More Fallacies About The GDP Accounting Identity

A reader asked me to comment on this article by John Tamny about why "weak GDP Does not a weak economy make".

First of all, it should be noted that GDP is far from perfect. There are problems, relating to for example inevitably imperfect data collection (which is why there are so many revisions) and the fact that GDP may not reflect for example capital consumption or factor income movements.

But Tamny's particular critique is not related to that and makes little sense (Though as we shall we see he makes some good points about the causal effects of improts and trade deficits):

"In another account covering Friday's GDP revision, one newspaper noted that "Friday's GDP report showed a surge in imports, which grew at the fastest rate in 26 years, during the second quarter. Growth in imports far exceeded U.S. exports and wiped out more than three percentage points of U.S. growth in the quarter." If so, let's thank heavens for a number that was revised downward.

A higher calculation, if higher due to reduced imports, would logically signal a weaker economy and the reason why is basic: all consumption - and imports are consumption - is the result of production first. In the real world we trade products for products, and since there's no evidence of compassion on the part of global producers, the surge in imports to record levels points to a substantial increase in productivity stateside in order to pay for those imports."

But if you do not exclude imports, the mere act of demanding (purchasing) goods will constitute creation of wealth. Assume that Americans had all decided to quit working and forfeit all capital income. Then clearly they wouldn't have been producing something. But assuming they could find some foreigners willing to supply them goods they might still enjoy a high level of consumption. Would it still make sense to say that the value of their [non-existent] production would be high simply because they order a lot of imported goods? That clearly makes no sense.

Furthermore Tamny contradicts himself in the following paragraph by complaining about the Keynesian "elevation of demand", because not excluding imports would in fact mean the elevation of demand.

Still, while Tamny expresses himself in a misleading way in this context, he is still right when he points out that trade deficits don't causally reduce GDP. But his error is that he in his rightful attempt to refute that fallacy, he tries to deny the accounting identity truth that given a certain level of domestic demand, imports will reduce GDP.

The accounting identity is valid, but it may be misinterpreted. If information exists about a certain level of domestic demand, and we find out that foreign producers covered a higher proportion of that demand, then it is valid to revise down the estimate of the value of domestic production. But that shouldn't be misinterpreted as imports having caused the decline in the value of production.
It is just as consistent with the accounting identity Y=DD+NX (Where Y is GDP, DD is domestic demand and NX is exports minus imports) to assume that a decline in NX caused an increase in DD as it is to assume that the decline in NX a decrease in Y.

And indeed, given the fact that the mirror image of increased imports is an increase in capital inflows and given the fact that it is associated with increased benefits from deepening division of labor, it is likely that increased imports caused a higher value of real GDP.

So Tamny was right in rejecting the argument that higher imports causes a reduction in GDP. But he was wrong in questiong the GDP accounting identity. Instead he should have pointed out that the GDP accounting identity does not in fact imply that higher imports causes a lower GDP, as it might just as well be that it causes higher domestic demand.

U.S. House Price Increase Likely Temporary

Though most indicators released recently indicates that the U.S. economy is weakening rapidly, today's Case-Schiller house price indicator showed strength. However, this is likely the effect of people buying homes in anticipation of the expiration of the home buyer's tax credit. As other reports have indicated a sharp drop in demand following the expiration of the tax credit, it seems likely that house prices will turn down again.

Initially Assuming The Final Conclusion

Louis Woodhill nails it on the evaluation of the Congressional Budget Office on the effect of Obama's stimulus on output and unemployment:

"The striking thing about the CBO analysis is that it is "reality proof". Rather than presenting evidence that "stimulus" works, the CBO employed economic models that assume that "stimulus" works. As a result, no matter what happened to 2Q2010 GDP and employment, the CBO's calculations would always show that "stimulus" worked exactly as intended....

To estimate the impact of "stimulus" upon 2Q2010 GDP and employment, the CBO applied "output multipliers" to the reported expenditures in eight different categories. Their calculations did not include any actual economic data. Accordingly, when the BEA reduced its estimate of second quarter GDP downward by 33% on August 27, there was no need for the CBO to revisit their calculations."

(Actually it was GDP growth that was revised down by a third, but that was probably what Woodhill meant, and it doesn't affect the underlying point)

Thus, the report wasn't really a study of how the economy performed after the "stimulus" was implemented. All it showed was that if you use the assumption that Keynesian stimulus work while analyzing a specific case of Keynesian stimulus, the conclusion will be that this particular case of Keynesian stimulus worked.

While the report might nevertheless make interesting reading for those who believe in the models and their alleged justification in the form of previous similar studies, it is not really an argument against those of us who have argued against such models when they were presented before the "stimulus" was implemented.

Nice Try

After the extremely strong German second quarter growth number, and the weaker American one, Germany seems to have become the great role model in terms of achieving growth. This is kind of strange since a lot of countries both in Europe and elsewhere have had stronger growth (It would be more understandable to view it as a role model in holding down full time unemployment, but that has little to do with growth and more to do with its work sharing scheme).

