Why Devaluation Doesn't Work Like In The 1930s

You can very frequently these days read pro-inflationist writers point to the experience of the 1930s as "evidence" of the effectiveness of inflation and currency devaluation/depreciation.

The storyline is basically that the countries that first abandonded the gold standars, such as Britain, recovered first, the countries that abandoned it somewhat later, like the United States recovered somewhat later while the countries that held on to the gold standard the longest, like France and Belgium, suffered the longest slump.

Actually, the empirical record wasn't quite as clear cut as it is sometimes claimed, but it is still fair to say that there was a strong correlation between leaving the gold standard and recovering.

Yet if you look at the empirical record for today's Europe, and for that matter the rest of the world, you find no positive correlation between devaluations and economic recovery.

It is true that there are some countries with floating exchange rates that have had a strong recovery, such as Poland and Sweden, and that there are euro area countries that are still depressed, like Greece and Ireland. But there are also strong euro area economies like Finland, Germany, Slovakia and Luxembourg and depressed countries with floating exchange rates, like Iceland, Hungary and Romania.

Furthermore, in the case of for example Sweden, the relative boom came after the krona recovered its previous loss in value (the loss in output in Sweden was actually significantly above the euro area average when the Swedish krona was at its lowest in early 2009) , so it seems very far fetched to attribute its relative boom to a weak currency. Instead, the real explanation is the supply side tax- and social benefit reduction strategy of the Swedish government that caused the strong recovery. The story behind the Polish recovery is similar.

Why then does currency devaluation/depreciation and inflation work so much worse this time than during the 1930s? Well, I hinted this the other day when I discussed the issue of secondary deflation. During the 1930s, the massive collapse of fractional reserve banks caused massive, double digit deflation, something which given the zero bound barrier for nominal interest rates implied double digit levels for real interest rates even for risk free loans. This meant that real interest rates were way above the level reflecting time preferences, or the natural interest rate, and so business activity was depressed. The fact that governments also tried to prevent nominal wage reductions despite the massive deflation also aggravated the crisis. And when other countries abandoned the gold standard, the increase in the exchange rate of the gold standard countries aggravated deflation, and so also the excessive real interest rates and excessive real wages, depressing their economies further.

The current situation, when real interest rates is at or below the natural rate is very different. Just because ending excessive real interest rates will stimulate a recovery doesn't mean that pushing real interest rates further below the natural rate will necessarily boost the economy. It could do so in the short-term under certain circumstances, but the returns are diminishing when interest rates fall below the natural rate. This is especially so if optimism is muted, as it is right now.

Countries With Big Deficits Should Focus More On Spending Cuts

The New York Times reports that Greece and other countries hit by fiscal woes plans a greater emphazis on tax increases rathet than spending cuts.

That's good for them, because while tax increases may in some cases be more politically convenient, they are also far less effective in terms of reducing a deficit, while being more destructive in terms of the effect on output compared to spending cuts. This a theory that has both strong theoretical and empirical support.

The Issue Of Secondary Inflation

A reader asks about the issue of "secondary deflation":

"What do you think about secondary deflation? Austrian economists are
divided about this. For example Hayek in his Prices and Production (1933)
argue that FED should do nothing and let deflation run its course. But later
he changed his opinion. In 1975 he wrote that FED should have done something
to prevent secondary deflation:

“More generally, intervention by the monetary authorities could bring
advantages ‘in the later stages of a depression’ when ‘deliberate attempts
to maintain the money stream’ would be justified to counter the ‘cumulative
process of secondary deflation’ - Hayek(1975)

“I agree with Milton Friedman that once the Crash had occurred, the Federal
Reserve System pursued a silly deflationary policy. I am not only against
inflation but I am also against deflation. So, once again, a badly
programmed monetary policy prolonged the depression.” - Hayek(1979)

Later Hayek proposed that central bank should stabilize MV money stream.
How can central bank stabilize MV money stream?

What should should have Bernanke done as a response to 2008 crash. Nothing?
Or should he has done "something" (rates cuts, QE...). What is your opinion about this?"

Well, first of all. "Secondary deflation" is indeed bad for the economy. While some Austrians likes to blame the Great Depression entirely on the preceding boom as well as the bad policies implemented by Herbert Hoover (tax increases, protectionism and prevention of wage cuts), that is not the entire story.

While the inflationary excesses of the 1920s and the disastrous Hoover policies certainly both contributed significantly to the problems, they are not the entire story. The fact that there was 10% annualized deflation, causing real interest rates to rise above 10%, also contributed to the severity of the downturn. The above 10% real interest rates didn't reflect time preferences, they reflected the fact that nominal interest rates can't fall below zero, while there was massive deflation.

Murray Rotbard once argued that this deflation would liquidate malinvestments faster. And it probably will, but the problem is that it will to an even more significant extent also liquidate a lot of fundamentally sound businesses.

So, yes, there is a strong case for preventing "seconday deflation".

Another thing to remember that in the absence of fractional reserve banking, "secondary deflation" would be impossible. Unless that is abolished this means that at some times active interventions from a central banks will be needed to prevent that outcome.

Short of the politically impossible goal of abolishing fractional reserve banking, what should be done then? Well, I don't know of any flawless solutions, but keeping interest rates near zero if (with emphasis on "if") there is a danger of "secondary deflation" seems like one of the least bad. Preventing banks from going under is also effective, but that is associated with the downside of "moral hazard".

Another Krugman Fallacy On Commodities

While Krugman casts others as being "worst economist in the world", he does his best to try to earn that title for himself.

"Higher commodity prices will hurt the recovery only if they rise in real terms. And they’ll only rise in real terms if QE succeeds in increasing real demand. And this will happen only if, yes, QE2 is successful in helping economic recovery.

What this official is saying is a version of the classic freshman mistake: an increase in demand leads to higher prices, and higher prices make people buy less, so an increase in demand leads to lower sales.

