National Review On Sweden

Interesting essay in National Review about Sweden (HT Fredrik Segerfeldt), pointing to how Sweden's relative wealth was created when it had a relatively free economy, and how more socialist policies during the 1970s and 1980s caused Sweden's economy to decline, and how free market reforms and spending and tax cuts have caused Sweden to perform relatively well.

But it also points to how Sweden is still too socialist, and how these policies have contributed to the low employment rate of non-Western immigrants (these policies have to a lesser extent also lowered the employment rate of other immigrants and the native born), something which in turn has contributed to the rise of the "far right" anti-immigration Sweden Democrats.

Why The Increase In Inequality Is Probably Exaggerated

John Stossel has an interesting column showing how upper income tax increases in New York State and some other American states have generated a lot less revenue than expected.

It could be argued that this is misleading in a discussion about federal tax increases, since some of this effect reflects people moving across state lines, and people are probably more reluctant to move away from the United States (especially since the IRS tries to tax American expatriates), than they are moving from say, New York State to New Jersey or Connectitut.

However, upper income tax increases will nevertheless generate less revenue than suggested by a static analysis (where it is assumed that behavior won't be affected) because first of all it will reduce productive activities, and secondly because it will increase both legal and illegal tax avoidance activities.

This point also has implications for the discussions about increased income inequality. As I have noted before, higher upper income tax increases won't just decrease after-tax income inequality, but because it will for the above mentioned reasons reduce the tax base it will also reduce apparent pre-tax income inequality.

However, this reduction in apparent pre-tax income inequality is not something which will benefit the poor and the middle class. To the extent this reflects lower productive activities, this will reduce GDP and in fact reduce income for the poor and the middle class as well. And to the extent it reflects increased ytax avoidance, the apparent decrease in inequality is an illusion.

Remember that income inequality statistics are based on tax returns. If upper income earners manage to use legal or illegal tax avoidance techniques to reduce their reported, but not their real, income than official statistics will show a reduction in inequality even as there has been no real decrease.

This also suggests that much of the apparent increase in inequality since 1979 that leftists complain about is probably an illusion. Because just as higher income tax rates will increase tax avoidance, lower income tax rates will decrease it. And as the top federal income tax rates has fallen from 70% in 1979 to 35% now, the degree of tax avoidance has probably decreased a lot, meaning that the actual increase in income for the rich has been smaller than the real increase in income.

Record Low Real U.S. Treasury Yields

The demand for U.S. Treasuries because of their perceived safe haven status keeps pushing down the yields to increasingly ridiculous levels. The yield on 10-year inflation protected Treasury securities has dropped to a record low 0.67% today (as always, this number may have gone down or up by a few basis points when you read this), compared to about 1.5% in the beginning of the year and about 2% in the beginning of 2009 when nominal yields last reached the lows that we have seen today.

The situation is even more extreme for the 5-year inflation protected Treasury security, where the yield is now -0.14%, that's right a negative number. This is also a dramatic drop from about 0.5% in the beginning of 2010 and about 2.1% in the beginning of 2009.

Some investors are thus so desperate to invest in Treasuries, that they're willing to pay the U.S. federal government to borrow their money, instead of the other way around.

You can say a lot of things about bond markets today, but definitely not that they're rational.

European Central Banks Halt Gold Sales

After having sold gold every year for more than a decade (Gordon Brown infamously sold large amounts of gold in 1999 when gold was trading at $250 per ounce), it now seems that they will stop selling gold.

This is bullish news for gold. Not because central bankers are good analysts, of course. If that had been the issue, this announcemnt would in fact be a bearish signal, given the central bank track record of foolishly selling gold only to see the price rise afterwards every year during the latest decade.

No, the reason why this is bullish is that this first of all will limit the supply of gold, something which will directly cause the price to increase. And secondly, one reason why they might be keeping their gold is because they plan to pursue even more inflationary policies in the future, something which is obviously bullish for gold as it is an inflation hedge.

Lars E.O. Svensson-The Swedish Ben Bernanke

Scott Sumner discusses the case of Lars E.O. Svensson, the by far most inflationist member of the board of the Swedish central bank, the Riksbank. Svensson has been very critical of the decision by his fellow board members to raise interest rates twice and signal a lot more of the same.

