Crowding Out Effect Confirmed

Contradicting the predictions of Keynesian economics, a new study shows that states that receive large "earmarks", which is to say big federal spending projects, actually experience a decline in private sector spending. Federal spending on certain states are thus crowding out private sector spending, something which is likely to be at least as applicable to deficit spending in general given the interest rate effect.

Beavis & Butthead-onomics

Here is a mind challenging quiz for you. Watch this Youtube-clip (more specifically the actions between 2:35 to 4:40 into the clip), and then ask yourself, first of all: what's the catch (after all, Beavis and Butthead are careful to always exchange actual dollars for the candy bars they buy and eat), and secondly what connection this has to Keynesian economics. I'll give you two days (until Tuesday evening) to think about it, and then I'll give you the answer to both questions.

UPDATE: The clip has now been removed. See a summary in my follow-up.

Fiscal Policy & Price Inflation

With much of Europe (not just Greece, Spain and Portugal, but also for example Britain, France and Italy) engaging in fiscal austerity programms, one question that arises is what effect this will have on price inflation.

Traditionally the view is that it depends on whether or not the central bank also tightens monetary policy. If a central bank is monetizing deficits, and responds to a decline in the deficit by monetizing less, then fiscal austerity will reduce inflation. If on the other hand the central bank tries to inflate more to compensate for the expected drag on growth caused by fiscal action, then it could increase price inflation.

This view is largely corrects, but in a way it begs the question of what happens given a certain monetary policy. Or in other words, what happens if monetary policy is not changed at all?

In general, the effect will be to reduce price inflation. The reason for that is that a lower deficit will reduce direct spending on consumer goods, something which will lower their price. Meanwhile, by reducing demand for loanable funds, fiscal austerity will lower interest rates and raise asset prices and the prices of capital goods.

However, this outcome presupposes two things. First of all, that fiscal action do not have significant negative supply effects. If the effects on supply is greater than the effects on demand, then price inflation will not go down but in fact increase.

If on the other hand fiscal austerity have a positive supply effect, then the inflation reducing effects from lower demand will be reinforced further.

The main example of a supply-reducing fiscal austerity actions is higher marginal tax rates (including increases in consumption taxes). Supply increasing fiscal austerity action includes for example reduced unemployment benefits and a higher retirement age.

Another thing which it depends on is to what extent the lower interest rates caused by fiscal austerity will cause the currency to depreciate or not. Generally this will be the effect, but it is uncertain just how great the effect will be. If the currency depreciation is great enough, then inflation might in fact increase as a result of fiscal austerity.

In the case of the euro area (or any other currency union, or group of countries with fixed exchange rates), relative inflation within the euro area will always be reduced (at least assuming that there isn't significant supply reducing effects caused by tax increases) as a result of fiscal austerity since there won't be any nominal exchange rate movements within the euro area. Because the euro will probably depreciate as a result of fiscal austerity, the net effect on inflation in countries tightening fiscal policy will be uncertain, but it is certain that it will raise inflation in countries that don't tighten fiscal policy.

Venezuela's Economy Continues To Decline

While most other countries are recovering, Venezuela's economy is still contracting, with the official number being a GDP contraction of 5.8% between Q1 2009 and Q1 2010. Given how tightly everything is under the control of Venezuela's loony dictator, Hugo Chavez, this number hardly exaggerate Venezuela's hardship, and in fact it likely underestimate the problems.

Given the loony economic policies of Chavez, these problems should hardly be surprising.

The Difference Between Outlays And Expenses

At the Naked Capitalism link page, a link to Ambrose Evans-Pritchard's latest is included, with the last paragraph being particularly recommended. What is in that last paragraph? Well, this:

"The second clause said that if any country finds it cannot raise funding for the rescue at interest rates below the 5pc charge agreed for Greece, it may opt out of the bail-out. BNP Paribas said this would escalate quickly into a systemic crisis if Spain were in such a position, because the other countries cannot carry an ever-rising burden. The bank warned the euro project itself may start to disintegrate rapidly if these rescue provisions are ever seriously put to the test."

It seems that Evans-Pritchard (and BNP Paribas) fails to understand, or properly apply, the distinction between outlays and expenses.

Outlays means the purchase of something, an expense is loss of value. The two are in some cases the same, like when you buy a burger and eat it (or throws it away, or lets it go bad). In other cases, they apply to the same objects but during different time periods. An example of this is when a company buys a machine that lasts 5 years. The entire outlay is in the first year, while only one fifth of the expense is in the first years, with the rest of appearing the coming 4 years.