Now Dean Baker tries to attribute the strong performance on increase in government purchases (which is not entirely synonymous with government spending since it excludes transfer payments). Baker says that since 2008, government purchases has increased more in Germany than in the United States, something which he claims disproves David Brooks suggestion that government spending increases don't boost overall growth.

But if you study the data more carefully, you can see that Brooks’s argument is actually more consistent with the data than the Keynesian argument advanced by Baker and others.

First of all, it should be remembered that the German slump was actually somewhat deeper than the American one. Between the first quarter of 2008 and the second quarter of 2009, GDP fell by 3.9% in the U.S. and by 4.4% in Germany*. Then in the three following quarters, U.S. growth was higher, 2.6% versus just 1.5% in Germany. Thus between the first quarter of 2008 and the first quarter of 2009, GDP fell by 1.3% in the U.S. compared to 2.9% in Germany.

How did government purchases develop in the two countries between Q1 2008 and Q1 2010 then? It rose by 2.8% in the U.S. and by 6.6% in Germany. Thus it is true that during the period when growth was weaker in Germany, German government spending rose more.

But what about Q2 2010 when German GDP rose by 2.2% while U.S. GDP rose by just 0.4% compared to the previous quarter? Well, during that period real government purchases rose by just 0.5% in Germany and by 1.1% in the U.S**.

Thus, during the period German government purchases grew more, its GDP was weaker, while during the period German government purchases grew less, its GDP was much stronger. Meaning that the actual correlation between government purchases and GDP has actually been negative, not positive as Baker and other Keynesians claim.

BTW, Krugman again invoke Hoover in this debate as an alleged example of a budget cutter, despite the fact that real government purchases actually rose by 11.0% between 1929 and 1932, with federal government purchases alone growing 18.1% between 1929 and 1932.

*=Note that the German recession ended a quarter earlier so to make the numbers comparable I have included that first recovery quarter in the "recession"-period.
**=If you visit the source pages that I link to, remember that quarterly growth is expressed differently in America and Europe.

How Effective Will The Fed's Measures Be?

The U.S. stock market rallied today on Ben Bernanke's announcement that the Fed will do "anything it can" to ensure recovery.

But just what can it do to "ensure recovery"? Create inflation? That's hardly a guaranteed path to prosperity as anyone in Zimbabwe would testify.

And even assuming that inflation will create prosperity, what can and will the Fed do to achieve it? It can't lower short-term interest rates any further. It could increase asset purchases, but as long as banks are unwilling to lend and/or their customers are unwilling (or unable due to a bad personal credit history), asset purchases won't do much good, especially considering the interest that the Fed is now paying on bank reserves.

Abolishing that interest or better yet making it negative would be more effective, but is the Fed really prepared to do that? I doubt it.

To be really effective in creating inflation, the Fed would have to be really unconventional, by perhaps large scale distribution of cash by helicopters or the legalization of counterfeiting. But that is not likely to happen, especially since it would require Congressional approval.

So, today's speech by Bernanke should instead be viewed as an attempt to boost confidence into the economy, without any real substance.

More Evidence Of U.S. Double Dip

Both existing and new home sales drop dramatically, as does core capital goods orders.

It seems increasingly clear that the U.S. economy is entering a double dip recession. These latest data increase the probability that we will see negative growth as soon as the third quarter.

Keynesians Advocate Emulation Of Hoover's Policies

Recently we have heard two positions from the prominent left-Keynesian pundits:

1) It is wrong with fiscal austerity, because that is what Herbert Hoover did and we all know how that ended.
2) It is right to raise taxes on people with high income.

The two propositions aren't necessarily contradictory if it had been possible to use the extra tax revenues to increase spending or reduce other taxes. Yet given current political reality with Republicans and centrist Democrats likely to block these other measures, it is in fact contradictory.

When faced with this contradiction they have often argued that tax cuts for people with high income are different, because they save most of their income. However, they never present any evidence of this assertion, and as a matter of fact evidence exist that proves it to be false.

Another falsehood is their assertion that Herbert Hoover was a budget cutter, when in fact he increased government spending. Between fiscal year 1930 and fiscal year 1933, federal government spending rose from 3.4% of GDP to 8.0% while the budget balance went from a surplus of 0.8% to a deficit of 4.5% of GDP. Even during the latest year, from fiscal year 1932 to fiscal year 1933, government spending rose from 6.9% of GDP to 8.0%, while the deficit rose from 4.0% to 4.5% of GDP.

Thus, Hoover was no deficit cutter. In fact, as it happens, the only "fiscal austerity" measure he implemented was in fact the very kind of measure which today's left-Keynesians regard as the only acceptable one, which is to say an increase in the top income tax rate from 24% to 63%.

Thus, even as they call others "neo-Hooverites", left-Keynesians in fact advocate fiscal policies that are nearly (it is true that their proposed increase is much smaller, but that doesn't alter the principle since they claim that higher taxes on high income earners won't affect the economy) identical to the ones pursued by Hoover: higher taxes on the wealthy combined with increases in government spending.

New Hampshire Vs. Maine

Two states in New England have chosen very different economic strategies, with Maine going down the leftist path and New Hampshire the libertarian path. As Amity Shlaes shows in her latest column, New Hampshire's economy has not coincidentally performed a lot better than Maine's.