His argument for this is decidedly Keynesian in the sense that he argues that there is "unused capacity" and that inflation is below the 2% target. He further claims that the fellow board members when asked hasn't provided any justification for hiking interest rates.

That assertion is something I find strange as I have in fact read and heard them explain why in the Swedish media. I don't know what they said at their meetings so it is possible that they provide any explanation then, but one would have thought that Svensson would read the media statements.

The explanation is that they realize that it is unhealthy to keep rates that low because it feeds a real estate bubble. Statistics released today shows that mortgage loans increased 10.3% in Sweden in August this year compared to a year earlier. That follows a 12.5% increase in the year between August 2008 and August 2009.

As a result, mortgage debt has reached record highs relative to GDP and household disposable income. The reason for this is that in the past the Riksbank has basically followed the strategy advocated by Svensson (though slightly less zealously than he wanted), a strategy that mirrored that pursued by the Fed in the early 2000s. There too there was concern about "unused capacity" and below target inflation, something which led them to hold down interest rates in a way that fueled a housing bubble.

The rest of the Riksbank board is trying to correct this in a way which is too little and too late, but at least they seems to be aware of the problem. Svensson by contrast, like his former Princeton colleagues Ben Bernanke and Paul Krugman is completely clueless about the link between low rate policies and housing bubbles.

Game Of Chicken Over Trade

Well, this news is certainly bad news, as it shows that in the escalating trade tensions with America, the Chinese government isn't too chicken to ruffle the U.S. government's feathers

A Week Of Inflation

U.S. Market movements this week:

-The S&P 500 gained 2.1%.
-10-Year Nominal Treasury yield dropped 14 basis points to 2.60%, while the 10-Year Real Treasury yield dropped 17 basis points from 1.00% to 0.81%.
-The dollar index fell 2.6%.
-The CRB commodity price index rose 1.4%.

In other words, the prices of stocks, bonds, foreign currencies and commodities all rose this week. When the prices of some of them rise and others fall, it could reflect other factors such as falling or increasing optimism about the economy, but when they all rise we have inflation.

One reason for this seems to be an increased belief that the Fed will take additional action to inflate the economy, something which in itself has an inflationary impact by reducing demand for money.

However, we have also seen a pick up in money supply growth. After declining somewhat for nearly a year, MZM growth has turned positive again, increasing more than 2% in 3 months, translating into an annualized rate of over 8%.

A Better Approach To China

Peter Coy is right on the issue of China-instead of complaining about the currency, the U.S. and other countries should complain about the barriers to imports China has on certain goods. Revaluation/appreciation of the yuan would do little to reduce the U.S. trade deficit, while representing no economic efficiency gain-indeed the extra exchange rate uncertainty would produce an economic efficiency loss. By contrast, while removing Chinese tariffs may not have a dramatic effect on the trade deficit either, it would create economic efficiency gains.

The Success Of The Swedish Tax Cut Policies

Interesting article in The Spectator on how the Swedish tax cut policies was both an economic and political success.

While the entry of the "far right" Sweden Democrats into parliament will end the parliamentary majority of the centre-right government this reflects the fact that the Sweden Democrats rose above the 4% threshold. The increase in their support reflected mainly a big drop in support for the opposition Social Democrats who dropped from 35% to 30.7%. By contrast the centre-right parties actually increased their share of the vote from 48.2% to 49.3%. That is a big accomplishment since Swedish governments during the last four decades have always lost support.

Meanwhile, the tax cuts as well as the cuts in unemployment and sick leave benefits have made Sweden one of the few countries with a higher level of employment than 4 years ago. The article mentions that the tax cuts could have created 100,000 jobs (2.2% of employment, the equivalent of 3 million in America), an estimate I think could be on the low side. And if you add the effects of reduced benefits, we could easily be talking about 200,000 jobs.

Republican Déjà Vu

Republicans promise to cut spending and keep taxes low if they gain control of Congress. Once that happens though, the Democratic president will veto their agenda and there will be political gridlock. But don't worry, as soon as we get a Republican in the White House, we will implement our agenda, Republicans say.

"Pledge to America 2010"? Actually, more like "Contract with America 1994", but the former fits the description too.

We all know what happened after Republicans took control of both the White House and Congress in 2001, so the question that needs to be raised to Republicans is that why one should trust them now when it was wrong to trust them in 1994?