Sometimes however, an outlay may not be an expense at all. If you buy a security, then that is an outlay, but unless the investment goes bad, then it won't be an expense at all. It will simply represent a shift in your asset portfolio from cash to the bought security (or a shift from a sold alternative security to the new, or an equal increase in total assets and total liabilities if the money needed to buy the security is borrowed). But what does this brief accounting lesson have to do with the contents of the quoted paragraph?

Well, because the paragraph assumes that the rescue will be loss making, and respresents an expense for the involved countries. Then it would make sense to argue that if some countries dropped out, the burden might be too heavy. But if you realize that the outlays are not loss making, but profitable as it is an arbitrage operation, then there would be nothing economically unsustainable about for example Germany alone doing the entire rescue, especially now that the German government can borrow at ridiculously low interest rates, with the 6-month yield being 0.2%, the 5-year yield 1.47% and the 10-year yield 2.61% (when this is written, when you read this the yields may have declined or risen a few basis points).

That's The Spirit

Labor market statistics from Taiwan today confirmed the strong recovery indicated by Thursday's GDP numbers. Employment grew 0.3% compared to the previous month and 1.85% compared to April 2009, while average pay increased 5.7% (note that in introductory text it is described as a decrease, but if you look at the table it is clear that it is an increase).

Apart from confirming that Taiwan and the rest of Asia is experiencing a rigorous recovery, there was another interesting aspect in the way the pool of potential workers was defined.

Both the employment rate and the labor force participation rate are calculated as employment or labor force relative to the working age population. The working age population in turn is usually defined as everyone in the age range of 15 to 64 (or sometimes 16 to 64, 20 to 64 or 15 to 74). People younger or older than that are considered too young or too old to work, so they aren't included.

Yet in Taiwan, the working age is defined as everyone older than 15. By assuming that even people older than 65 or 75 is capable of working they have the kind of spirit which can solve the problems associated with an ageing population (meaning the increased burden of providing for people that have retired).

There are many proposed solutions to this problem, including increasing the birth rate, increasing immigration and the use of robots and other forms of mechanization, yet none is as effective as raising the retirement age. Because not only will this mean more workers, it will mean that the number of people the workers have to provide for will be fewer.

Of course, as long as only a small fraction of old people work, it can in some contexts be analytically misleading to include old people in the working age population, so the popular Western definitions are not always wrong. But to the extent Taiwan's definition an attitude that anyone capable and willing to work should do so no matter how old that person is, it increases Taiwan's chance of avoiding the problems associated with an ageing population.

U.K. Fiscal Situation Deteriorating Further

The U.K. budget deficit continues to deteriorate, with the deficit increasing from £8.8 billion in April 2009 to £10.0 billion in April 2010.

The numbers are even worse if you consider that tax receipts were boosted by the VAT increase (VAT receipts increased £1.5 billion), and if you consider that the balance was according to the statistics bureau boosted by some one-time items.

Considering that other statistics indicates a recovery (albeit only a weak one) this is somewhat surprising. This suggests that either there were some other temporary factors which worsened the outcome but was unnoticed by the statistics bureau, or that the economic recovery may be illusory.

Particularly if the latter explanation is true, and this implies a continuing deteriorating trend, this makes the pledge by the incoming Conservative-Liberal Democrat government to undertake austerity measures all the more important. And it makes the recent rally in British government bonds somewhat puzzling, except as a vote of confidence in these future unspecified austerity measures (though it should be noted that specified austerity measures in other countries, particularly Greece but also Spain and Portugal has been met with a lot less enthusiasm).

Japanese Economic Boom Driven By China

While less than in most other Asian countries, and less than some analysts had expected, Japanese growth was nevertheless relatively strong, beating both the U.S. and the EU. After adjusting for terms of trade, GDP was up 0.9% or 3.5% at an annualized rate (Before adjustment, it was 1.2% or 4.9% at an annualized rate) compared to the previous quarter.

Compared to a year earlier, the gain was 3.3% in adjusted terms and 4.4% in unadjusted terms. The main reason for the increase was an increased trade surplus, as real domestic demand only increased 1.1% compared to a year earlier. Meanwhile the nominal increase in exports was 36.4% versus only 15% for imports.

A separate report shows the current account surplus in March was 2,534 billion yen (roughly $28 billion) versus only 1,535 billion yen (roughly $17 billion) in March 2009.

This is the flip side of the rapidly decreasing Chinese trade surplus, as it is mainly higher net exports to China that accounts for the increased trade surplus. The high real interest rates in Japan also contributes to higher savings, something which contributes to a higher trade surplus.