Does Low Bond Yields Suggest Stocks Are Cheap?

Are stocks at current levels cheap or not? If you look at a historical comparison, the clear answer is "no", as the P/E ratio is above the historical average.

One counter-argument from stock market bulls is that bond yields are unusually low, which is to say the "P/E ratio" of bonds are unusually high.

It is true that all other things being equal, lower interest rates justify higher stock prices. But the flaw in the counter-argument is that all other things may not be equal. In particular, low interest rates might suggest low growth expectations, something which will depress investment demand for loanable funds. And if these expectations turn out to be true and economic growth is low or non-existent, then profits will be low, something which in turn will lower stock prices.

An example of this in practice is Japan, which in 2000 had even lower yields than America has today. The 10-year yield was for example less than 2% then.

Yet despite that low yield, you still would have been far better off buying that bond rather Japanese stocks, as the Nikkei index has dropped 43.6%, from 16,280 to 9,179 between August 20, 2000 and August 20, 2010. Including dividends would improve the relative performance of stocks somewhat, but not by much as dividend yields in Japan has typically been low (lower than bond yields).

This is not to say that stocks will necessarily fare as bad as in Japan as the U.S. economy might perform much better during the coming decade than the Japanese economy during the latest decade. But given how destructive economic policy has been that is far from sure. And the point is that there is no necessary negative link between bond yields and the attractiveness of stocks.

Confusing Effect With Cause Again

This New York Times story claims to have found a strong correlation between financial bubbles and income inequality.

I don't doubt that a strong historical correlation exists, but from that it doesn't follow that income inequality causes bubbles. Instead, the correlation exists because a common factor, inflationary monetary policy, causes both. Or more specifically, inflationary monetary policy creates higher inequality by creating a bubble that by lifting the net worth of the wealthy and by enriching financial companies causes inequality to increase. Inflationary monetary policy creates the bubble which in turn creates higher inequality.

Thus, higher top income tax rates will not reduce the risk of financial bubbles. Only less inflationary monetary policy will.

U.S. Monthly GDP Drops

While one should take these unofficial estimates with an extra grain of salt, the monthly GDP estimates created by Macroeconomic Advisors confirms the overall picture of a U.S. double dip that most other data indicate, as monthly GDP drops in June for the second month in a row.

Australia Following Britain?

This seems to be the year of "hung parliaments" (where neither of the mayor parties-or coalitions will get a majority) as it increasingly looks as if Australia will like Britain get it . And as I mentioned before, this outcome could very well happen in Sweden as well in next month's Swedish elections.

Anyway, returning to Australia, it seems more likely that Labor will form a minority government than that the centre-right coalition of Liberal and National Party will do so. The reason for that is that the Independents which hold the balance of power in the House have said that they will side with whoever has the best chance of forming a stable government. And since the Greens hold the balance of power in the Senate and since the Greens presumably are more inclined to support Labor that would probably mean Labor.

However, with Greens and Independents being necessary to make future decisions, the ability of Labor to push through major changes will probably be constrained. While the Greens will presumably support taxation of mining (including coal mining) and Australia's version of the "cap and trade" scheme (two policies which would both be destructive to the Australian economy), it remains to be see whether the Independents (most of whom have a background in the National Party) will support it.

North Korea Aiding U.S. Economy?

According to this story, the U.S. State department accuses the government of North Korea of counterfeiting $100 bills on a large scale. The State department further argues that this constitutes an act of aggression and is part of an effort to "sabotage" the U.S. economy.

But if we are to believe Paul Krugman and other Keynesians who claim that the U.S. economy faces a destructive deflationary spiral, North Korea is (if these accusations are true) actually aiding the U.S. economy. After all, if the problem is too much deflation, then more money will help alleviate the problem as an increased quantity of money will mean less deflation. Whether it is the U.S. or North Korean government (or other governments or private counterfeiters) which increases the quantity of money is irrelevant. Regardless of the source, more money will tend to raise prices or reduce price cuts.

So, if we are to believe the Keynesian analysis that most (if not all) of Obama's economic advisors believe in, we should be lauding North Korea for its efforts to fight the threat of deflation!

About The Industrial Production Data Anomaly

Yesterday I noted that almost all data point to a double dip recession in the U.S., with the strong July industrial production number being the one significant anomaly.

Robert Wenzel now tips me of a post by Dean Baker which explains that a large part of that apparent boom in industrial production reflected faulty seasonal adjustment.

Obama Repeats Nixon's Mistake On Oil

Alex Epstein has another interesting article about oil. This time he discusses the similarity of Obama's response to the Gulf oil spill to Nixon's response to a similar spill. In both cases they decided to ban oil drilling. While the ban would have (and will, in Obama's case) have negative effects regardless of outside events, the disastrous effect of that was clearest during the Arab oil blockade in 1973-which is also why Nixon lifted the ban after that . Let's hope that it wont take something that drastic and destructive to end Obama's ban.