This is not to say we shouldn't root for (and perhaps even vote for, if you're an American) Republicans in the upcoming Congressional election, as divided government is generally better as it at least means that changes for the worse are more often blocked. But one shouldn't have too much faith in the actual implementation of the "Pledge to America".

Larry Summers Quits

Larry Summers is now reportedly planning to quit as chief of the National Economic Council.

Given the fact that he seems to be relatively sensible for being a Democrat, and given the fact that Obama will unfortunately be President for at least another 28 months, that might appear to be bad news.

However, given how bad Obama's policies have actually been it is not clear whether he really had that much influence. Moreover, now that he will no longer be employed by Obama maybe can again openly state truths that he was previously aware of but that contradicts Obama's policies, such as the truth that more generous unemployment benefits increases unemployment or the truth that mandatory health insurance is a de facto tax.

Irish Net Emigration Soars

When asked why for example Ireland should have its own currency, while Florida shouldn't, some euro critics argue that this is because of greater labor mobility within the United States than in the euro area.

But as it happens, at least in the case of Ireland, labor mobility is very high. In 2006, during the height of the boom, net immigration was 71,800 or 1,7% of the population (more than 3 times the aggregate U.S. number), in line with the numbers seen in Florida and California.

Now that the Irish boom has turned into a bust, this net immigration has turned into a net emigration of 34,500 people, which is quite high for a country with less than 4.5 million people. Since 2006, gross immigration has fallen from 107,800 to 30,800 while gross emigration has increased from 36,000 to 65,300.

However, as I explained here, it is not certain that labor mobility will really help limit problems related to housing bubbles and the subsequent crashes, as it will further increase housing demand during the boom and reduce housing demand during the bust.

Nothing Is Stopping You, Mr. Gruener

"Venture capitalist" Garret Gruener complains that he is not paying enough taxes, and for that reason calls on politicians to raise his taxes.

But as it happens, if Gruener really is serious about wanting to pay more to the U.S. federal government, he can do so right away, regardless of how the future political battle over the possible extention of the Bush tax cut ends. Just go to the website of the Bureau of Public Debt and follow the instructions on how to pay more money to the U.S. federal government. If he is really serious about wanting to give more money to the government he can set an example by doing so right away.

And so can by the way any other American reader who for some reason feels that it would be good if they paid more money to their federal government. Note however that while I do inform you of the possibility I do not recommend it and I would not view that as rational. If you can spare some money and want to give it away to others who deserve it, there is at least one person a lot more deserving than the U.S. federal government.

About Swedish Election Results

Yesterday there was a general election here in Sweden. The final results aren't in yet as not all absentee ballots have been counted but we know a few things for sure:

Even though the centre-right coalition that has been ruling Sweden for the last 4 years might when the final votes have been counted get marginally more votes than the left-wing parties and the nationalist, anti-immigration Sweden Democrats get together, and even though the Swedish election is supposed to be fully proportional (with the exception of a 4% threshold to get represented in parliament), they will based on the preliminary results probably only receive 172 out of 349 seats in parliament.

The reason for this is that the 4 centre-right parties in the coalition appears to have had bad luck in rounding when the votes are translated into seats (Swedish language link), while particularly the biggest left-wing party, the Social Democrats, seems to have had good luck.

Because of this, Sweden will indeed as I predicted it might, follow Australia and Britain and get a "hung parliament".

Sweden might also have a similar situation as Norway where the centre-right parties had more votes than the left-wing parties but received fewer seats in parliament and as the United States had in 2000 when George W. Bush won over Al Gore despite receiving fewer votes.

The irony is that the coalition actually increased its share of the vote somewhat, but might still lose its majority because the Sweden Democrats who was previously below the 4% threshold (with 2.9% in 2006) now rose above it with their 5.7% of the vote and because of bad luck with rounding.

All of the established (both centre-right and left-wing) parties have ruled out cooperation with the Sweden Democrats, so this means the current coalition will have to seek support from the Green Party and/or the Social Democrats (the centre-right parties have also ruled out cooperation with the third left-wing party, the Communists).

This is unfortunate for Sweden as it will probably prevent more of the tax and spending cuts that have been so successful in boosting employment.