Basic Monetary Economics For The Monetary Economics Challenged

I have been asked by a reader to comment on this article that Mark Thoma linked to that criticized Ron Paul's monetary economics:

"The Fed has the ability to create money "out of thin air!" Whenever I hear this expression, I chuckle. We all have the power to create debt out of "thin air." When Microsoft creates shares to finance an acquisition, it creates the shares "out of thin air." If you bum a beer from a friend and promise to repay him next week, you create a debt obligation "out of thin air." Ooooo..."out of thin air!""

While this may appear convincing to some at first glance, it is actually nonsensical. The difference between these transactions is of course that debt or equity is not the same thing as money. When the Fed buys some asset (and doesn't neutralise it by selling some other asset) it doesn't require for someone else to voluntarily give up his money, whereas when Microsoft issues shares or you borrowing money from a friend to buy beer does require for someone else to give up his or her money. The reason why the Fed can buy stuff without convincing someone else to give up his or her money is of course because the Fed unlike everyone else can create money out of thin air. Issuers of shares or or debt obligations financing beer purchases doesn't involve the creation of money, but the re-allocation of already existing money.

The appropriate real life analogy to the money creation abilities of the Fed and other central banks would in fact be the legalization of counterfeiting.

Euro Debt Panic Will Have Deflationary Impact Upon U.S.

Tim Duy discusses here whether or not the European debt panic will benefit or hur the United States. His conclusion is that the crisis will do more good than harm.

Duy acknowledges that one of the key effects of the panic, namely the dramatic drop in the euro's exchange rate relative to the U.S. dollar, will hurt U.S. exporters, primarily those that export to the euro area (and countries whose currency has a fixed exchange rate to the euro, like Denmark), but also exporters to other countries as European competitors will gain an advantage. For example it will be easier for Airbus to outbid Boeing in bids for airplane contracts from China or India.

Furtherore it could be added that the general panic has caused not only the euro and currencies with a fixed exchange rate to the euro to drop in value, it has also dropped most other currencies to drop against the U.S. dollar, though usually not quite as much as the drop of the euro and currencies pegged to the euro.

A stronger U.S. dollar will furthermore reduce the dollar value of factor income from U.S.-owned subsidiaries in not only the euro area, but in most other countries as well.

On the other hand, the stronger U.S. dollar will reduce the dollar price of oil, and most other commodities, and for that matter (to a lesser extent, at least in the short term due to the pricing to market practice) finished products, something which will increase the purchasing power of the U.S. dollar.

In conclusion, while the effect on real GDP/national income in the U.S. of the European debt panic remains uncertain, it seems very clear that it will lower nominal GDP/national income by lowering export revenues and net factor income from abroad, while increasing the purchasing power of the U.S. dollar. Thus, the only certain impact on the U.S. economy is that it will be more deflationary, with lower nominal growth but also a higher purchasing power of each dollar.

Today's negative PPI number will thus likely be followed by more.

Matthew Yglesias Distort The Record About Denmar & Sweden

This is an old one (though only today discovered by me) , but Leftist blogger Matthew Yglesias, tries to explain away the labor market facts of Sweden and Denmark that I discussed in March(with Casey Mulligan as middle man).

The argument advanced by Yglesias was that this was due to Sweden having a floating (or at the time actually sinking) exchange rate, while Denmark pursued a fixed exchange rate policy (relative to the euro).

But if Yglesias had bothered to read my post more carefully, he would have noticed that I noted that the drop in GDP in Denmark and Sweden was roughly similar (slightly smaller in Denmark, in fact), so hypothetical "stimulative" effects from a weaker currency can't explain the Danish-Swedish divergence

By contrast, improved incentives for low income workers in Sweden through reduced taxes and unemployment- and sick leave benefits can explain this since it will theoretically increase employment more than output. And since the newly employed after all did produce something, it can be inferred that the drop in Swedish GDP would have been even greater without the improvement in incentives.

Even so, it can be conceded that the weaker Swedish currency could to a lesser extent explain this since it generated higher inflation which in turn given a certain level of nominal wages reduced real wages. But given the small difference in inflation that was probably only a minor factor, and at any rate it shouldn't be a factor which leftists should embrace since they normally abhor wage cuts.

Gold Rise Above €1,000

While this is not noticed by most people, because they focus only on the dollar price of commodities, the euro price of gold hit a new high today, rising for the first time ever above €1,000 per ounce of gold. When this is written the dollar price of gold was $1,236 per ounce, while the euro stood at 1.2278, implying a euro price of gold of approximately €1,008 per ounce. This is roughly 30% higher than 6 months ago, when the euro peaked against the dollar.

I bet those European central banks are glad they sold off gold now.....

In part this increase in the price of gold probably represents an increase in inflationary expectations in Europe, and in part it reflects general safe haven demand.

Detroit Starts To Destroy Homes

No, I am not talking about the [formerly] big three car companies, I am talking about the city of Detroit.