Amazing stuff, and further evidence of the Dark Age of economics now descending."

First of all, while it is true that higher commodity prices won't necessarily derail the recovery, it will to an uncertain (it could be partially, fully or more than fully) extent prevent higher nominal demand caused by quantitative easing from causing an increase in real demand and real output. This goes both for the general increase in prices as well as the terms of trade loss discussed below.

And what he misses is that since commodity prices are a lot more flexible than most consumer and producer prices, it is all but certain that quantitative easing will in the short term raise commodity prices disproportionately, or in other words raise real commodity prices.

And while that will benefit commodity exporters like Australia, Russia and Brazil, that will by creating a terms of trade loss hurt net commodity importers like the United States.

Free Trade, Immigration & Income Inequality

I have pointed out before that the increase in inequality is probably exaggerated, and that the primary cause of the real increase is probably inflationary policies and to a much lesser extent the top marginal tax reductions.

This however doesn't necessarily mean that there couldn't be other partial explanations as well. Two explanations that are often suggested is free trade and immigration. I will now analyze them both in the same post since most of the analysis is similar and as they both involve interaction with foreigners and as they both (assuming that government intervention hasn't subverted incentives) will increase aggregate income of both the native born and foreigners, while hurting some groups.

But just how are they supposed to increase inequality? Well, there are three possible ways:

1) By increasing wage inequality.
2) By increasing profits relative to labor income. As the rich tend to own a much higher percentage of shares, this will increase inequality.
3) By moving poor people from poor countries to rich countries.

The third is obviously only applicable to immigration. It doesn't mean that the poor people become poorer (indeed, they almost always increase their income by moving to rich countries), but since they are now included in the inequality statistics of rich countries, it does increase inequality as long as their income is significantly below average in their new country). Note also that this is the only way in which the arrival of unemployed immigrants will increase inequality. The below analysis of the effects of factor 1 and 2 from immigration is only applicable to employed immigrants.

Starting with the effects of free trade on inequality, it should be noted that the effects on factor 1, wage inequality, depends on exactly which goods and services are traded.

The key thing to remember is first of all that the higher the extent certain (net) imported goods are purchased by the poor, free trade will reduce inequality-and vice versa for the extent to which the rich purchase it. And secondly, that the higher the extent certain (net) imported goods are produced by low wage workers, free trade will increase inequality-and vice versa to the extent to which the rich produce it.

As far as I know, no evidence exists that any income class are under- or over-represented when it comes to either production or consumption of net imported or net exported goods in general. There are sectors with net imported tradable goods where workers have low wages, and where consumers might have high incomes, such as production of expensive clothes where free trade likely increased income inequality, but that is probably not that common. In other sectors, where workers are better paid and/or consumers poorer, free trade will have a more ambigious effect on wage inequality, or even reduce it.

As for the effect on profits relative to labor income, there exists no good reason to believe that free trade alters it. Some opponents of free trade argues that because free trade allows capitalists to move production offshore, this will improve the capitalist's bargaining power and so increase profits at the expense of labor income.

But while it is true that free trade increases the ability of domestic capitalists to threaten workers with moving production to other countries this doesn't mean that it will increase the profit share for two reasons. That is because first of all, free trade will also increase the ability of foreign capitalists to start production here, improving the bargaining power of workers. And secondly, because the inflow of foreign goods will create a downward pressure on the margins of domestic capitalists when trying to sell their products to domestic workers.

All in all, the theoretical analysis shows that free trade in general doesn't increase inequality. While free trade in a few goods (such as production of expensive clothes) have that effect, free trade in most other goods have either an ambiguous effect or the opposite effect.

With regard to immigration, the effect on wage inequality depends on what country you're talking about and which immigrants they accept. Countries that only accept highly skilled immigrants probably reduce wage inequality, as their arrival will lower the relative wages of high earners and thus raise the relative wages of people with low wages, unless (this is probably rare) the buyers of those services are similarly relative high income.

However, in countries where employed immigrants disproportionately work in sectors with low pay, immigration will increase wage inequality, unless (again probably rare) the buyers of these services are similarly low income.

In the case of immigration, there are stronger reasons to believe that employer's bargaining power compared to workers is increased. That is because just as in the case of free trade, domestic employers will increase their ability to substitute from domestic to foreign workers.

But unlike in free trade, there is no mechanism apart from lower wages which will make it more profitable for foreign capitalists to enter. Competition from foreign producers in the sense of producers in foreign countries is by definition inapplicable here. A smaller effect to the extent that immigrants who can't find normal jobs try to create new companies could however create this effect on competition to some extent.

All in all, immigration still likely improve the bargaining positions of employers.

With regard to skilled immigrants, the effect on inequality is therefore ambiguous, with lower wage inequality counteracting an improved bargaining position of employers.

With regard to low skilled immigrants, the effect is clearly to increase inequality as it not only increase wage inequality but also improves the bargaining ability of employers and moves poor people from poor to rich countries.

So, in conclusion, low skilled immigration as well as free trade in certain goods will increase inequality. Highly skilled immigration and free trade in most goods have a more ambiguous effect on inequality, while free trade in some goods will decrease inequality.

When Accounting Identities Are Useful

Sometimes people reject accounting identities in economics, such as the GDP formula Y=C+I+G+NX or the fact that current account deficits/surpluses means equal size net capital inflow/outflow which can be written as CAB=-NCF (CAB stands for current account balance, while NCF stands for net capital[in]flow), as being "empty tautologies".

However, while they can be (and often are) misinterpreted, they are in certain contexts useful in understanding the economy-and dispelling myths.

One example of this can be seen in this protectionist article. The article has many other outright false or half-true but misleading statements that I won't bother to refute as it is besides the point of this post. Instead I want to focus on the fact that the author first claims (correctly) that the U.S. runs a trade deficit and then claims (incorrectly) that the U.S. suffers from capital outflows.