U.S. Economic Double-Dip Is Coming

Signs that the U.S. economy is moving into a double dip recession continue to gather with initial jobless claims rising to 500,000, and the Philly Fed manufacturing index dropping into negative territory. Most other data this week confirms this picture, with the strong July industrial production data being the only real anomaly. But given how consistent other indicators have been, that is probably a misleading aberration.

The most important cause of this is the lagged effect of the stagnant (slightly contracting) money supply numbers during the latest year. For some time, this was masked by a decline in money demand (a decline in money demand has a similar effect as an increase in money supply), but now that pessimism is increasing the decline in money demand has halted and perhaps started to reverse.

The expectation of significant tax increases in January 2011 as the Bush tax cuts expire is another key factor behind the weakening economy.

The fact that Treasury yields continue to drop despite the horrible fiscal situation of the U.S. government is a sign that money demand is increasing as many investors perceive them to be as safe as money.

UPDATE: About the industrial production numbers see this follow-up post.

How Did Fiscal Austerity Reduce Greek Growth?

While all other euro area economies that has published second quarter growth numbers have indicated that their economies are recovering (though at different pace). Greek GDP statistics indicated a continuing and indeed deepening recession, with GDP dropping 1.5% (nearly 6% at an annualized rate) compared to the previous quarter and 3.5% compared to the same quarter last year.

A Der Spiegel article that I found at Mark Thoma's blog blames this on the fiscal austerity program (while also acknowledging that it has been successfull in reducing the deficit). Is that really true?

Yes, it is true, sort of. But the primary reason for this wasn't that the austerity itself directly reduced growth . Instead, the drop in output was caused by the wave of strikes that the Marxist unions launched to protest the reductions in government spending.

But if the unions come to their senses and/or the Greek government takes decisive action to rein them in and stop the strikes, then the Greek economy should recover.

Case in point is the three Baltic countries, which all saw positive growth "despite" their austerity programs.

Missing The Point On China's Low Per Capita Income

Mark Perry points out that while China has a large GDP, it's GDP per capita is still relatively low due to its large population (1.33 billion people).

While the observation is correct, the problem is that Perry doesn't quite understand the implication of this fact. He writes that this means that it has a long way to go before achieving "super power" status. But "super power" status has never been about having a high per capita income. If it did, countries like Qatar, Luxembourg and Liechtenstein would be super powers, and no one talks about these tiny countries in that way. Per capita GDP measures how affluent the average citizen is, while total GDP measures what one might call "[economic] super power" status.

Furthermore, the low per capita GDP level of China is in fact a key argument why China is almost certain to surpass the U.S. I was once asked by someone who had heard my prediction that China will almost inevitably surpass the U.S. in total GDP how I was sure that this prediction wouldn't turn out to be as false as similar predictions by some about Japan in the late 1980s. My answer was simple: there are more than ten times as many people in China than in Japan.

And there are more than four times as many people in China than in the U.S., so it is not necessary to assume that China will reach the same per capita income as the U.S. for China to surpass the U.S. in total GDP. It is sufficient to assume that China will reach a per capita income one fourth of America's. And since per capita income is a lot higher than that in other majority-Chinese countries, particularly Hong Kong and Singapore, and to a lesser extent Taiwan, that is certainly not something that Chinese people are incapable of achieving.

And the fact that per capita income is currently so far behind means that Chinese growth will continue to be boosted by the "catch-up effect" for a long time.

The Location Of The Bond Vigilantees

Paul Krugman and other American Keynesians have recently gloated over the fact despite the deteriorating underlying fiscal situation for the U.S. federal government, it gets to borrow cheaper and cheaper.

They are right when they say that the massive Keynesian deficit spending initiated by the Obama administration hasn't significantly raised U.S. bond yields. If you compare the yields the U.S. federal government has to pay compared to the yields paid by governments with a similar or stronger fiscal position, it is clear that the U.S. federal government is treated far too positively compared too other governments.

This is a result of the fact that many investors perceive the U.S. federal government as a "safe haven", a perception which then becomes a self-fulfilling prophecy unrelated to any fair assessment of its situation.

But let's leave the issue of the relatively far too low U.S Treasury yields aside for the moment, and instead focus on the overall impact of the deficit on global money markets and the global economy.

Keynesians claim that because U.S. Treasury yields remain ridiculously despite record deficits, this proves that no "crowding out" effect exists. But this overlooks that when large budget deficits increase overall demand for loanable funds, this effect will not be limited to the country that increases its borrowings, it will instead affect all countries. And indeed, in a situation where there is still a lot of pessimism, it will affect countries that are perceived as "un-safe" (like Greece, Portugal, Spain and Ireland) disproportionately while countries perceived as safe (like Germany and the U.S. government) might not be affected at all.

But by pressuring borrowers in other countries to reduce their demand for credit, it will still be a "crowding out" effect (resulting in a higher U.S. trade deficit), even though U.S. Treasury yields don't increase.

Comparing Apples With Oranges On China

Paul Kedrosky expresses doubt over the forecast that China's economy will become larger than the U.S. economy arguing that:

"(a 6%-plus pro-China delta in GDP growth for 20 years is wildly unlikely)"

Actually, first of all, I wouldn't call that projection "wildly unlikely" as the growth differential has been higher (7.5%) during the latest decade.