Detroit has for long been an extreme left-liberal Democratic stronghold, in fact it is the most extreme left-liberal stronghold in America, even more so than other infamous left-liberal Democratic strongholds like San Francisco and Washington, D.C..

As such, it has pursued failed policies that makes Detroit extremely unattractive for businesses, so unattractive that because of the lack of jobs, people feel compelled to leave the city.

Because of this, there is an abundance of empty, abandoned homes in the Detroit area. Realizing that their policies have made Detroit so unattractive that even at the extremely low prices of these homes, no one wants to move in, the Detroit city council has now started to demolish many of these empty houses.

Euro Falls To Lowest Level Since April 2006

The euro today continued its decline, falling below the March 2009 lows against the U.S. dollar, and closing at the lowest level since April 2006.

The weak euro is of mixed blessings for the euro area, benefiting some and hurting others. Since the key beneficiaries include debtors, including euro area governments perceived as week, the weakness of the euro will ease the debt crisis, especially since it this time is not associated with higher nominal bond yields for countries perceived as week.

What's Behind Recent European Market Movements

After rallying initially on Monday, the euro has fallen back to the pre-rescue package lows. Does this mean, as Paul Krugman suggested, that the rescue package failed to restore confidence?

No, as usual Krugman is wrong.

If the problem really had been that fear of defaults persists, then bond yields in troubled countries would have risen at the same time. But as it happens, they have not only not given up the initial drops, they have continued to drop.

But why then has the euro dropped in value?

To answer that question we need to remind ourselves of what factors influence interest rates:

In short, it is:

1) Time preferences of households, companies and governments.
2) Inflation premium
3) Liquidity premium
4) Perceived risk of default
5) Central bank demand.

There is no reason to assume that factor 3) has changed, so that can be ignored in the continued analysis.

Factor 4) is a factor which certainly has changed (the perceived risk has gone down), and which has contributed to strengthening the euro and reducing bond yields in the crisis hit countries. The reduced decline in the perceived risk of default is mainly a direct effect of the rescue package, but also in part a result of the inflationary effect of a weaker euro, which will increase nominal GDP and ease the relative debt burden.

Factor 5) is a factor which also has changed since the ECB by changed its asset portfolio from consisting entirely of loans to banks to partially consisting of loans to government (bond purchases in other words). This will have the effect of reducing bond yields, while it has little effect on the euro's exchange rate.

Factor 1) has also changed and also contributes to lower yields in the entire euro area. By lowering interest rates it also likely lowers then value of the euro. The reason why it lower yields is that because of the austerity measures announced, government demand for loanable funds will drop.

Given the rally in gold, with the euro price of gold approaching €1,000 per ounce for the first time ever, factor 2), it seems likely that markets distrust the ECB's pledge to "sterilize" their government bond purchases, and therefore expect higher inflation, something which other things being equal will weaken the euro and raise nominal bond yields in the entire euro area.

Applying this theoretical analysis to the specific phenonenoms, factor 4) contributes to a stronger euro, but this is counteracted by the weakening effects of factors 1) and 2). Empirically in this case, factors 1) and 2) appears to be slightly stronger than the effects of factor 4).

For German bond yields, factors 1) and 5) contribute to lower yields, but factor 2) increases them. As German bond yields have been roughly unchanged, the effects of factors 1) and 5) appears to be roughly equal to the effects of factor 2)

For yields of bonds issued by Greece, Italy, Spain and Portugal, factors 1, 4 and 5) contributes to lower yields while factor 2) increases them. As these bond yields have dropped dramatically, it appears as if the combined effects of factors 1, 4) and 5) are a lot bigger than the effects of factor 2).

In summarize, inflation fears seems to have increased, while fears of default and net government supply of debt securities have dropped. The net effect of this implies continuing weakness in the euro, unchanged German bond yields and lower bond yields in Greece and other Southern European countries.

Spain Chooses Sounder Austerity Measures Than Portugal

In exchange for the rescue package announced last Sunday, both Spain and Portugal committed to making further austerity measures.

Now the details have been released. The difference is that while both countries chooses to both raise taxes and reduce spending, Spain primarily relies upon reductions in government spending increases, while Portugal relies primarily upon tax increases. The Portuguese Prime Minister Jose Socrates argued that the emphasis on tax increases instead of spending cuts. this mix would have "the smallest recessionary impact possible".

But tax increases do not have a smaller recessionary impact. Quite to the contrary. Spending cuts and tax increases have the same demand side effects, but tax increases also have a negative supply side effect by worsening incentives, meaning that tax increases are a much worse option.

Perhaps Socrates hopes that tax increases will invoke less Greek-style strikes and protests from labor unions and other Marxist groups, but a representative for the Portuguese Communist Party has said that they will still launch protests.