The Virtue Of Hyperinflation?

The Washington Post has a story claiming that not only is price deflation necessarily bad, but even low price inflation is also bad because:

"Hoarding, in turn, weakens the economy further, putting more downward pressure on prices.

But that vicious cycle doesn't suddenly kick in only when inflation moves from slightly positive to slightly negative. For example, businesses that forecast a very low rate of inflation would be more inclined to hold onto cash than they would if inflation were higher. Yet without new investment, the jobless rate could remain high, keeping wages - and ultimately prices - from rising."

So "hoarding" due to low inflation is the main thing preventing growth, according to this theory. Since hyperinflation would encourage people to "hoard" nothing and instead always spend all the money they have immediately, I guess this means that hyperinflation will cause great economic booms, just like it did in Germany in 1923 and recently in Zimbabwe...

Krugman Misleads About Spain & Ireland

Paul Krugman has co-authored with his wife Robin Wells an article about the U.S. housing bubble where he tries to deny the role of the Fed in creating it. Much of it is simply a restatement of Alan Greenspan's and Ben Bernanke's theories about "global savings glut" (including the myth that short term interest rates has no impact on housing) that I have refuted repeatedly in the past for example here, but it also contains a partially new argument: the ECB weren't as aggressive in cutting interest rates as the Fed, yet Spain and Ireland still had housing bubbles, so this supposedly proves that Fed policy had nothing to do with it.

But there are two problems with this argument: first of all, the while the ECB may not have been as aggressive as the Fed, they were in fact quite aggressive too, with real short-term interest rates being negative for several years during the boom and with money supply growth well above the alleged ECB target of 4.5% for the entire period.

Secondly, while Spain and Ireland did have higher increases in housing prices than the United States, that hardly proves anything, as they are a small part of their monetary area whereas the United States is a whole monetary area. Just like some parts of the United States had only limited house price increase, so were house price increases much more moderate in the rest of the euro zone than in Spain and Ireland. Indeed, house prices actually fell in the biggest euro area country, Germany.

Spain and Ireland should thus not be compared with the United States, but with the American states that had the biggest house price booms, such as California, Nevada and Florida. And the United States should not be compared with sub areas of the euro zone, but with the entire euro zone. Using this "apples to apples" comparison approach we can see that the bubble was greater in America than in Europe.

Hong Kong's Low Unemployment Rate

While America and many other Western countries suffer from high unemployment, unemployment declines rapidly in the world's freest economy, Hong Kong. Compared to a year earlier, the unemployment rate has dropped from an already relatively low 5.5% to 4.2%, while the underemployment (people with part-time jobs that wants full-time jobs) rate has dropped from 2.4% to 1.9%.

While unemployment is still somewhat higher than during the lows reached during the previous economic boom, Hong Kong unemployment is only slightly above pre-crisis levels and is among the lowest in the world in an absolute sense.

Straw Man Argument About Inequality

Commenting on numbers that again reflects that America has much higher income inequality than others while also showing that many other countries have similar median income and most OECD countries have higher income for the poorest 10% of the income distribution, Ryan Avent says that this disproves that "prosperity requires an unequal distribution".

But few, if any, people really argue that high inequality in itself is something which necessarily promotes (much less is an absolute requirement for) prosperity. The argument that is made with regard to for example tax policy is that government attempts to reduce inequality through fiscal redistribution and many other means reduces growth.

This doesn't mean that other factors (like for example Norway's large oil assets) can't compensate for it. Nor does it mean that low inequality will damage growth if low inequality is caused by for example limited differences in skills in the population or the absence of asset price bubbles or other government interventions that benefit the wealthy. What is damaging to growth is if redistribution efforts weaken incentives for wealth creation.

As If There Really Was Much Difference

Paul Krugman writes about how this is the second anniversary of the Lehman crash:

"shouldn’t the papers this morning be full of retrospectives about The Event That Ended The Economy As We Knew It? (Not to mention the event that guaranteed an Obama election win.)"

While the Lehman crash did cause a temporary acceleration in the pace of economic contraction, the underlying cause of the problems can be dated to several years earlier.

