Tax Cut Expiration Could Create Profit Opportunity

It is not clear at this point whether or not the Bush tax cuts will be extended or not. They are set to expire 31 days from now, but almost all leading politcians wants to prevent that from happening. However, as they disagree on whether or not the tax cuts should be extended also for people with a family income above $250,000 per year or an individual income above $200,000 per year, it is not certain that there will be any extension at all, much less if there will be an extension for people with high income. I am not familiar enough with the inside dealings with the political establisment in America to predict whether or not there will be a full, partial or no extension. But what I do know is that if there is no extension or only a partial one, then a profit opportunity for investors will arise. If there is no full extension, then the capital gains tax will rise from 15% to 20%. As a result, people who were planning to sell anyway in the near future will have an incentive to sell before the end of the year so that their capital gains tax will be lower. This will create an extra selling pressure that will depress stock prices and other asset prices until the new year. However, this depressed price level will create an opportunity for other investors totake advantage of the depressed price level created by the planned tax hike. Both the sellers and the buyers will be able to benefit from this because the lower current tax wedge compared to the future one will both mean that the sellers will receive a higher net price and that the buyers will have to pay a lower price.

Euro Area Money Supply Growth Collapses

While the main reason for the European debt crisis is fear that causes investors to flee perceived risky assets (and others to make speculative bets against them), one overlooked factor is the collapse in money upply growth.

Annual money supply (M1) growth has fallen from a high of 13.4% in August 2009 to 4.9% in October 2010. But if you look at 6-month and 3-month rates, it is clear that this number underestimates how tight monetary conditions are. The 6-month rate of increase is only an annualized 1.6% and the 3-month rate of increase is only an annualized 0.7%.

As this causes a general increase in interest rates, this collapse in money supply growth has aggravated the debt problems. However, if demand for euros continues to fall, the euro's exchange rate might continue to depreciate, despite the collapse in money supply growth.

European Debt Crisis & Republicans Negating Effects Of QE2

After two months of strong inflationary tendencies in the markets, with the U.S. dollar prices of Treasuries, stocks, commodities and foreign currencies all rising sharply in anticipation of the new round of "quantitative easing", we have in November seen these prices fall back after the actual implementation of it. Why is that?

There are several reasons for this. One is that the markets likely engaged in over-shooting and this is a correction from this. Another could be that increased Republican opposition to the Fed's inflationary policies makes markets believe it to be more unlikely that Bernanke and the other in the FOMC will dare to implement more "quantitative easing". A third reason is that the debt panic in Ireland and others are increasing demand for dollar assets.

All of the above mentioned reasons imply a higher demand for money in America, something which has a similar effect as a lower supply of money. This has been partially, but only partially as we have seen, cancelled out by a continued increase in money supply.

A Depression As A Keynesian Role Model

This may be the first time that a country who has seen a drop in real GDP by 8.4% in the latest year even as most other countries are recovering is actually held up as a role model by Keynesians Paul Krugman and Brad DeLong. Not only are Keynesians unable to get the logic in their theories right, they can't even get the definition of success right.

Why The U.S. CPI May Underestimate Consumer Price Inflation

Interesting post by Frederick Sheehan on why the official U.S. consumer price index underestimates consumer price inflation in the U.S. that I recommend you to read.

One Reason For Airport Porno-Scanners

Given the facts that I analyzed last week, that porno-scanning at airports not only violates people's privacy but also creates health risks and will be ineffective in stopping determined would-be bombers one can wondet why the U.S. government as well as some other governments are so determined to implement them.

Well, one partial explaining could be that the producers of the machines are simply getting what they paid for in the form of campaign contributions, as Mark Perry points out.

Spanish Government Abandons Green Schemes

Chris Horner at the Planet Gore blog reports on how the Spanish government is now reluctantly pulling the plug on the environmentalist schemes that Obama and other environmentalists have held up as a role model. This is of course partly because the Spanish government faces a fiscal crisis and so faces pressure to cut back spending on everything, but it is also because it has been proven to be exceedingly expensive in relation to supposed benefits.

Knowledge About Austrian Theory Weakens Fed's Power

Interesting article by John Carney about how more widespread knowledge of the Austrian business cycle theory (ABCT( could help prevent the scenario it describes, or in other words reduce the Fed's ability to manipulate the economy.