And secondly, and more importantly, Kedrosky is engaging in an apples and oranges comparison with regard to growth of the purchasing power of GDP and the differential in GDP at current exchange rates.

At current exchange rates, U.S. GDP was 2.86 times larger than China's GDP in 2009. But just about all economists agree that at current exchange rates, the domestic purchasing power of the yuan is far greater than that of the U.S. dollar. As a result, the difference in purchasing power adjusted GDP is much smaller, more in the order of a multiple of 1.5-1.6.

To get an "apples to apples" comparison you should either base your result on current differentials in purchasing power adjusted GDP and growth differentials, or compare differentials in GDP at current exchange rates and growth differentials plus movements in real exchange rates.

Kedrosky's analysis are based on the view that the GDP differential at current exchange rates is the correct one, while implausibly assuming that no appreciation of the yuan will take place despite the Penn effect and despite the great pressure to increase the value of the yuan.

Assuming a differential of 1.6, equality in purchasing power adjusted GDP would come in 2025 at a very modest growth differential of 3.2% per year, and in 2020 at a growth differential of just 4.8%.

And as I explained in a previous post on the subject, equality of GDP at current exchange rates will come as soon as 2024 if we just assume a growth differential of just 5% and an average real appreciation of the yuan by 2.5% per year.

Gross Or Net Debt?

When discussing U.S. federal debt, I have usually focused on gross debt, which is now $13.3 trillion, or 91% of GDP. Others however argue that one should exclude so-called intragovernmental debt, debt held by other government agencies (mainly the Social Security trust fund) which stand at $4.5 trillion. If you exclude that you are left with a debt of $8.8 trillion or roughly 60% of GDP.

The argument for excluding intragovernmental debt may seem convincing at first glance: why should you include debt which is an asset for another government agency, thus being no net liability for the government as a whole?

Assuming that it doesn't represent some external liability for the government agency that holds it, this would indeed be a valid argument for excluding it. But at least in the case of the U.S. government the vast majority of it does in fact represent external liabilities.

When a corporation partially pays it employees in the form of future pensions, the rule in corporate accounting is that the present value of those future pensions should count as a liability in the balance sheet. It is certainly not permissible for the company to count the assets in the pension fund that in the future will make those payments as equity.

The same rule should apply to the assets of the Social Security trust fund. Since these assets are supposed to cover future payments of Social Security to senior citizens, it is not valid to subtract the holdings of the Social Security trust fund, or any other intragovernmental holding that represents similar external liabilities, from estimate of government debt.

One problem is that unlike in the Swedish pension system there is no exact link between the level of assets in the Social Security trust fund and the level of payments to retirees. Payments are instead determined by the development of inflation, while the value of the fund is determined by income from Social Security taxes plus interest minus Social Security payments. This means that the present value of future payments could differ from the assets of the Social Security fund.

However, unless you have specific reasons for believing that there is a certain difference, the value of the trust fund is a good proxy for the value of future payments. After all, the trust fund could just as well underestimate the value of future payments as overestimate it. And clearly the value of the trust fund is closer to the truth than the zero value that advocates of excluding the holdings of the trust fund from government debt implicitly assumes.

By contrast, in some other countries assets of funds should be subtracted from gross debt as they are not linked to future external payments. One good example of this is Norway where the government has saved revenues from oil exports in a special oil fund that is not directly related to future payments of pensions and other benefits. Indeed, in Norway the value of that fund is greater than gross debt, so that the Norwegian government has no net debt at all, and instead has a large net worth.

More On Finland & Slovakia

I noted in my previous post that Finland and Slovakia topped the European growth league. While I don't really regret what I wrote in that post, I do regret that I didn't write an explanation for why Finland and Slovakia had higher growth than others, which is why I am writing this follow-up post.

In the case of Finland it seems to be basically a case of it having a more cyclical sectoral structure, with heavy exposure to cyclical industries like the forest industry. Also, the fact that Russia is an important trade partner, and as the Russian economy is highly dependent on the price of oil and other commodities, the Finnish economy will indirectly be affected by the cyclical swings in the price of oil and other commodities that Russia exports.

Finland had higher growth than both neighboring Sweden and the Euro-area average in the years preceding the 2007-09 financial crisis. However, during the slump GDP fell by nearly 10%, significantly more than in both Sweden and the Euro area average. Now, it is again growing faster than both Sweden and the Euro area average. So this seems to be at least mostly a case of a more cyclical industrial structure.

Slovakia is a more interesting case. While it like Finland has a heavy exposure to cyclical industries (in this case mainly the car industry) and while this is part of the explanation for its current boom, that is not the entire story. In the years preceding the financial crisis, Slovakia was a star performer with annual growth rates at around 10%. Due to its exposure to many cyclical industries, Slovakia then suffered a drop in output similar to the euro area average. But unlike Finland it did not see a deeper slump than the average and it had a much stronger boom preceding the slump.

While there are many more contributing factors to Slovakia's success, perhaps the most important one is its strategy of cutting government spending and marginal tax rates.