It seems that the Iberian Peninsula divide on economic policy wisdom persists.

The Limitations Of Keynesian Arguments For Tax Cuts

Martin Feldstein tries to justify extending the Bush tax cuts (which are set to expire in 2011) by another 2 years, using the Keynesian argument that the recovery is too weak for the government to reduce purchasing power through higher taxes.

But as Mark Thoma points out, one could just as well implement temporary increases in government spending of the same amount as the tax cuts, while letting the tax cuts expire. So Keynesian analysis is not (at least not by itself) enough to justify tax cuts as opposed to spending increases.

The real economic argument for the tax cuts instead consists in that they (unlike spending increases) improve incentives and thus improves structural growth. But accepting that would of course create a case for making the tax cuts permanent, and not extend them for merely 2 years like Feldstein advocates.

European Growth Heats Up

First quarter Euro area growth came in at a slow, but faster than expected, 0.2% compared to the previous quarter (or 0.8% using the American way of expressing growth) and 0.5% compared to the Q1 2009. Particularly Germany and Italy came in stronger than expected, something which was partially counteracted by a weaker than expected French number.

First quarter growth in Germany and other Northern European countries were depressed by the weather factor, something which will not be a factor during the second quarter. The disruption to air traffic following the Icelandic volcano ash cloud will however be a factor depressing growth, but the impact will probably be smaller than the effects of the cold snap.

Judging by the industrial production and manufacturing orders numbers released, growth will indeed almost certainly be higher in the second quarter, despite the turmoil in certain bond markets.

Among EU countries for which numbers are available, Slovakia had the strongest yearly growth rate at 4.6% while Latvia had the weakest number at -5.1%. Among euro area countries, Greece was weakest with a 2.3% contraction. And unlike Latvia which saw a small quarterly gain, Greece saw its GDP shrink compared to the previous quarter too. This was likely in part a result of the disruptive strikes organized by the Marxist unions, a factor which will depress second quarter growth too.

By contrast, the other crisis struck countries (Spain, Portugal and Italy) had positive quarterly growth rates and two of them (Portugal and Italy) had positive yearly growth too.

Conservative-Lib Dem Coalition Is Illogical &Unsustainable

It increasingly looks as if the Liberal Democrats won't go into coalition with Labour but with the Conservative Party.

This may in some sense seem like the logical choice since Labour and the Liberal Democrats couldn't get a majority of their own, but would be dependent upon separatist parties from Scotland, Wales and Northern Ireland, while by contrast a coalition of the Conservatives and the Liberal Democrats would get a majority.

But that appearance is deceptive, as the fact is that on economic policy, the Liberal Democrats are in fact to the left of Labour, while the Conservatives of course are to the right of Labour. This means that either the Conservatives or the Liberal Democrats or possibly both will have to betray their ideals and the policies they pledged before the election.

It is difficult to see how that sort of arrangement could last. And even if it did, voters would almost certainly punish the parties involved, especially since Britain now faces a period of probably not too popular austerity measures to bring down the huge budget deficit.

About EU Rescue Package

I am somewhat busy now, but I should perhaps still briefly comment on the rescue package agreed upon by EU leaders. It is not quite what I would have preferred, as it would have been better to not specify any amounts, but simply impose an open ended mechanism that I described here, where countries with low borrowing costs offer in exchange for a reasonable yield premium (with an interest rate of say 5%) and commitment to fiscal austerity measures. That way there wouldn't be any potential risk of having to return to new "crisis meetings" because someone argued that the sums were insufficient, something which in turn would cause another round of panic.

Still, the €700 billion or so now specified should probably be sufficient. If the panic subsides, then only a small fraction of it (or even nothing at all) will have to be actually exercised (Because if for example Portugal and Spain can borrow at a cheaper rate in the bond markets, there will be no reason for them to tap into any of the pledged €700 billion). But even if it doesn't, this amount should be sufficient for at least the coming year and probably even longer. So it was clearly a big step in the right direction.

In addition to that, the ECB now opens up the possibility of it buying government bonds, something which will improve the odds that the panic will subside.

One question is whether this is inflationary or not. The answer to that depends on whether or not the ECB keeps its pledge to "sterilize" these purchases or not. If it does, then it will not affect the size of the monetary base and thus not be inflationary. If however it doesn't keep this pledge, then this action will indeed increase inflation.