He points out that one of the responses to the rational expectations critique of ABCT that businessmen shouldn't be fooled by the artificial reduction in interest rates is that so few know about ABCT and are for that reason likely to be fooled by the Fed. And now that the theory is more popular, fewer will be fooled. Moreover, even many of those who aren't conscious believers in ABCT, still more or less understand the key points, namely that a Fed-induced boom will end in a bust.

Still, I am not so sure that this will completely end the Fed's power to start booms because first of all there are still many businessmen who don't believe in it, and secondly because there is another reason why the rational expectations critique of ABCT fails: namely that even if you are aware of the fact that the boom is unsound, you might still want to participate in it because you plan to sell your assets around the time the boom peaks, and hope until then to take advantage of the unsound boom.

Does Low Irish Corporate Income Tax Hurt The Rest Of Europe

While it now looks as if an increase in the Irish corporate income tax won't be a condition for an EU loan package to Ireland, there are many politicians who thinks it should be a condition. And even many of those that don't think it should be a condition still says that they think Ireland should raise its corporate income tax.

The reason for this is that while they acknowledge that a low Irish corporate income tax has made a lot of companies invest in Ireland instead of other European companies, and also caused companies to attribute profits in their accounting to Ireland solely to take advantage of Ireland's lower tax rate, they argue that the expansion of the tax base that this has brought has come at the expense of other EU countries, meaning that the total tax base hasn't increased and that the main result is simply to benefit companies and their owners at the expense of others and that the secondary result is to benefit Ireland at the expense of other countries.

This line of argument, while perhaps plausible to some at first glance, however overlooks two important things.

First of all, while the competition for the tax base (both in the form of the quantity of real investments and the extent of corporate tax planning) to some extent takes place within the EU, it also takes place relative to non-EU countries. A higher corporate income tax rate in Ireland might drive companies to these countries instead, producing no gains for other EU countries. Indeed, because they are more geographically distant and have more trade barriers, the economic ties are generally weaker in relation to their size. This means that relocation of businesses from Ireland will be bad for the rest of Europe.

And secondly, by holding taxes low in Ireland, not only will Ireland attract companies from other countries, but it will also enable investments that would have otherwise taken place in any country. This means that total global investment and total global output will be increased because of low Irish corporate income taxes.

Thus, EU as a whole benefits from the low Irish corporate income taxes something which means that Ireland's gains doesn't (at least not fully) come at the expense of other EU countries.

The Myth Of Green China

Advocates of subsidies for "renewable energy" and taxes on oil and coal sometimes point to China and claims that its economic boom is associated with a great expansion in "green" or "renewable energy".

But while it is true that China is increasing its use of "renewable energy", what is left out is that China is increasing its use of all sources of energy, and that compared to primarily coal, the use of "renewable energy" provides only a small fraction of its energy, as Alex Epstein explains in this interesting post.

Krugman, The 1990s & Government Spending

Paul Krugman again lauds the 1990s as a good example of Democratic policies creating success.

Yet apart from the increase in the top marginal income tax rate, policies weren't especially statist. Indeed, the Clinton years featured the biggest reduction in government spending relative GDP since the end of World War II, with federal spending relative to GDP dropping from 22.1% in fiscal year 1992 to 18.4% in fiscal year 2000.

This decline was mostly the result of lower military spending after the end of the Cold War (and before the beginning of the "War on terror") and lower interest payments due to the surpluses, but even excluding military and interest spending, federal spending fell from 14.1% of GDP to 13.1%.

Also, while the taxation of regular income rose for top earners, the capital gains tax was actually reduced. The 1990s was above all incidentally a decade of fiscal austerity, with a deficit of 4.7% of GDP turning into a surplus of 2.4% of GDP-hardlu consistent with Krugman's current "deficits are good"-theory.

The boom in the 1990s was of course partly the result of the unsound tech stock-bubble, but to the extent it was sound, it was because it feayured the biggest reduction in the burden of federal spending since the end of World War II. By contrast, growth has been weak after first Bush Jr. and then Obama started to dramatically increase the burden of federal spending.