Finland & Slovakia Too Small To Be Superman?

The German economy expanded by a much higher than expected 2.2% (9% at an annual rate)in the second quarter compared to the first quarter and by 3.7% compared to Q2 2009.

Also, previous growth numbers were upwardly revised by a cumulative 0.8%.

Commenting on this in the Bloomberg News story about it, Carsten Bszeki at ING Group likened the German economy to super man:

"Superman is wearing black, red and gold this year, Germany’s national colors. But at some stage he’ll become Clark Kent again. The economy can’t keep growing at this rate."

While I thought this was a mostly good analogy to illustrate that the German numbers are impressive, at least by European standards, and that growth will soon slow, it seems unfair to Finland and Slovakia to describe the German economy the "Superman" of Europe. Finland after all saw GDP rise by 4.8% compared to the previous year, while Slovakia had a growth rate of 4.6%. But perhaps Finland and Slovakia are considered too small to count.

Less Than Zero

This Tuesday, the yield on the 5 year Inflation Protected Treasury Security fell below zero for the first time ever, more specifically to -0.02%.

When this is written, the yield has dropped further, to -0.06%.

What is going on here? Are investors crazy? Yes and no. Clearly, they have far too much faith in the fiscal situation of the U.S. government, who has both a budget deficit and a debt level that is somewhat larger than that of Portugal relative to GDP. U.S. government bonds definitely don't deserve the AAA-rating and general "safe haven"-status that have caused these low yields.

On the other hand, with the economy heading for a double dip recession, many alternative investments like stocks don't look very attractive either, so in part these low yields are understandable.

There are of course many countries whose government bonds look a lot more attractive as they have higher yields and/or a stronger fiscal situation, including for example Brazil, Australia and Sweden, but that is associated with exchange rate risks for investors that live outside these countries.

Misinterpreting Accounting Identities

Bloomberg News journalist Bob Willis quotes UniCredit Global Research chief economist Harm Bandholz with a positive spin on today's U.S. trade deficit numbers:

"The expiration of export-tax rebates on some Chinese commodities beginning in July may also cut U.S. imports from China in coming months, helping to narrow the deficit and thus contributing to growth in the third quarter, said Bandholz."

But here he misinterprets the GDP accounting identity: Y= I+C+G+NX. Where Y is GDP, I is investments (including inventory investments), C is private consumption, G is government consumption and NX is net exports (the trade balance).

He interprets this accounting identity as an improvement in NX (the trade balance) as causing an imrpovement in Y. In reality though, an improvement in NX is just as consistent with a reduction in I, C or G as an improvement in Y. The accounting identity only says that given a certain level of I, C and G, a change in NX will cause an equal change in Y. This analysis has relevance for GDP forecasters when they have knowledge of the values of I, C and G, but in the real world an "improvement" of NX will almost always be associated with a reduction in I, C or G.

Specifically in this case, if retailers in America wanted to import more before the expiration of the expiration of a Chinese export tax rebate, then that would certainly increase the trade deficit. But that doesn't mean that it will reduce GDP, because this accumulation of Chinese goods will be associated with either an increase in I (inventory investments, as companies store goods meant to be sold later) or an increase in C (as companies sell the goods they import). For this reason, this import surge doesn't causally reduce GDP because the apparent statistical reduction overlooks that this surge raised I, C or G.

The flip side of this is that the drop in the trade deficit in the coming quarter won't causally increase GDP because the improvement in NX will be cancelled out by a drop in I if the goods were stored, or a drop in C if the goods were sold.

Sharp Increase In U.S. Trade deficit

The U.S. trade deficit saw its biggest monthly increase ever in June.

One implication of this is that the already low second quarter growth estimate will be revised down further.

Another important implication is that this will further aggravate trade tensions, particularly with China.

The Non-News From The Fed

So the Fed has decided to retain its current asset holdings. Not really surprising-nor anything that anyone should find surprising or more worthy of noting than the news item that Barack Obama is still President of the United States.

Canadian Housing Boom Ending?

A Canadian reader tipped me of this story that indicates that the Canadian housing boom that I have previously discussed might be ending:

"Canada led in the global housing recovery in the first quarter of 2010, but moderating global growth, heightened financial market volatility and sluggish job creation have led to a “dramatic” slowdown in Canada, according to the Global Real Estate Trends report released Tuesday from Scotia Economics.....

...The recent slowdown has been most dramatic in Canada,” Warren noted. “Average home prices in (the second quarter) were up just 6.8 per cent year-over-year, compared with 16.6 per cent year-over-year in (the first quarter). Sales, while still at a high level, have trended steadily lower alongside reduced affordability and exhausted pent-up demand.”

For instance, figures from the Canadian Real Estate Association released last month showed seasonally adjusted national home sales activity via the Multiple Listing Service Systems fall 8.2 per cent in June from the previous month. Sales fell in almost 70 per cent of local markets."


While this might just be a temporary setback, the most likely scenario is that it represents the end of the boom, particularly with the Chinese and U.S. economies both cooling.