Why "Starve The Beast" Has Worked So Poorly

These days, I only rarely agree with Bruce Bartlett’s writings. But he does have a point here, citing Bill Niskanen, about why the "Starve the Beast"-strategy for containing government spending may not work:

"For some years Bill Niskanen of the libertarian Cato Institute has argued that STB actually increased spending and made deficits worse. His argument is that the cost of spending is ultimately the taxes that will have to be raised to pay for it. Thus fear of future tax increases was the principal brake on spending until STB came along. By eliminating tax increases as a necessary consequence of deficits, it also reduced the implicit cost of spending."

The point here is that if people do not associate higher spending with the sacrifice consisting of higher taxes, then many voters will feel that all higher spending results in is more money from the state, while in the past when deficits were shun, people associated higher spending with the sacrifice of higher taxes.

If for example Bush's big spending increasing schemes, the "No Child Left Behind" act, the Medicare prescription drug benefit act and the Iraq war, had been fully funded by tax increase, then it seems likely that there would have been stronger opposition to them.

Thus, at least in the short-term, "Starve the beast" might increase spending.

The fact that interest payments will become a bigger cost in the budget if a government runs up a big national debt is also something that in the long term will increase spending.

Whether or not that remains the case in the long run depends on how high cost in the long term that high deficits are associated with, something which in turn depends on how vigilant the bond market is.

If a country's bonds are considered a "safe haven" (and through the self-fulfilling prophecy mechanism becomes a "safe haven") by credit rating agencies and the bond market, like for example the United States and Germany (and to lesser extent Britain and France), then the political price of high deficits will probably be lower than the political price of higher taxes, meaning that tax cuts or the absence of tax increases probably increases spending.

By contrast, a country's bonds are considered to be "unsafe" (and through the self-fulfilling prophecy mechanism becomes "unsafe"), as is the case these days (but wasn't until recently to any major extent) with Greece and Portugal (and to a lesser extent Spain and Italy), then deficits will put stronger pressure to reduce spending than higher taxes.

Also relevant is the relative popularity among the general population for keeping taxes low or keeping spending high. If keeping taxes low taxes is more popular than keeping spending high, than "Starve the beast" might work. But if the reverse is true, than it will never work.

That is of course why a popular fix is raising taxes for the wealthy. The majority of people usually don't mind if a small majority of rich people pay more in taxes, but they usually do oppose paying higher taxes themselves. The problem is that tax increases for the rich can usually at best only fill a small part of the large budget gaps that most countries have, especially if you consider the growth depressing (and tax evasion increasing) effects of such tax increases. Indeed, if you have gone too far along the Laffer Curve, such tax increases might even reduce revenues. In reality, politicians will be forced to either cut spending or raise taxes for people with low or moderate income-or both cut spending and raise taxes for "normal people".

A Short Note On U.S. Employment Statistics

The April U.S. employment numbers were quite robust, with payroll surevey employment increasing strongly and household survey employment increasing even more. While the unemployment rate rose, that was only due to a higher participation rate. Also, the average work week rose, meaning that hours worked increased even faster. This clearly suggests that the U.S. recovery accelerated in pace in April.

The only thing that was bearish was that average hourly earnings were essentially unchanged after decreasing slightly the previous month, causing the yearly increase to drop to a new low of just 1.6%. This suggests that the increase in employment wasn't just a matter of higher economic growth, but also of unemployed workers finally lowering their wage demands so that they can finally get jobs.

Britain Gets A "Hung Parliament"

Votes are counted pretty slowly in Britain, and the full results are not yet in as of this writing. But it seems clear that the Conservatives will fail to win a majority. What is also clear is that the Liberal Democrats fared much worse than expected. While they increased slightly in the popular vote, they didn't increase as much as expected and they actually lost seats due to the British electoral system.

The two "far right" parties, the U.K. Independence Party and the British National Party, both of whom strongly oppose both immigration and EU membership (with the difference being mainly that the BNP is openly racialist and views the immigration issue as more important, while the UKIP denies racial considerations and views leaving the EU as more important) both gained significantly, increasing from 2.2% and 0.7% respectively to 3.1% and 1.9%. But due to the electoral system they gained zero seats. If their voters had instead voted for candidates from the moderately immigration and EU skeptical Conservatives, then the Conservatives would have likely won, and would have been able to push through actual anti-EU and anti-immigration policy changes.

With the Conservatives having roughly the same number of seats as the combined total of Labour and Liberal Democrats, it will likely come down to smaller, usually regional parties to decide whether David Cameron or Gordon Brown will be PM. The two "far left" parties, the Green Party and the Social Democratic Party, will presumably side with Labour and the Liberal Democrats. The sympathies of the three regional separatist parties, the Scottish National Party, Sinn Fein (Northern Irish Catholic separatists) and Plaid Cymru (Welsh separatists) is less clear, but since Labour has historically been more sympathetic to regional autonomy, they are more likely to side with Labour and the Liberal Democrats. The Northern Irish Protestant Democratic Unionist Party will by contrast likely side with the Conservatives. The disposition of the one "other" seat is less clear, as is the disposition of the self-described "non-sectarian" Northern Irish Alliance Party.