But in one sense, Krugman is unintentionally more right than he realizes. The Lehman crash and the panic that ensued probably did on the margin push the election to Obama's favor (in the two weeks before the crash, McCain lead in the polls). That has in turn pushed America significantly on the path of socialism, with the partial government take over of health care, the increased power over the financial sector, the dramatic increase in government spending and government debt and higher taxes.

Though it may be hyperbole to characterize this as "Ending The Economy As We Knew It", it has represented a significant and probably largely permanent change in the statist direction

U.S. Industrial Production Downwardly Revised

Perhaps not surprisingly given what I wrote about here, July industrial production in America was downwardly revised, from increasing 1.0% to increasing 0.6%. As a result, now reported August industrial production was actually lower than previously reported July industrial production.

Obama's Tax Policy Worst Possible From Growth Perspectiv

Interesting analysis from Alan Viard that points out that Obama's proposed tax policy, to extend the Bush middle class tax cuts while allowing the upper income tax cuts to expire is actually the worst possible from a growth perspective.

The reason for this is that the upper income tax cuts affects incentives for a group particularly sensitive to such changes, while the middle class tax cuts have little or no effect on incentives (Indeed, it should be added, they can actually have negative effects on incentives for many because they are phased out as income rises).

He also points out that while it is true that this will mean that tax rates return to the Clinton era levels in 2011, taxes will rise further in 2013 as a result of provisions in the health care bill passed previously this year.

Japanese Intervention Will Probably Not Have Much Effect

After having had a "hands off" approach since 2004, the Japanese government intervened in the currency markets again today following new record highs for the yen against the U.S. dollar. Even though they didn't specify the amount, the yen still dropped some 2% after the announcement.

There are two causes for the strong yen. The first is the persistent deflation in the Japanese economy. While British consumer prices rose by roughly 3% and while they rose by 1-2% in the United States and the Euro area, they fell by roughly 1% in Japan.

Deflation first of all causes the relative purchasing power of the yen to gradually rise, and secondly given the fact that most central banks have near zero short term nominal interest rates, real interest rates are in fact higher in Japan than in most other countries.

The second reason is the increased safe haven demand caused by the European debt panic and the slowdown in the U.S. economy.

As long as these factors persist, it will be difficult for the Japanese government to really reverse the trend. The Swiss central bank has spent enormous sums to stop the franc from appreciating yet failed to do more than slow the gains.

UPDATE: Tim Duy discusses an interesting aspect of the "safe haven" factor that I mentioned, namely that much of that buying is made by the Chinese central bank. It would be interesting to see to what extent the Swiss franc's appreciation is caused by purchases by China and other governments.

Why Deflation Could Be Good

I have in the past covered the subject of why deflation is not necessarily bad for economic growth before, but David Beckworth also provides a good post on the subject, and he also points to how the failure to distinguish between different causes of price deflation was to blame for the Fed's ominous decision to hold down interest rates in the 2001-05 period, a decision that caused the housing bubble.

However, I would prefer to phrase the cases where deflation is bad for [short-term] economic growth as being caused by increases in money demand or reductions in money supply, rather than being caused by reductions in "aggregate demand".

How Fiscal Austerity Can Boost Growth

Via Kevin Hassett, I see this interesting paper by Alberto Alesina, who argue that fiscal austerity can actually be expansionary on both theoretical and empirical grounds.

Alesina mentions three ways (there is actually a fourth way too in the form of a reduced trade deficit) by which the apparent demand reduction caused by fiscal austerity can be nullified. First of all, to the extent that there isn't Ricardian equivalence, interest rates will be reduced. And secondly, to the extent there is Ricardian equivalence, households and firms will be more willing to spend whatever income they still have. And thirdly, spending cuts such as reduced unemployment benefits and other means tested benefits boost supply, this will boost growth. However, tax increases that reduce supply, such as higher marginal income tax rates, will have a negative effect on growth.

Alesina then empirically test 107 cases of fiscal austerity and finds that they can be associated with both lower and higher relative growth after its implementation, The most striking result is that deficit reduction primarily based on lower government spending was usually expansionary, while deficit reduction primarily based on higher taxes was usually contractionary. This is exactly what could have been could be expected given the third theoretical point mentioned in the previous paragraph.

George Will On The Failure Of "Obamanomics"

George Will has a really good column on why Obama's economic policies have failed and the similarity between these policies and Herbert Hoover's similarly failed policies.