The latter statement is extremely misleading because while some Americans invest in other countries, these investments are far smaller than the investments of non-Americans in America. And as the accounting identity CAB=-NCF shows, this must necessarily be the case as long as America has a current account deficit. Thus, if it is true as the author of the article claims that capital flows benefits the receiving countries at the expense of the countries from where they claim, than this point is a pro-American argument for free trade.

If you are aware of this accounting identity, you will easily see through this kind of nonsense, and that is one example of when accounting identities can be usefuul.

The Great Baltic Recovery

After having contracted far more than the EU average during the economic crisis, the Baltic countries in general and Latvia are now in a strong recovery. This was confirmed in today's Eurostat report on industrial new orders in the EU in August, which showed that industrial new orders was up by 59.2% in Latvia, 41.9% in Estonia and 26% in Lithuania in the three month period June-August (I use a 3-month period because monthly numbers are quite volatile) compared to the previous year. By comparison, the average gain in the EU was 19.6%.

Krugman & Oil Prices

Paul Krugman argues that competitive devaluations won't raise the price of oil:

"Why do dollar commodity prices tend to rise when the dollar falls? Because other countries buy commodities too, so that a constant dollar price would mean a fall in terms of other currencies. To a first approximation, in fact, you’d expect commodity prices to remain constant, other things equal, in terms of a GDP-weighted basket of currencies around the world.

So yes, a fall in the dollar tends to raise the price of oil in dollars — but it also tends to reduce the price of oil in euros. A fall in the euro tends to raise the price of oil in euros, but raise reduce it in dollars. [whoops!] So what would devaluations that raise commodity prices in terms of all currencies look like? I have no idea.

There is, I think, a tendency to think of devaluations as reductions in the value of currencies relative to something external and eternal — and hence as making us all poorer. But the reality is that my depreciation is your appreciation, and vice versa; we can’t all devalue at the same time."

Actually, Krugman is entirely right about this, assuming that it involves exchange rate movements unrelated to monetary policy easing. However, he misleads when he tries to create the impression that this is applicable to this case, as the latest decline in the dollar's value (and corresponding oil price increase)is clearly related to the latest round of "quantitative easing".

While depreciation/appreciation of currencies relative to other currencies is indeed a zero sum game where one country's depreciation must be another's appreciation, inflation is not a zero sum game between countries, and one country can certainly have higher inflation without others having disinflation or deflation.
Indeed, it is possible for all countries to simultaneously have higher inflation.

And because it is caused by "quantitative easing" the dollar price of oil will increase even as oil prices in terms of euros, yens, yuans etc. don't decrease. Indeed, because oil, like other commodities, has a more flexible price than normal goods, American "quantitative easing" could at least in the short term increase oil prices in terms of even other currencies. This is of course especially true if other countries pursue similar policies to limit the appreciation of their currencies.

How Affirmative Action Can Hurt Even Intended Beneficiaries

Affirmative action, or "positive discrimination" is primarily wrong because it is unjust against those it directly hurts (in this case Whites and Asians) and because it will lead to lower productivity when less qualified people are hired just because of their ethnicity/race.

But interestingly, it might not even be good to the seemingly favored groups (in this case Blacks and Hispanics) as many people will assume that anyone with a high ranking position from that group are simply there because of affirmative action-perhaps even in cases when they are actually genuinely qualified.

Boomtown District Of Columbia

Yesterday, a report about employment and unemployment in various American states was released. One of the most interesting facts was that District of Columbia (aka Washington D.C. or simply Washington) had a lot stronger employment growth than any other state, rising 2.3% in September 2010 compared to August 2010 and 3.3% compared to September 2009.

Why is District of Columbia growing so fast? Well, it might just ben related to the fact that District of Columbia is the seat of the U.S. federal government, and the fact that the federal government is growing rapidly.

That is confirmed by the national employment statistics which said that federal employment rose by 0.9% during the latest year. If you exclude the U.S. Postal service, which operates under a different mechanism (and has its employees spread out through the country to a higher extent) than normal government agencies, federal employment is up by as nuch as 3.2%.

So contrary to the assertions of Paul Krugman, Menzie Chinn and some other leftist economists, the U.S. federal government under Obama is growing rapidly not just in terms of the cost of transfer payments handed out but also in terms of employment. That state and local governments (and the Postal service) makes different decisions doesn't change the fact that government directly controlled by Obama and the Democratic Congress has expanded a lot.

British Fiscal Austerity Will Weaken Pound

The new British government have announced a far reaching fiscal austerity program. Given that the current deficit levels are unsustainable and unhealthy, that is mostly a good thing. However, as Britain -like for example Germany, the United States and Japan- has a "safe haven" status, the benefits will be smaller than they would have been in countries perceived as risky like for example Greece, Spain or Ukraine. Furthermore, the tax increases -as well as one spending cut- will have a negative supply side effect.

But leaving aside the issue of the effect on economic growth, how will this impact the pound's exchange rate?

Well, it will in short lower it. Even assuming that it has no effect on Bank of England monetary policy, a lower deficit will lower interest rates and so lower demand for pound assets.

To the extent it might provoke the Bank of England into further "quantitative easing", the negative effect on the pound's exchange rate will of cource be even greater.

This doesn't necessarily mean that the pound will depreciate in value in the near future compared to its current exchange rate, as traders might have already priced in these effects. What it clearly does mean however is that the value of the pound will be lower than if there hadn't been any fiscal austerity program.

The Problem With "Potential GDP"

A key concept in Keynesian theory is that of "potential GDP", as opposed to actual GDP. That is supposed to be GDP if there is full employment and capacity utilization.

There are several problems with this. First of all, surely there are more things which could be organized in a more rational way than just employing more workers or using unused existing capacity. For example there could be higher growth in capacity through higher investments, improved skills of workers, improved use of existing skills and better technology. To only include some possible ways to boost output and not others is an arbitrary distinction.