To hang on to power, Gordon Brown might make concessions in terms of greater regional autonomy and the electoral system.

Another thing to note is that regardless of whether Gordon Brown or David Cameron is more successful in luring over smaller parties, their governments will be very weak. Will such a weak government be able to push through the necessary deficit reduction measures? That seems dubious to say the least, something which bodes ill for the fiscal future of Britain.

The Easily Solved EU Contagion Problem

As you may have noticed today, financial markets suffered yet another panic attack today related to the issue of Southern European debt. Unless action is taken, this problem will likely only get worse, because of the self-fulfilling prophecy mechanism, which is to say in this case that fears of default drives yields higher, and then the higher yields helps further boost those fears, which in turn increases yields further, which in turn further raises default fears which in turn further raises yields and so on in a vicious spiral.

Thus, at this point, the primary problem isn't the large deficits but the vicious spiral self-fulfilling mechanisms, something which is illustrated by the fact that bonds from the governments of the United States, Japan, France and even Britain are considered "safe havens" while Italian bonds are considered risky even though Italy had in fact a much lower deficit than these other countries.

If this continues, then the economies of Europe and to a lesser extent the rest of the world will suffer. Isn't there something that could be done to break this vicious spiral? Yet, it is, and it is surprisingly easy.

All EU leaders need to do is to essentially extend the problem-solving mechanism I discussed for Greece to all euro area countries, which is to say the ability to borrow at 5% in case you can't borrow cheaper on your own in return for pledges of significant austerity measures.
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Since this is an arbitrage, and not a subsidy scheme, there is nothing economically unsustainable or irrational about this, no matter how many hundreds of billions of euros it requires. Greater sums will in fact only mean higher interest income for lenders like Germany and lower interest costs for borrowers like Spain or Greece in this arbitrage arrangement.

As a result of this Germany will be able to lower taxes for its citizens using the interest income, while borrowing countries will be able to whether the panic as they reduce their deficits under orderly conditions. It remains to be seen however, whether or not EU leaders will be rational enough to defuse this threat to the economic recovery in this simple way. Whether or not they respond in this way will be a simple test of how rational they are.

New Zealand Interest Rate Hike Imminent?

The latest unemployment report in New Zealand showed a big drop in the unemployment rate during the first quarter, from 7.1% to 6.0%.

As a result, New Zealand might soon as fourth advanced economy (after Australia, Israel and Norway), soon start raising short-term interest rates, currently at 2.5%. If that happens, the attractiveness of the New Zealand dollar as a target currency in carry trade will again increase.

The seemingly ever escalating Southern European debt panic might derail this, but probably not since New Zealand is very far away from Europe (It's on the other side of the planet) and has therefore stronger economic ties to Australia, America and Asia than with Europe.

Furthermore, the biggest European economy, Germany, shows increasing signs of booming despite the problems in Southern Europe, with manufacturing orders up 5% compared to the previous month, up 10.4% compared to 3 months earlier and 30% compared to 12 months earlier.

Well Said

Radio Free New Jersey doesn't mince words about the Marxist led Greek protestors. An excerpt:

"Morons

There is no money. There is no one else’s pocket left to pick. You can’t borrow anymore, you can’t print anymore, and you can’t steal anymore from anyone else....

....Socialism always was (and frankly – still is) a horrible idea. It’s the reason you’re in this embarrassing position in the first place. In the eyes of the world you all look just as stupid and spoiled as can be. You could be protesting in diapers and demanding that ‘the state’ wipe your behinds and it would only marginally affect your public image. You need to accept the fact that there are no circumstances under which politics can arrange for nothing to be equal to something. You can not make a contribution of zero and expect to get a benefit greater than that.

You’ve thrown your bottles, burned your flags, waved your signs and had your fun. Now it’s time for you to learn the lessons of history and abandon this idiocy before we finally lose our patience with you. Grow up – and get back to work."

The Forgotten Icelandic Meltdown

These days, when media focus is on the panic surrounding Greek debt, the Icelandic drama is largely forgotten. When Iceland is mentioned it is usually related to the recent Volcano eruption, and not its 2008 meltdown and its repercussions. But the problems have not disappeared, contrary to the presictions of prominent pro-inflationist columnists.

Consider first of all the collapse in real wages for Icelandic workers. Average hourly earnings rose in nominal terms by 3.6% between March 2009 and March 2010, after having risen by 5.5% between March 2008 and March 2009. As a result the cumulative 2 year increase is 9.3%, not so bad, eh?