Just like I have done repeatedly in the past, he points out that contrary to popular myth, Hoover dramatically increased federal spending. He also points to the failure of "cash for clunkers" who despite a high price tag, did little to boost new car sales permanently (it did have a substantial effect during the months it was in place, but largely at the cost of lower sales later) while also reducing the standard of living for low income workers as a lower supply of used cars increased prices, thereby reducing real wages.

Canadian Housing Bubble Hasn't Bursted-Yet

I recently linked to an article suggesting that the Canadian housing bubble might be ending.

Now however, I see several reports suggesting that the article was probably misleading, or at least premature. First of all, a house price index made using a similar methodology as the U.S. Case & Schiller index reports that house prices in fact continues to increase, rising by 1.5% in June 2010 compared to May 2010 and by 13.6% compared to June 2009. The annual increase matches the record set in the previous month

Secondly, other indicators, including a rising trade deficit (despite rising commodity prices) and a declining household savings rate, suggests that the Canadian economy is still in a bubble phase.

The deceleration in Canadian money supply growth in recent months and is likely to continue to see given the latest interest rate hike, however makes it likely that we will see a slowdown in the housing sector later this year.

Yuan Appreciates More Than 3% In Real Terms

Inflation in China rose to a new high of 3.5% in August, while the rate of growth of industrial production, retail sales and money supply accelerated again after having decelerated for several months. This suggests that the Chinese economy might not be slowing as much as many have forecasted.

The fact that inflation is accelerating and is higher than in the United States also implies that the real exchange rate of the yuan is continuing to rise even though the nominal exchange rate haven't increased so much. While the U.S. August inflation numbers aren't available yet, the inflation rate was 1.2% in July.

Assuming this stays unchanged in August, this implies an inflation differential of 2.3%. Together with the 1% nominal appreciation since the slight June modification of Chinese currency policy, this implies a real appreciation of 3.3% during the latest year.

While it is up to Chinese policy makers to decide to what extent this will involve nominal appreciation, real appreciation is over a longer period inevitable, not because of posturing by U.S. politicians, but because of the Penn effect and because high money supply growth will in the long run follow from high reserve growth caused by currency intervention.

However, since the Penn effect involves a relative price increase of non-tradable goods and services over tradables, and since it is the prices of tradable goods and services that matters for international competitiveness, this may not mean that Chinese competitiveness will decline very much.

The Link Between Price Inflation & Unemployment

Is there a link between inflation (in this context meant to mean price inflation) and unemployment, as suggested by the so-called Philips Curve?

Yes there is. Obviously, the correlation is not perfect, or even close to being perfect, but in most cases there is.

Exceptions from the rule is when there is some form of negative supply shock, for example when certain Arab countries initiate an oil blockade, or when there is a dramatic drop in the exchange rate associated with a weaker economy.

But setting aside such examples of negative supply shocks, it generally holds true that higher inflation is associated with lower unemployment and vice versa.

But why is that? There are two possible explanations: either that higher inflation causes unemployment to drop, or that lower unemployment causes inflation to rise.

The first explanation is actually relatively uncontroversial among Austrian/ free market economists: when there for whatever reasons exist nominal wage rigidity and wages in some sectors are too high, causing unemployment, then higher inflation by reducing these excessive real wages can reduce unemployment. As the inflation solution has negative side effects, this doesn't necessarily mean that inflation is desirable, but it does mean that it has one positive effect.

The second explanation is more controversial, as that explanation is perceived as Keynesian and therefore rejected. Until recently I too rejected it, but having thought it through I realize that it could be partially true.

That is for two reasons. First of all, the Penn effect, which says that there is a positive correlation between income levels and price levels, something which in turn implies that higher growth will raise inflation. And as higher growth is associated with lower unemployment, it follows that lower unemployment will raise inflation. However, if there is a floating exchange rate (including managed float) it is possible that nominal exchange rate movements instead of relative inflation can accommodate the Penn effect.

And secondly, price inflation is not entirely determined by monetary inflation (money supply growth). It is also determined by money demand and the supply of goods and services. Regarding that last point, it should be noted that assuming at least some wage flexibility (and that is in fact a reasonable assumption, even though the assumption of full wage flexibility is not reasonable) then a higher rate of unemployment will mean that the price of labor will go down. Though that will mostly manifest itself in terms of a lower real wage, a cheaper price of labor will also induce capitalists to use this to lower prices with maintained margins., something which will mean lower price inflation.