A second problem is that potential GDP is in fact unknowable. The first reason for this is that we don't know just what rate of unemployment and capacity utilization constitutes full employment and full capacity utilization. In practice 0% unemployment and 100% capacity utilization is never reached, so that's not the answer. But what is the answer then? No one knows.

Furthermore, it is not certain what the marginal product of more workers or higher utilization really is. It will probably not increase output proportionately.

Some Keynesians like Paul Krugman choose to simply extrapolate previous growth. But there is no way of knowing that "potential GDP" really continues to increase at the same rate. And in fact there are good reasons to believe that potential output is lowered.

First of all, a weak labor market will limit immigration and make many workers lose contact with the labor market, reducing the size of the labor force. And lower investments during the recession will reduce industrial capacity. Official U.S. industrial capacity was for example 1.1% lower in October 2010 compared to Ovtober 2008, while during the previous boom industrial capacity rose 1-2% per year. And the real level of capacity that will ever be used again has probably fallen more.

Contrary to what Krugman claims, there are thus good reasons to believe that this unusually long and deep slump will result in a permanent reduction in output. It is however not possible to know just how big this reduction will be. For this reason, we should be very skeptical toward Keynesian estimates of "potential GDP".

China Raises Interest Rates

First increase since December 2007. As this will reduce demand, this has caused stock- and commodity prices to drop today. It also in effect helped cause the yuan to appreciate against most currencies as it was unchanged against the U.S. dollar while the U.S. dollar rose.

This move could be seen as a hint hint that the growth and inflation numbers from China released later this week will be stronger than previously expected.

Foreigners Losing Money In U.S. Treasury Securities

The U.S. Treasury department reports that foreigners acquired as much as $117.2 billion in Treasury securities in August.

That was very irrational. And I'm not writing this just because I have the benefit of hindsight (with the ridiculously low yields and the falling dollar the value of these investments are lower now).

No, I'm writing this because U.S. Treasury securities historically have historically had much lower return than government securities in other. As I pointed out kast year, they yielded on average 1.1% less per year in the period of 1984-2008 than in other "safe haven" countries like Japan and Switzerland. Compared to for example Australia and New Zealand, they yielded 2.3% and 4.3% receptively less per year on average in that period.

And with the yields even lower than in the past there is no reason to expect that it will be different this time.

Now, perhaps it can be justified for particularly risk averse Americans to invest in U.S. Treasury securities since they at least carry no exchange rate risk for them. But for foreigners, they suffer both the additional exchange rate risk and the lower expected return, making it very irrational for non-Americans to invest in U.S. treasury securities.

So why do they do it? Either 1) they want to give away part of their money to the U.S. government, or 2) they are ignorant of the fact that U.S. Treasuries for them is both risky and have a low expected return or 3) They have ulterior motives for their investments, such as preventing their exchange rate from appreciating too fast.

Explanation number 1 is probably not so common. Explanations number 2 is the likely explanation for the vast majority of private bond investors and explanation number 3 is the likely explanation for most governments and central banks.

Why Hong Kong's U.S. Dollar Peg Should End

While all attention has been on the slow appreciation of the yuan against the U.S. dollar, little attention is given to the Hong Kong dollar, which hasn't moved at all.

This is largely understandable since Hong Kong is far smaller than mainland China, so it is even more obvious here that a change in Hong Kong's currency policy wouldn't have a significant effect on the trade balances of the U.S. and most other countries.

However, the question of the fixed exchange rate between the U.S. dollar and the Hong Kong dollar is still interesting from the perspective of the best interest of Hong Kong.

The economic case for fixed exchange rate rests mostly on the fact that decreased exchange rate volatility and uncertaintly can facilitate trade and other forms of economic interaction. However, as long as some countries have floating or adjustable exchange rates, it is only possible to have a fixed exchange rate to one currency bloc, while you must have a floating or adjustable exchange rate to the currencies that have a adjustable exchange rate relative to the currency that you have a fixed exchange rate to.

You must in other words choose which currency or currency bloc (if any) to have a fixed exchange rate and which currencies you shouldn't have a fixed exchange rate with. Since as stated above the purpose of fixed exchange rates is to facilitate trade, the most rational choice is to have a fixed exchange rate with the country that you have the largest degree of economic interaction with. That is why it is for example natural for Denmark to have its peg of the Danish krone to the euro.

In Hong Kong's case that means mainland China, which stood for 48.6% of Hong Kong's total trade in 2009. While the United States came in second, it was a very distant second with only 8.3% of Hong Kong's trade.

Now, as long as the yuan too had a fixed exchange rate with the U.S. dollar, it really didn't matter whether the peg was with the U.S. dollar or the yuan. Since the yuan was in effect part of the U.S. dollar bloc it moved up or down in the exact same way as the U.S. dollar, meaning that by having a fixed exchange rate with the U.S. dollar, the Hong Kong dollar also had a fixed exchange rate towards the yuan.

However, owing to outside pressure and to a lesser extent a will to contain inflation, China has now given up the peg and instead started to have a managed and adjustable exchange rate for the yuan that gradually appreciates against the U.S. dollar. This means that the yuan will also gradually appreciate against the Hong Kong dollar, greatly weakening the exchange rate stability against its by far most important trade partner. This means that to maximize efficiency gains from its fixed exchange rate, Hong Kong should instead peg the yuan.

Furthermore, another important consideration also argues for ending the U.S. dollar peg. That consideration is how sound or unsound monetary policies are in the country you have a fixed exchange rate with. If you have a fixed exchange rate and free capital flows you will no longer have an independent monetary policy, and you will instead adopt the policy of the country you have a fixed exchange rate to.

And with the Fed pushing forward with "quantitative easing", while China has started to gradually increase the value of the yuan, it should be clear that a peg to the yuan would be less inflationary than a peg to the U.S. dollar.