Or actually, yes, it is bad, since consumer prices rose 11.6% between March 2009 and March 2010, after having risen by 19.9% between March 2008 and March 2009.

As a result, real wages fell 7.2% in the latest year, after having fallen 12% during the previous year, for a cumulative 2 year decline of 18.3%.

An 18.3% decline in real hourly earnings would by itself be more than bad enough, but it gets worse as Icelandic workers that have kept their jobs have also seen a decline in the number of hours they get to work, meaning that their real weekly/monthly pay declined even more. With the average work week declining by 5.5%, from 41.9 to 39.6 hours, this implies a decline in real earnings for workers who have kept their jobs of 22.8%.

And it gets even worse if you consider that the employment rate fell from 81.3% in 2007 to 75.1% in 2009. Add that into the equation, and you'll find that the average real pay of all people in Iceland fell by as much as 28.7%.

And note that all of these numbers reflect on the situation before the Volcano eruption (whose effect on the Icelandic economy is unclear, but probably negative), so it can't be blamed on that.

The lesson here is that having your own currency, and the ability and will to seriously debase its value, is not something which will enable you to escape negative consequences of economic mismanagement, as some claim is the conclusion to be reached from the Greek debt panic.

And As A Semi-Personal Note

I was lured into buying a Pringles "Sea Salt & Black Peppar" potato chip package today. Since I generally like Pringles, and since there was a rebate for that particular sort, I decided to try it.

The result: IT WAS HORRIBLE. Quite frankly, it's the worst tasting potato chips I've ever tasted. I had to throw away most of it. And no, I am not (unfortunately) paid by some rival company to write this (something which should also be apparent from the fact that I wrote that most Pringles chips are good), it reflects my honest opinion. Buying it even with a rebate is throwing your money away.

Euro Falls Below 9 Yuan

Back in November, Paul Krugman complained that the Chinese government had kept the yuan/[U.S.]dollar exchange rate stable despite a drop in the U.S. dollar's exchange rate:

"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."

But in recent months, the U.S. dollar has in fact risen against other major currencies, particularly the euro. As a result, the euro has dropped from a high of 10.3 yuan in November to less than 9 yuan today. The gains have been lower against other currencies, but the yuan is also up against for example the yen and the pound. Does this mean that China has carried out a benefit-thy-neighbor revaluation? Or does this indicate that the Chinese might not have been motivated as much by a desire for a low exchange rate but for a stable exchange rate against the dollar? It would be interesting to hear Krugman's take on it, though I personally view the latter as more plausible.

As a sidenote, I analyzed the various other fallacies in that column here.

Another interesting thing to note is that for the people who argued that Greece needs a weaker currency, they are in fact getting just that right now, so they should also be pleased by this development.

Australia's Beggar Thy Neighbor Tax Policy

More news from "Down Under": The Australian government is planning a 40% tax on profits of miners. This is bad news not just for the miners, but for the world economy as a whole as well.

The result of this tax will inevitably be to reduce mining activity in Australia. The result of that in turn will be to push up commodity prices. For Australia's economy the effect is ambiguous, as lower output volumes will be counteracted by higher export prices. For the world economy as a whole, the effect is by contrast unambiguously negative as the higher prices are simply redistributive (Australia as well as other miners will gain while the buyers will lose an equal amount). By contrast the lower mining output won't be compensated by higher output in other sectors. Indeed, the effect of higher input costs is probably negative.

So while the net effect on Australia's economy is uncertain, and while miners in other countries will gain, it is certain that the net effect for the rest of the world is negative and that total global output will be lower. The Australian government is acting as a "text book monopolist" that tries to gain at the expense of others by raising prices and restricting output.

Australian House Prices Continues To Soar

Australia's housing market continues to boom, despite much higher interest rates than in other advanced economies, rising as much as 20% in the year to the first quarter.

This will probably prompt the Reserve Bank of Australia to raise interest rates again (though not necessarily at their next meeting). That might cool, but will likely not stop (just like previous five rate hikes haven't stopped it) a housing boom driven by the general economic boom and a housing shortage related to rapid population growth.

UPDATE: The RBA did in fact raise short-term interest rates at the next meeting which was already today.

A Historically Weak U.S. Recovery

The Wall Street Journal editorial page points out that the U.S. recovery has been very feeble compared to the 1983-84 recovery, which came from a similarly deep recession. I myself wrote last year on the subject. Since then, growth numbers have come in somewhat stronger, but even now they are relatively weak considering the circumstances.

The big difference between then and now is that then there were aggressive marginal tax rate reductions, whereas no reductions of that kind has been seen now, and America faces big increases next year as the Bush tax cuts expire, and the tax increases included in the health care bill kicks in.