat it because he doesn't want to gain weight.

Fifth RBA rate hike

The Reserve Bank of Australia raised interest rates for a fifth time, to 4.25%. Judging by this formulation in the statement by RBA Governor Glenn Stevens, it seems likely that there will be more rate hikes in the near future:

"Interest rates to most borrowers nonetheless have been somewhat lower than average. The Board judges that with growth likely to be around trend and inflation close to target over the coming year, it is appropriate for interest rates to be closer to average. Today’s decision is a further step in that process."

While Stevens is right to note that by historical Australian standards, interest rates aren't high. However, compared to other advanced economies, interest rates in Australia are relatively higher than normal. The interest rate spread is more than 4% compared to the U.S., Japan, Switzerland and Sweden, nearly 4% compared to the U.K., 3.25% compared to the euro area and 1.75% compared to New Zealand. The Australian dollar's status as a key target currency in carry trade is thus stronger than ever.

The Failed Massachusetts Experiment

Boston Globe reports how people are "gaming the system" in Massachusetts, by buying health insurance only when they face expensive treatments, something which drives up cost for everyone else, after that state adopted a system nearly identical to Obamacare.

Once Obamacare is enacted throughout the United States, this will happen all across the country as the fines people face are much cheaper than buying insurance. Meanwhile, those that don't buy insurance because they really don't need it will see their situation worsen, just as Obama used to argue.

So contrary to Mitt Romney's assertions, his scheme has definitely not been a success, and the fact that he tries to pretend otherwise is the key reason for disqualifying him as a 2012 (or later, for that matter) Republican presidential candidate.

As for the Democrats, they will likely simply use the certain coming failure of Obamacare as arguments for further steps in the socialist direction. It remains to be seen whether Republicans can instead push for free market solutions.

What's Holding You Back Now?

There are reports that the U.S. government will postpone and perhaps cancel a planned classification of China as "currency manipulator" (Which China is of course, but not more than other governments, including the U.S.) in exchange for Chinese support for tougher sanctions on Iran. Britain, France and Russia already agree, so if the Chinese too agree to it, it can pass the UN Security Council.

Meanwhile, Iran's loony President Mahmoud Ahmadinejad tries to pretend that Iran won't be affected by sanctions:

"Faced with the prospect of new sanctions because
of Iran’s nuclear defiance, Ahmadinejad said that such penalties would only strengthen his country’s technological advancement and help it to become more self-sufficient.

“Don’t imagine that you can stop Iran’s progress,” Ahmadinejad said in remarks broadcast live on state television. “The more you reveal your animosity, the more it will increase our people’s motivation to double efforts for construction and progress of Iran.”"

But if "self-sufficiency" would be so good, why not impose it yourself? Why not double those "efforts for construction and progress for Iran" without foreign inducement? After all, you can always copy the successful implementation of "self-sufficiency" of fellow pariah state North Korea.....

Price Cuts Boosts Japanese Economy

The Australian has an article blaming Japanese price deflation on housewifes seeking out bargains using new technology, something which pressures stores to reduce prices as this means that competition is tougher. The article describes the increased bargain awareness this has created as "catastrophic".

But this is bad only if you view deflation as something bad in itself. Remember, these housewifes and other Japanese (and other non-Japanese for that matter) have a limited budget. If they can find bargains that means that they'll be able to afford more of these things-and even more of other things.

Tougher competition because of increased bargain awareness by consumers thus in effect represent a positive supply shock, with lower prices and higher volumes. Thus, while it will "increase deflation", it will also raise real output. Only in the twisted worldview of deflationphobes is that "catastrophic".

U.S. Employment Report Observations

Because it is "Good Friday" today, not much has happened in the economic world today-Except for, of course, the U.S. employment report.

As expected, it was overall relatively strong with significant gains in jobs and even greater gains in hours worked. However, this was largely related to the reversal of the weather factor that had depressed the February number, and also to Census 2010 hirings by the government.

The one really weak item was average hourly earnings, which fell by 0.1%, the first drop in several years. As it is difficult to see how the weather factor could have affected this, this was clearly a sign of weakness. It could however be a sign that the weak labor market are making workers more willing to accept lower pay, something which will depress the average hourly earnings number, but boost the number of employed people and hours worked. '

Another interesting factor is that the number of people unemployed for a long period of time (27 weeks or more( has risen significantly while the number of people unemployed for a shorter period of time (26 weeks or less) is falling significantly. Compared to the previous month, the seasonally adjusted number of long-term unemployed is up by 414,000, from 6.133 million to 6.547 million. Compared to 12 months earlier, the number of long-term unemployed has doubled, from 3.241 million to 6.547 million.

Meanwhile, the number of short-term unemployed has dropped to 8,31 million, down from 8,856 million the previous month and 9.92 million 12 months earlier.

Why has short-term unemployment dropped while long-term unemployment continues to soar. While there are probably several explanations for this, the likely most important one is the fact that the U.S. Congress has significantly expanded the duration of unemployment benefits. In the past, you could only get it for 26 weeks, but now you can get it up to 99 weeks (or in other words, nearly 2 years). This has significantly reduced the incentive for the long-term unemployed to accept jobs whose pay level or tasks they don't like, and as a result, they choose to stay unemployed rather than take jobs they don't like.

Purpose Of Mathematical Formalism: Incomprehensibility

Normally, being lucid and comprehensible is considered to be a virtue. Unless it compromises the analysis, you should always express yourself as lucid as possible. This is for example the basic idea behind Occam's razor (and Rand's razor).

But not so in academic neoclassical economics, particularly not at the "advanced" level. There the idea seems to be to make it as incomprehensible as possible. Everyone who has taken such courses knows what I'm talking about. The advanced mathematical formalism used there make the theories much more incomprehensible, yet at best they do nothing to advance the real world analysis and often it is worse than that, as theories are adjusted to enable them to be mathematically formalized. For more on this subject see my post "The Real Problem With Non-Austrian Economics".

So why do they do it? In part it is because of the delusion that the use of advance math somehow makes it more "scientific", even though no one has ever been able to point to anyway in which it has enabled us to learn more about anything else except...well, advanced math.

The Free Exchange blog at The Economist today reveal another function:

"The maths may even serve a filtering function, by making those with a tenuous grasp of the subject matter less likely to directly cite the research (out of fear of saying something stupid). Instead, they may consult acadmemic experts for comments"

In other words, the purpose with making it incomprehensible is to ensure that people will think that they're stupid because they can't understand papers that were made deliberately incomprehensible. This in turn will make people think that the people who expressed themselves in an incomprehensible way are really smart, and that only they can have an opinion on economic issues.

It's a fraud, of course, which is used to conceal the deficiency in grasping the actual subject matters of economics by many of these academic neoclassical economists.

U.S. Manufacturing Strong-Construction Weak

Stock- and commodity prices rallied all over the world today as manufacturing surveys just about everywhere surprised on the upside.

The U.S. number in particular was strong, coming in at 59.6, the highest since July 2004. But on the other hand, construction spending in America was weaker than expected and continued to decline rapidly. Construction spending was 6% lower than 3 months earlier, implying an annulized rate of contraction of 22%. There is little doubt that the U.S. economy overall is growing, it is not growing strongly and growth is unusually uneven with a strong manufacturing sector and a continuing deep construction recession.

To some extent, the weather factor was probably involved in both depressing the February construction number and boosting the March manufacturing number, but there is little doubt that the underlying strength of the manufacturing sector is nevertheless greater than the strenth of the construction sector.