It should be noted that while the above reasoning does provide theoretical support for the Philips Curve, it doesn't provide support for Keynesianism as they both involve structural supply issues.

Has Government In America Shrunk?

There are a lot of people that has pointed out and criticized that government under Obama has increased in size. Now some supporters of Obama try to claim that it is a myth. The latest example of this is Menzie Chinn who in his latest post has a chart that appears to show that government has recently started to shrink in size.

But the charge against Obama wasn't that he and his fellow Democrats in Congress necessarily have expanded government in general, as they can't decide over budgets in state and local governments, but that they have expanded the federal government.
And that is certainly something that they have done.

If you look at government purchases for example, you can see that it was unchanged between the fourth quarter of 2008 and the second quarter of 2010 at 20.5%. However, this unchanged number masked that federal purchases rose from 7.9% to 8.3% of GDP, while state and local governments has reduced their purchases from 12.6% to 12.3% of GDP.

Moreover, transfer payments such as unemployment benefits have also increased at the federal level. As a result, "core" (excluding TARP and support for Fannie & Freddie) federal spending rose 7.6% from a year earlier during the first 11 months of fiscal year 2010. Nominal GDP by contrast increased less than 4% in the year to the second quarter of 2010, and even less during Q1 2010 and Q4 2009.

During the same period in fiscal year 2009, the increase in "core" spending was even greater, 12.6% even as nominal GDP fell.

So, while it is true that many state and local governments are cutting back as they have no central bank to support their borrowing, federal spending is at an all-time high in absolute numbers and relative to GDP the highest since World War II, and by any measure a lot higher than when Obama became president.

Slightly, But Only Slightly, Above Zero

That is basically the picture of economic growth in America given by the so-called Beige book by the Fed.

Possible Shaky Ground For Strong Icelandic Krona

Responding to my request for an explanation of the recent strength of the Icelandic krona despite the very weak Icelandic economy, reader Edward tipped me of this link discussing the Icelandic Krona.

In short, the article says that the ECB might be ready to prop up the value of the Icelandic Krona, something which in itself makes investors demand Icelandic Kronas.

This, along with the general drop in the value of the euro due to worries about government debt in certain euro area countries probably explain most of the recent ISK strength. However, given the increasing popilar hostilty in Iceland to the idea of EU membership (a precondition for support in the long run), the rally looks very shaky.

Wage Cuts Needed For Full Employment

Kevin Hassett points out correctly that the most important reason of the high unemployment rate in America -and for that matter also many other countries- is insufficient downward wage flexibility. Amazingly, wages have actually continued to rise this year (albeit at a slower pace than before) despite the high level of unemployment. Hassett has some interesting suggestions on how to achieve the wage cuts needed to reduce unemployment.

Some leftist economists dispute the fact that wage cuts can reduce unemployment (at least if it comes in the form of nominal wage cuts, as opposed to real wage cuts through inflation). I refuted their arguments here.

More On Iceland

While Iceland has long been a "poster child" for currency depreciation (But as I explained in the previous post, it is not something which anyone would want to emulate), and while that was until recently a fair characterization of the Icelandic economy, the Icelandic krona has recently rallied.



I am not sure why it has rallied so much recently (if anyone has a clue, then please e-mail me). But at any rate, the recent currency movements aren’t going to provide any relief. While it will raise the seriously depressed level of domestic purchasing power, it will also reduce net exports. And because of the extra exchange rate uncertainty, and the disruptiveness of large and unexpected changes, this introduces it isn't going to be a zero-sum game. It will instead cause a reduction in total output.

Icelandic Devaluation Role Model Melts Down

We keep hearing from various pro-inflation pundits like Paul Krugman and Ambrose Evans-Pritchard how the problems in various countries with the euro or with a currency pegged to the euro, like Ireland or Latvia, would have been eliminated or at least significantly reduced if only they could have and would have devalued.

As a role model, Iceland is often used. While they concede that Iceland has big problems, the problems are less severe than in allegedly comparable countries like Ireland and Latvia, something which they claim is due to its massive currency depreciation in 2008.