Chinese Government Success Creates New Problems

The Chinese trade surplus surged by 170% from a year earlier in July to $28.7 billion, as exports increased 38.1% while imports increased by only 22.7%.

This is a direct result of the success that the Chinese government has had in curbing excessive credit expansion. By limiting that, it has limited malinvestments and asset bubbles, and thus reduced future problem emanating from that.

However, a lower credit expansion will limit import growth, which in turn translates into a larger trade surplus.

And this, along with the yuan's trade weighted value again dropping due to the drop in the dollar against the euro, pound and most other currencies and the increasing likelihood of a double dip U.S. recession, increases the risk of a U.S.-Chinese trade war, which would be mutually destructive, but might be "good politics" for some politicians and pundits.

Really Just A Coincidence?

Another thing about Friday's U.S. employment report: After having risen relentlessly since 2007, the number of long-term (27 weeks or more) unemployed, as well as the median duration of unemployment, fell back in July.

July was also a month when due to Republican resistance, the extension of unemployment benefits was delayed so that many long-term unemployed lost their benefits.

Coincidence? We'll see what happens next month to get the definite word on this, but I for one believe it is not a coincidence

Underlying U.S. Federal Deficit Continues To Increase

According to the preliminary numbers from the Congressional budget office, the U.S. federal deficit for the first 10 months of fiscal year 2010 (October 2009-September 2010) fell to $1,174 billion from $1,267 billion in the first 10 months of fiscal year 2009 (October 2008-September 2009).

However, this shift reflects entirely that much of the feared costs from the bailouts seem to be recovered. During the first 10 months of 2009, the budgeted costs of TARP and the aid to Fannie Mae and Freddie Mac totaled $252 billion, whereas in fiscal year 2010, these two posts produced a net gain of $67 billion.
Also, the cost of deposit insurance fell by $50 billion.

Furthermore, revenues from the Federal Reserve rose by $37 billion as its interest income from holding mortgage backed securities far exceeds the cost of paying interest on bank reserves (not to mention the zero interest cost for another liability in its balance sheet, issued Federal Reserve Notes (aka physical cash)).

While the deficit fell by $93 billion including these posts, the deficit excluding these posts rose by as much as $313 billion. Considering the fact that there has been a recovery (albeit a very weak one) this is very bad.

Part of this is due to the fact that there is a certain time lag between economic activities and tax payments (while income tax receipts are down for the budget year as a whole they have been slightly above year ago levels in recent months), but it is mostly related to a continued surge in core (excluding TARP and Fannie & Freddie) federal spending which is up by 10% compared to a year ago. This in turn is in part due to the "stimulus package" and in part due to Obama's long term strategy of expanding the size of government.

Boycotts Aren't Always Easy To Do

Bad news for the Israel-haters who wants to "boycott Israel":

"Israeli business executives here like to point out that most of the angry Turks who protested Israel’s deadly raid on a Turkish-led flotilla to Gaza this past spring do not know that their cellphones, personal computers and plasma televisions were made using parts and technology from Tel Aviv.

For Menashe Carmon, chairman of the Israel Turkey Business Council, such ignorance is a blessing for Israelis and Turks.

“Turks would find it very hard to boycott Israeli goods because you won’t find any in Turkish supermarkets,” Mr. Carmon said. “But most of the software Turks use in everything from cell phones to medical equipment is made in Israel. So unless Turks want to stop using their computers, boycotting Israel would mean punishing themselves.”"

Actually, boycotts (and sanctions) always mean punishing yourself since you abstain from a good which you would have otherwise deemed to have the highest value relative to its price. If you didn't believe that you wouldn't be boycotting it on that ground, so boycotts almost by definition mean punishing yourself.

However, sometimes the punishment is quite small when a nearly as good substitute is at hand, something which may be the case when one chooses to buy fruits from other countries instead of Israel (or whatever country you're boycotting). But if you have to abstain from whole product lines and if you view these products as important -something which most people do with regard to for example cell phones- then the self-punishment will be very severe.

And as exports of high tech components of final products assembled elsewhere these days are far more important for Israel than agricultural exports, boycotting Israel is far more difficult and involving a lot greater sacrifices than most people wishing to boycott Israel thinks. The same thing is also often to a lesser extent true of other countries that some people wish to boycott (such as France, China and the United States).

Mixed U.S. Employment Report

Today's U.S. employment report was somewhat stronger than last month's report, but not really strong in absolute terms.

The household survey was quite weak, showing a job loss of 181,000. This was the third consecutive decline in household survey employment, with a cumulative job loss of 495,000 since April.

There were however some stronger spots in the payroll survey, most notably the increase in the average work week. Average hourly earnings also again increased, though probably not by enough to compensate for the inflation that probably occured.

Overall, the report suggests that growth is still above zero-but not by much.

German Recovery Strengthens Even More

German factory orders recovered more than expected in June, increasing 3.2% compared to May 2010, 17.5% compared to December 2009 and 28.4% compared to June 2009.

These new numbers confirm the overall picture of a strengthening European recovery that I have repeatedly reported about in the latest month. The debt panic we saw earlier this year seems to have hurt growth less than almost all analysts (including me) expected.