Hong Kong should therefore as soon as possible end its peg to the U.S. dollar, and instead peg the Hong Kong dollar to the yuan. In the long run, the Hong Kong dollar should, as Jim Rogers has argued, be abolished and replaced with a monetary union where the yuan is currency in Hong Kong. However, that should wait until the yuan is fully convertible. To make that future transition smoother, a fixed exchange rate to the yuan would be a good first step though , especially if they decide (as I think they should) upon a 1:1 exchange rate between the Hong Kong dollar and the yuan.

To Starve The Beast You Must Restrain The Central Bank

Good article in Investor's Business Daily about how anyone interested in limiting government spending must also advocate doing away with or at least restraining the central bank.

It could be added that real life examples of this include the many euro area governments like Greece that now implement spending cuts because they lack a central bank that can finance their deficit spending. Similarly, because California and other American states don't have central banks of their own they are similarly forced to reduce their spending, unlike the U.S. federal government that can expand spending all it wants since the Fed can finance it through "quantitative easing".

Don't Be Fooled By Tame CPI

Today's U.S. CPI report came in below expectations, rising only 0.1% compared to the previous month and only 1.1% compared to 12 months earlier. However, you shouldn't misread this as signaling low inflationary pressures.

The relatively low increase reflects the previous tighter monetary condition, with MZM dropping roughly 2% between June 2009 and June 2010. However, since late July, money supply growth has returned, with MZM increasing 2.8% ( an annualized rate of 15.6%) in the 10 weeks between July 26 and October 4.

And with the dollar index dropping 13% since June, and with oil and other commodities increasing rapidly in value, a pick up in consumper price inflation can be expected in the coming months.

Dollar Fall To Raise Dollar Oil Price?

According to this news story, the drop in the dollar could make OPEC demand a higher price of oil, up to US$100 per barrel. Actually, the dollar price of oil has already risen, but if OPEC were to aim at $100, and if they back it up with production cuts, then it could rise further still?

Is Singapore In A Depression Or Spectacular Boom?

Singapore is usually the first to report preliminary growth numbers, and that was the case this quarter too. Yet depending on what number you looked at, it could have either suggested that Singapore is in a depression or that it is enjoying a spectacular boom.

If you for example go to the statistics Singapore web page you can see in the center of the page the news that GDP contracted by an annualized rate of 19.8%, while in the left side bar you can see that GDP is up by 10.3%.

This is bound to lead to confusion for people who haven't been regular readers of this blog for some time or learned these distinctions some other way. In short, the 19.8% contraction number expressed growth in the American way, while the 10.3% growth number expressed growth in the Chinese way. Expressed in the European way, there was a 5.4% contraction. In case you are unaware of it, see my previous explanation of the difference between the American, European and Chinese way of expressing growth.

What then can be learned from this? First of all, that quarterly change in output in Singapore is even more volatile than in other countries. And secondly, given the fact that quarterly change is unusually volatile in Singapore, it makes more sense to look at the yearly change (the "Chinese" way of expressing growth), and the answer to the question of how Singapore's economy is performing is that it is doing great, and that the quarterly contraction simply reflected normal (for Singapore) volatility.

And thirdly, it illustrates given the second point, just how misleading the American way of expressing growth can be. The American way of expressing growth is based on the implicit assumption that quarterly growth will stay constant during four quarters. Yet that has clearly not been the case in Singapore where growth expressed in the American way was -1% in the fourth quarter of 2009, 45.9% in the first quarter of 2010, 27.3% in the second quarter of 2010 and then -19.8% during the third quarter of 2010.

The quarterly variations is less extreme in other countries, but very big too, and since this way of expressing growth gives people the misleading impression that output in for example Singapore actually rose by 45.9% in the first quarter and contracted by 19.8% in the third quarter, it is bound to be misleading

In a way the Chinese way of expressing growth is the best since it first of all expresses actual changes and also smoothes out quarterly volatility, but it has the drawback of missing or underestimating turning points The European way also uses actual numbers and directly spots turning points, though compared to the Chinese way it is bound to reflect erratic short-term fluctuations. The American way of expressing growth is therefore the worst way. However, because other financial news and commentary sites will use it and because many readers are used to it, I will usually in the case of countries with statistics bureaus that use it (primarily the United States) use it too.

Three Dollars-One Value

Right now we have the interesting situation that the three biggest dollars in the world-the U.S., the Canadian and the Australian, have almost exactly the same value. As of this writing, the U.S. dollar was valued only 0.06% higher than the Canadian dollar, and only 0.42% higher than the Canadian dollar.

Right now, there are only three major currencies with a higher value than the U.S. dollar: the British pound, the euro and the Swiss franc. With the Fed pushing ahead with "quantitative easing 2" while the Bank of Canada and even more so the Reserve Bank of Australia are tightening monetary policy, it seems likely that the pound, the euro and the franc will soon be joined by the dollars of Canada and Australia.

Inflationary Expectations Continue To Rise

Today, the yield spread between regular and inflation-protected U.S. treasuries rose above 200 basis points for the first time since the before the Lehman Brothers collapse in 2008. The regular yield is as of this writing (as usual, when you read this, these numbers have probably changed with a few basis points up or down) 2.46% while the inflation-protected yield is 0.43%, implying an expected inflation of more than 2% per year during the coming decade.

By contrast, on September 1, the regular yield was 2.58% while the inflation-protected yield was 1.02%, implying an expected inflation of just 1.56% per year.

Not coincidentally, gold rose to a new all time high in U.S. dollar terms today.

If, as many suggests, the Fed is actively trying to increase inflationary expectations, then it certainly looks as if they are succeeding.

Another Thing About Employment Report

I noted in my analysis of the U.S. employment report that the household survey was stronger than the payroll survey in terms of the number of people employed.

What I missed was however that the household survey was weaker than the payroll survey in terms of how much time the employed worked.

The payroll survey claimed that the average work week for those employed was unchanged. Yet the household survey claimed that part-time unemployment (or underemployment) increased dramatically, from 5.7% to 6.1%.