I have already discussed why the relative performance of Iceland is less favorable than some claim, and why it is not fully comparable due to the fact that Ireland and Latvia had bigger booms before the bust.

New numbers released this week now make the Icelandic example look even more like a horror example. First of all, the 2009 growth number was revised down further (or perhaps more accurately the rate of contraction was revised up).

Perhaps even more significantly, the second quarter GDP number shows that the contraction continues-and continues at a faster pace.

Compared to the previous quarter, GDP fell by 3.1% (11.8% at an annualized rate) compared to the previous quarter and by 8.4% compared to the second quarter of 2009.

That is what Krugman calls "post-crisis miracle" and what Evans-Pritchard calls "magic wand" [that works] its "magic cure".

While the sharp drop in the Icelandic krona has boosted net exports, it has also reduced domestic purchasing power dramatically.

Capital Outflow & Economic Growth

Sometimes, the flip side of a fallacy is also a fallacy. For example, import tariffs are often defended with the argument that the producers (or "jobs") are more important than consumers. Other times however, trade is restricted in the form of exports ban (like Russia's recent ban on exports of wheat) on the view that consumers are more important than producers.

Just because the "producers are more important than consumers" argument is false doesn't mean that the "consumers are more important than producers" view is correct. Both "producers" and consumers are equally important as all producers are consumers and as all consumers are either producers or dependent on producers.

Now we see the flip side of the mercantilist "trade deficits are necessarily bad" view in the form of the argument that "capital outflows are necessarily bad" (Note the emphasis on "necessarily". Just as trade deficits can be symptoms of bad policies, so can capital outflows. The below reasoning assumes that it reflects voluntary preferences as Reich's argument is based on that).

In an op-ed at the New York Times, Robert Reich argues for income redistribution on the basis of how it will stop supposedly harmful capital outflows:

"The rich spend a much smaller proportion of their incomes than the rest of us. So when they get a disproportionate share of total income, the economy is robbed of the demand it needs to keep growing and creating jobs.

What’s more, the rich don’t necessarily invest their earnings and savings in the American economy; they send them anywhere around the globe where they’ll summon the highest returns — sometimes that’s here, but often it’s the Cayman Islands, China or elsewhere."

The first statement about the "thrifty rich" has been proven false. There is no evidence (at least, I haven't seen any evidence) for the second claim that they invest their savings abroad to a higher extent than others, but it really wouldn't matter even if it was true.

The reason for that is that capital outflows equal a trade surplus (or a reduction in the trade deficit in the case of America) given the balance of payments accounting identity. From that it follows that capital outflow from American will either be cancelled out by capital inflows from foreigners, in which case it won't make any difference in terms of availability of capital for entrepreneurs, or it will result in a reduction of the trade deficit, something which will cancel out the reduction in domestic demand caused by their savings. Either way, this capital outflow will not result in reduced output.

Overlooking Construction, Car Sales & Employment Numbers

U.S. stocks rallied a very significant 3% today on news that the ISM manufacturing index was significantly stronger than expected.

While the ISM numbers were indeed stronger than expected, they hardly justified such a response, especially considering that the three other key data released today, the ADP private employment estimate, car sales and construction spending all were
very weak and indicated an economic contraction.

If Friday's official employment numbers are as weak as they likely are, today's rally will be quickly reverted.

Australian Economy Grows Nearly 10%

Second quarter Australian growth surprised on the upside, with the volume measure growing 1.2% (4.9% at an annualized rate) compared to the previous quarter and 3.3% compared to a year earlier.

The results were even more impressive if you consider the massive terms of trade gain and a drop in deficit in net factor income from abroad, as real net national disposable income rose as much as 5.1% (22% at an annualized rate) compared to the previous quarter and 9.5% compared to a year earlier.

The swing from a deficit to a surplus in trade as well as the decline in net factor income deficit also helped dramatically reduce the current account deficit.

The main factor driving the boom is the successful mining industry. As long as it booms, the Australian economy will also boom.

The mining industry (and therefore also the Australian economy) however faces two threats. One is the short term threat that the weakening U.S. economy could reduce growth in Asia, something which would reduce demand for its products. The other is the medium term threat that a Labor Party government supported by the Greens is going to implement environmentalist policies which would inhibit its growth.