That is clearly good for the effort to solve the debt panic and it is also bullish for the euro, though the fact that the euro has already rallied so much limits the potential for future euro appreciation.

Krugman Misleads About Reagan

Responding to people who note (See Dan Mitchell's take here, see my own here) that the recovery we have seen so far after the 2007-09 recession is a lot weaker than the recession of 1981-82, Paul Krugman claims that the vigorous recovery in the 1980s was simply a case of the Fed fueling a housing boom with interest rate cuts.

"The 1981-2 recession was a very different kind of event from the 2007-9 recession: basically, it was a recession deliberately created by the Fed to bring down inflation. The Fed raised interest rates sky-high, causing a plunge in home construction, which was the main driver of the slump. When Paul Volcker believed that we had suffered enough, he cut rates, housing sprang back — and it was housing that mainly drove the recovery. Reaganomics was basically irrelevant."

It is interesting that he assigns to monetary policy such a great role in driving the housing sector. When discussing the 2001-06 housing boom, Krugman and other Keynesians have denied that interest rate policy played a significant role and instead claimed that "lax regulation" caused the bubble.

Anyway though, while Krugman is right to argue that Volcker's dramatic interest rate reduction certainly fueled a strong boom in housing, it is clearly not true that it was "mainly housing". GDP rose by 4.5% in 1983, and 7.2% in 1984, for a cumulative 12% (as I showed in my post about the Reagan recovery, the numbers are even more impressive when comparin fourth quarters than when comparing full years). While residential investments rose the most, a cumulative 62.3%, consumer spending also rose, by a cumulative 11.3% while business investments rose by 16.1%.

And since residential investments was only 3.2% in 1982, and 4.6% in 1984, this means that GDP excluding residential investments rose by 10.4% in 2 years (at an average annual rate of 5.1%). The boom was thus very broad based.

Furthermore,in the 5 following years (1985-89) when GDP rose by an average of 3.7% , per year, the share of GDP going to housing fell from 4.6% to 4.4%.

It is thus false to say that the Reagan boom was simply driven by housing. It is true that the impact of monetary policy isn't limited to housing, the unusual strength of the boom clearly suggests that other factors, meaning the tax cuts, also played a role in fueling the boom.

Aussie Exports Soar

Australia continues to ride the commodity price boom. Seasonally adjusted exports in June 2010 rose by 7% compared to May 2010, and by more than 30% compared to June 2009.
As imports rose a more moderate 2% compared to May 2010 and 11% compared to June 2009.

The high increase in the value of exports is mostly driven by the dramatoc recovery in commodity prices from the lows of late 2008 and early 2009. Due to the use of futures, there is a time lag between the movements in quoted commodity prices and actual trade values.

As a result of this export boom, the trade surplus rose to a new record of $3.5 billion, compared to a surplus of $1.8 billion in May 2010 and a deficit of $400 million in June 2010.

This means that despite having higher real interest rates and thus higher real investment returns, Australia might have become a net capital exporter (Australia has a factor income and unilateral transfers deficit which in the past have been larger than any trade surpluses), something which normally implies that a currency is undervalued.

However, given the fact that the Australian dollar appreciated so much in value in 2009, and given the fact that the weakening U.S. economy could lower commodity prices, the short to medium term upside potential of the Australian dollar is very limited.

However, because of the higher yields, Australian bonds is nevertheless a long term winner.

Reflections On Recent Exchange Rate Movements

The exchange rate between the euro and the U.S. dollar has been going through something of a roller coaster ride the last few years. After having strengthened from $1.18 in 1999 to $0.83 in 2002, the Euro then appreciated (interrupted by a few minor stebacks) to as high as $1.60 in July 2008. Then it fell to as low as $1.25 in March 2009, only to appreciate to about $1.50 in November 2009. Then it started to fall dramatically again, to $1.20 in June 2010. But since then it has risen again to $1.323 (when this is written, when you read it it might have changed somewhat).

The point of this point is not to create a full explanation of all of these ups and downs, but rather a explanation of the most recent rally.

There are basically two explanations. First of all, during its lows during the European debt panic, the euro was heavily oversold, while the U.S. dollar was overbought. Many traders over-reacted, owing in many case to trading programmes (with automatic selling rules).

And secondly, it has become increasingly clear that markets have been too optimistic about U.S. growth prospects and too pessimistic about European growth prospects. Yesterday's manufacturing survey's illustrated this, with the U.S. survey continuing its downward trend, and the Euro area survey resuming its upward trend. Other reports from Europe and the U.S. confirm a cyclical upwing in Europe and a cyclical downturn in the U.S.

This basically eliminates the risk/chanse of a Fed interest rate hike, while improving profit opportunities in Europe, thus leading investors to Europe.

To some extent, this movement might be self-preventing as the renewed euro strength and dollar weakness will make life more difficult for European exporters and more easy for American exporters. This is especially true given the negative effect that a stronger euro will have on European governments with excessive debt. However, increased exchange rate uncertainty
will hurt companies on both sides, and the negative effects on European exporters will to some extent be mitigated by positive effects for importers (and vice versa for American companies).