While it is possible that this discrepancy can be accounted for by a decrease in voluntary underemployment, the most likely explanation is that there is a statistical discrepancy between the two surveys.

As I've explained before, the household survey and the payroll survey should give the same result since they're supposed to describe the same thing. But because they use different methods in data collection, they often get different results.

The payroll survey is usually more reliable in terms of monthly fluctuations. But the likelihood that the real numbers differ in a certain direction increases when the household survey gives a certain result. And in this month, the household survey suggested that the change in the number of employed may have been stronger than what the payroll survey suggested, but that there might have been a decrease in the average work week (and therefore also in average weekly earnings) instead of the flat number suggested by the payroll survey.

California's Environmentalist Nightmare

You often hear from leftists that ending the use of fossil fuels and nuclear power will not be costly, and will in fact produce "green jobs".

But the experience from countries or states that have invested in it clearly shows that whatever "green jobs" are created comes at a very high cost for the government and in the form of losses of more "non-green" jobs. Stephen Moore has a very interesting article about the horrifying experiences from California that I recommed you to read.

Peter Diamond Is Not Qualified For Fed Board

One more thing about one of the economics laurates, Peter Diamond. He was previously rejected as a nominee for the Fed board by Senate Republicans who pointed to his lack of experience in the monetary economics area and his pro-inflationist views.

Does the fact that he is now a co-recipient of the Nobel Economics price make him more qualified?

In short: no. Remember, this price was about problems in bringing together buyers and sellers in for example labor markets. This has really nothing to do with monetary policy, and so the arguments againt Diamond are still valid. This is similar to how Paul Krugman's previous largely valid research in the economics of trade doesn't make him a good macroeconomic analyst.

Of course, it is possible for an economist to be a good analyst in more than one subject. But the fact that someone is good in one specialized field of economics doesn't prove that this person is good in other fields as well.

Relatively Sensible Economic Laurates This Year

This year's winners of the Nobel price in Economics, Peter Diamond, Dale Mortensen and Christoper Pissarides, are relatively sensible. The point of their theories is that in many markets we can experience simultaneous shortages and surpluses, because some buyers and sellers have a difficult time finding each other. One example of this is the labor market, where so-called "frictional unemployment" in the form of many jobs openings remaing vacant even as there are many unemployed willing and able to perform them, because jobseekers and employers are unaware of or don't realize that they could solve each other's problems.

Some would belittle these insights as being trivial, but that overlooks that many economic models in fact overlooks these insights. One example of this is the Classical models that assume that wage adjustments are sufficient to eliminate unemployment, or Keynesian models that assumes that increased "aggregate demand" can solve unemployment.

It should further be noted that the laurates note that more generous unemployment benefits will increase "frictional unemployment" as the unemployed will put less effort into finding a new job. That means that more generous unemployment benefits will increase unemployment even if wages are completely rigid. And it also means that even in a recession, as long as there are any job openings, increased unemployment benefits will increase unemployment.

Obama-Small Spender?

In fiscal year 2008, the last fiscal year that Obama had no influence over, core federal spending (excluding interest payments and financial market bailouts) was $2,723 billion. In fiscal year 2010, core federal spending was $3,292 billion.

This means that there has been a 2 year increase of 20.9% in core federal spending.

Yet Paul Krugman still claims that Obama is a "small spender". His arguments for it is pretty strange. The first argument is that aid to people with little or no income, such as unemployment benefits, food stamps and Medicaid isn't really spending-a quite odd and indeed false view of what constitutes government spending.

His second argument is that state and local governments have recently begun to reduce their spending. This is largely true, yet it is not relevant for analyzing the economic policy of Obama and the Congressional Democrats as they don't make these decisions. They can influence them through aid to the states-and that has in fact increased.

So in order to reach the conclusion that Obama is a "small spender" Krugman has arbitrarily excluded the spending that has increased the most and included spending that Obama doesn't decide on. That says more about Krugman than about Obama.

A Better Reason Not To Cheer "The Deficit Decline"

Stan Collender points out that the reduction in the U.S. federal deficit in fiscal year 2010 (October 2009 to September 2010) was according to preliminary estimates the biggest ever in nominal terms yet no one seems to cheer this news.

Collender explains this with people either believing for Keynesian reasons that a lower deficit is bad or that people points out that the deficit is still extremely high- the second biggest ever in nominal and real terms and the second biggest since World War II relative to GDP.

But there are other reasons not to get cheery about it, including for example that it makes little sense in this context to use nominal terms and far more importantly, that the underlying fiscal deficit in fact increased.

If you look at the preliminary report from the Congressional Budget Office, you'll see that the deficit fell by $125 billion, from $1,416 billion to $1,291 billion.

Yet the entire reduction, and more, was accounted for by the effects of financial market interventions. In fiscal year 2009, the net result of revenue from the Fed, TARP and aid to GSE (Fannie Mae and Freddie Mac) was a drag of $211 billion. By contrast, in fiscal year 2010, these items produced a net gain for the budget of $144 billion, an improvement of $355 billion.

Excluding these items, the deficit in fact rose by $230 billion, from $1,205 billion, to $1,435 billion. In addition, the cost of deposit insurance (only the change, but not the exact level is specified) fell by $55 billion, meaning that the underlying deficit rose as much as $285 billion.

Quantitative Easing Has Already Started

The prices of just about all assets have recently soared in terms of U.S. dollars, whether be bonds, stocks, commodities or foreign currencies. That is something that I highlighted already 2 weeks ago, and that trend is something that has continued accelerated.

For example the yield on the 10-year inflation protected Treasury security has dropped from 0.81% ( a record low at the time) to 0.40%, while the yield on the 5-year inflation protected Treasury security has dropped from 0.06% to -0.47%.

Had this been the result of simply "flight to safety" due to increased economic pessimism, this drop in real bond yields would have been associated with falling stock prices, but instead the S&P 500 gained another 1.5%.

Meanwhile, the prices of commodities, particularly oil and gold has continued to soar, while the U.S. dollar has continued to lose value against most other currencies, particularly the euro.

When all prices rise like this at the same then we are clearly experiencing inflation. This inflation is in turn driven by two factors. One is reduced money demand as people expect that an expected Fed announcement about quantitative easing to reduce the purchasing power of money. The other is that we have in fact already experienced "quantitative easing".

In the 9 weeks between July 26 and September 27, MZM rose 2.3%, which translates into an annualized rate of 14%.

Mediocre U.S. Jobs Report

What's there to say about today's U.S. employment report? The best way to describe it is "mediocre". It indicates that the U.S. economy grew, but at a very slow pace.

The strong part was found in the household survey, which showed an increase in employment by 141,000. That's not much compared to much other countries given how big America is, and it is barely enough to compensate for population growth, but is much stronger than the payroll survey which showed a contraction in the total number of employed.

The payroll survey is a lot weaker. Even excluding Census workers, the number of people employed fell slightly, as a slight increase in private sector employment was overshadowed by a slightly bigger drop in government employment.

Meanwhile, weekly and hourly earnings were flat in nominal terms, something which likely means a drop in real terms as consumer prices likely rose.

Looking forward, the revival in money supply growth that I will discuss more in a later post will provide support, but this will be counteracted by the looming tax increases that are scheduled for January.

Offsetting Effect With Cause?

Alcoa is projected to post a decline in profits, something Bloomberg News explains with "a weaker dollar raised costs in Europe, Australia and Brazil, offsetting an increase in the price of the metal".

But as it happens, the weak dollar is the key cause of the increase in the dollar price of aluminum. So it would be more accurate to say that the price of aluminum was basically unchanged in terms of the currencies of producer countries.

Australia's Commodity Driven Boom Continues

As commodity prices continues to rise due to inflationary policies in most countries, the Australian economy contniues to boom, and booms at an accelerating rate.

We saw new confirmation of this today as employment rose by as much as 49,500 (0.45%) in September compared to August. That's the equivalent of nearly 700,000 jobs in the United States.

As long as commodity prices continues to rise, this positive trend for the Australian economy is likely to continue. This could pave the way for more interest rate increases from the Reserve Bank of Australia, something which combined with a new round of "quantitative easing" from the Fed might soon push the Australian dollar above parity against the U.S. dollar.

Stiglitz Goes Semi-Austrian

Leftist economist Joseph Stiglitz points out that Fed interest rate policy will likely again create asset price bubbles, while doing little to revive the weak U.S. economy. Probably without realizing it, Stiglitz thus endorses Austrian conclusions.

"Please, U.S. Government. Take My Money"

Some investors gets more and more eager to lose money to the U.S. government as the real 5 year yield has now fallen to -0.40% as of this writing.

Brazil Raises Tax On Foreign Investments

With yields in the United States, and certain other countries, falling to increasingly absurd levels (the real 5-year yield is -0.28% when this is written) many investors turn to more attractive destinations, such as Brazil, that I wrote about a few months ago.

The yield differential is even more attractive now than when I wrote that post, with the 10-year yield in Brazil being roughly 9.5 percentage points higher than in the United States and with the differential being more than 10 percentage points at earlier maturities.

In part this can be justified by somewhat higher inflation in Brazil. but on the other hand, Brazil's higher growth means that because of the Penn effect, the exchange rate of the real will not fall that much.

Indeed, the problem for Brazil is that the real, far from falling as the Uncovered Interest Rate Parity would have predicted, has actually appreciated in value. The real is trading at roughly 59 U.S. cents, up by 6% from a year ago, and about 10% compared to a decade ago. Investors that have carry traded with the real as target currency have therefore enjoyed very high profits.

That worries Brazilian politicians, who are now trying to stop this by raising the tax on foreign holders of bonds from 2% to 4%. This is arguably the smartest way to prevent the real from appreciating further. Buying foreign assets, like China and most other countries that intervenes in currency markets, would have made much less sense as this would have meant that Brazil would have borrowed from foreigners at interest rates above 10% in order to lend to other foreigners at interest rates near zero.

Even so, considering how ridiculously low yields are in for example the United States, even this might not be enough to prevent investors from pouring in money to Brazil and therefore raise the value of the real. The after tax yield differential is after all still 5.5% for 10-year securities and more than 6% for securities of shorter maturity.

Hong Kong's Strong Boom Continues

The boom in the world's freest economy seems to have continued in August as exports increased 36% (while imports rose 28.4%) while at the same time, real retail sales rose by as much as 14.7% compared to a year earlier.

While total GDP growth is probably not as high as these numbers suggest, as that also depends on government consumption, non-retail sales private consumption, fixed investments and inventory changes, it does nevertheless imply that it is likely that growth in Hong Kong accelerated during the third quarter.

Means-Testing Social Benefits Equivalent To Tax Hike

The British government announced today that they will abolish child benefits for higher income earners in Britain.

That might at first glance seem like a sensible move. Presumably, people with high income are in no need of government hand-outs. But the problem is that by phasing out such benefits, people's net income will rise less if they work more. This means that this move will have the same economic effect as a formal marginal income tax rate increase, with the only difference being that childless high income earners won't be affected, while the effect will be greater than an equal sized tax increase for high income earners with children.

Latvia On The Right Track

Remember Latvia? Before the attention turned to Greece, Latvia was portrayed as the country with the biggest crisis (partly unfairly).

But now the Latvian economy shows clear signs of recovery, with retail sales in August increasing by 1% compared to the previous month and 4.6% compared to August 2009. And industrial production increased 3.5% compared to the previous month and 20.5% compared to August 2009.

While output is still significantly below pre-crisis levels and unemployment still far too high, Latvia's economy is clearly in a recovery. This recovery comes "despite" the fact that Latvia hasn't devalued and implemented tough but necessary austerity measures.

Meanwhile, the government that pushed through the tough these austerity measures was re-elected with a wide margin.

Both of these news will help Latvia bring down the budget deficit and thereby qualify it for entry into the euro area.

Australia Fact Of The Week

The commodity price boom have now according to one measure made Australia surpass the United States in per capita income.

Seasonally adjusted quarterly GDP in Australia was A$340.32 billion, or A$ 1361.28 billion at an annual rate. With the Australian dollar trading at 97.25 U.S. cents, this means that Australia's GDP is US$ 1323.85 billion. With a current population of 22.48 million, that implies a GDP per capita of US$ 58,900.

By contrast, the United States had a seasonally adjusted nominal GDP of US$ 14,578.7 billion at an annual rate during the second quarter. With a population of
310.39 million, this imples a GDP per capita of US$ 47,000.

Per capita GDP at current exchange rates is thus more than 25% higher in Australia than the United States.

However, the United States is still ahead if we focus on purchasing power parities that the OECD uses. The OECD claims that the correct purchasing power parity is A$ 1.46/US$. If we accept that estimate, then the local purchasing power of per capita GDP is equivalent to US$ 41,500.

In principle, the purchasing power adjusted number is more relevant than the number based on current exchange rates in terms of determining where the standard of living is higher However, the problem is that the purchasing power estimates are very uncertain and often misleading, while by contrast you always know for sure what the current official/market exchange rate is.

China Offers To Buy Greek Bonds

Chinese Prime Minister Wen Jiabao is visting Greece and there promises to strengthen trade ties and to buy Greek bonds, which China already owns, though it seems less clear when these purchases will take place. Wen's own words hints immediate purchases, while statements by other Chinese officials says it won't happen until Greece starts to borrow on their own again, instead of as they do now (with the exception of some short-term security sales) through the IMF and other Euro area countries as intermediaries.

Given the fact that the markets already given the current 785 basis points yield spread to Germany already prices in a 100% certainty of a 53% writedown of debt, that would seem attractive to the Chinese. One alternative explanation would perhaps be though that the Chinese could lend money to the Greeks in return for Greece opposing in the EU sanctions against China due to its currency policy or other EU protectionist measures against China.

Surprising & Not So Surprising Article Of The Day

While Paul Krugman and other leftists argue for trade war with China and other policies to reduce the value of the U.S. dollar, Robert Reich somewhat unexpectedly (at least to me) express disagreement, pointing to how a weaker currency will reduce domestic purchasing power.

Meanwhile, John Taylor studies data that hint that low interest rates on Treasuries created by the Fed led to increased demand for riskier assets such as mortgage backed securities, something which in turn fueled the housing bubble.

Swedish-Danish Labor Markets Again

I previously used the comparison between the labor market developments in Sweden and Denmark as evidence of the effect of incentives for reducing unemployment. I pointed out then that employment during the financial crisis fell a lot less in Sweden than in Denmark.

While leftist Matthew Yglesias tried to attribute this to the fact that the Swedish krona depreciated during the crisis while the Danish krone had (and still has) a fixed exchange rate to the euro, that was never very convincing as the main effect of this exchange rate policy, assuming foor the sake of the argument that the theory that a weak currency boosts growth is true, would have come in the form of higher growth (or less contraction), yet as I pointed out before, Sweden's loss in output was no smaller than Denmark's (and in fact revised numbers shows that the Swedish drop in out was in fact greater). The most striking difference between the countries was that the decline in output in Sweden was associated with a much smaller decline in employment.

While the weaker Swedish currency could have contributed to this to a very small extent as the higher inflation this caused helped reduce real wages, the main explanation is clearly the fact that the Swedish government has aggressively pursued a strategy of reducing marginal income tax rates for the poor and the middle class, while reducing unemployment- and sick leave benefits, while the Danish government has done almost nothing to improve incentives to go from unemployment to employment. (Unlike the Swedish government it has however reduced the top income tax rate. But while this can be expected to improve GDP growth it has little effect on employment growth).

Now things have changed in both the sense that the European business cycle have gone from bust to boom (at least for now) something which has boosted growth in both Denmark and Sweden more than average and also in the sense that the Swedish krona has appreciated more than 25% relative to the euro and therefore also the Danish krone since its March 2009 lows. But there is one thing that hasn't changed, namely that employment has been much stronger relative to output growth in Sweden compared to Denmark.

As stated, growth in both Sweden and Denmark has been higher than the European average, with Sweden's GDP growing by 4.6% and Denmark's by 3.7%.

Yet employment, in terms of hours worked has during this period increased by 2.1% in Sweden while declining by 1.3% in Denmark. And do please note that this much stronger Swedish performance happened after the Swedish krona appreciated by about 25% against the Danish krone, seriously undermining the relevance of Yglesias' currency weakness theory.

The Increasingly Manipulated U.S. Dollar

When the Japanese central bank launched its intervention on September 15, the yen stood at 83 versus the U.S. dollar. It then briefly dropped so that a dollar would cost 86 yen. Today however, we can see that the yen is back to the 83 level.

However, it is not so much the yen that has regained it's strength, it is the U.S. dollar that has depreciated. During the same period, the euro and the Swedish krona has appreciated nearly 6% against the U.S. dollar, the Australian dollar is up 3% and the pound and the Swiss franc are up 2%.

Why it is not clear why the euro and the Swedish krona in particular have risen so much, it is more clear why the dollar is down: namely the factors that I wrote about last week, in the form of higher inflation and inflationary expectations.

The latest week has featured a continued drop in bond yields (with the real yield down another 16 basis points and the nominal yield down 10 basis points as of this writing), rise in commodity prices while stock prices have remained largely unchanged all suggesting increased inflation and expectations of inflation. Much of it can be traced to the signals that Fed officials have given about another round of quantitative easing.

What would you call it when a central bank like the Fed does now pursues policies designed to debase the value of a currency? I would call it currency manipulation, the thing that U.S. politicians hypocritically points fingers at (and threatens with sanctions for) others for doing.