Tim Geithner's "Laffer Gaffe"

Art Laffer was widely, and largely correctly, mocked for warning what would happen if Medicare and Medicaid were done by the government. Of course, Medicare and Medicaid already are, and have always been, government programs so this was a quite, shall we say laffeable (or laughable to use the normal spelling) argument. But now we see Obama's Treasury secretary Timothy Geithner make an equally laughable argument. Commenting on the proposal from some Republicans that the Fed should no longer have "full employment" as part of its mandate, Geithner said "It is very important to keep politics out of monetary policy". But politics is already involved in monetary policy, even accepting for the sake of the argument the flawed premise that unlimited discretionary power for Fed officials would be "non-political". The mandate of the Fed to pursue "price stability and full employment", was the result of a polirtical decision in 1978 known as the "Full Employment and Balanced Growth Act". Changing this is no more political than keeping it.

Irish Vs. Greek Debt Crisis

There are some similarities between the Greek crisis earlier this year and the current Irish crisis.

Both involve euro area countries with large deficits who initially saw interest rates rise because of the large deficits, but then the increase in yields got a life of its own and became self-reinforcing. The increase in interest rates was itself seen as a reason to drive yields up further (as the perceived risk of default increased), something which in turn drove up yields yet further and so on.

Yet there are some differences:

One is that  while the Greek crisis involves long time fiscal mismanagement with systematically too large deficits even during the boom, the Irish crisis is instead a case of a bursted property bubble that has created big problems in the banking system. Indeed, Ireland actually had a surplus during the boom. However, that surplus was of course largely based on revenues from the property bubble.

A related difference is that Ireland last year actually had a debt level below the euro area average (65.5% of GDP versus 79.2%). This year's massive deficit will probably push it above the average, but it will still be significantly less than Greece and some other countries.

A third related difference is that whereas the bulk of the Greek deficit is structural, the Irish deficit this year is mostly a result of the one time factor known as the bank bailouts. This means that even without either austerity or recovery, the Irish deficit will drop dramatically in the coming years once the recapitalization of the troubled banks are finished with.

Indeed, history shows that bank bail-outs aren't just one time outlays. Often some or even most of the outlays are recovered once the bank which is taken over recovers. This means that the Irish deficit could be dramatically reduced very quickly.
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A fourth difference is that Ireland has more to lose from a IMF-EU rescue package. In Greece, there was no real disadvantage in taking that package because the austerity measures was needed anyway (though they arguabley chose to rely too heavily on tax increases and too little on spending cuts) and because it lowered their cost of borrowing. While Ireland too needs more austerity measures (preferably spending cuts) and can lower its cost of borrowing, theere is a risk that the other EU countries might condition aid on an increase in the Irish corporate income tax rate.

Such a tax increase would probably reduce and not increase Irish tax revenue, as it would make multinational companies attribute less of their profits and to a lesser extent it will also reduce real investments in Ireland. But it will probably lead to higher tax revenues in other EU countries, which is why they push for it.

The Irish Problems & Fiscal Austerity

Recently, there has been a self-fulfilling panic about Ireland and its ability to borrow. I'll return soon within the coming days for a more in depth analysis of the Irish situation, but for now I'll focus on whether the problems prove that fiscal austerity was a failure.

The answer to that question depends on what you mean by failure. If you're talking about whether or not its previous austerity measures have calmed the erratic bond markets, then clearly it has been a failure, an issue which I again will return to.

But if we turn to the question of whether the problems prove that the Keynesian theory that fiscal austerity will necessarily lower growth, then now, it proves no such thing.

Indeed, by some measures Ireland is actually recovering faster than the EU average. Industrial production in Ireland rose by an average of 11.5% in the third quarter compared to a year earlier, compared to an EU average of 6.9%.

Other indicators like unemployment are somewhat less rosy, but even unemployment has started to drop in recent months. 

So while the recovery hasn't been quite as strong as in other Northern European countries with austerity programs, like the Baltic states, the underlying economy is certainly a lot stronger than in Greece, where strikes by Marxist unions have lowered output.

Thus, the Irish problems isn't as some Keynesians would claim, that austerity has weakened its economy, but instead results from a combination of the previous inflationary boom, incompentently handled bank bailouts and a self-fulfilling panic.

Why Weaker Dollar Might Not Reduce Trade Deficit

Caroline Baum points out that by strengthening the incentives to borrow and weakening the incentives to save, quantitative easing could reduce net exports, or in other words increase the trade deficit. This effect could very well be stronger than the apparent opposite effect from a weaker dollar.

This is an observation that I've made before. The example of Japan is even more conspicous than it was then as the yen is now at 1.2 U.S. cents (which in the normal inverted terms means that a dollar costs 83 yen) compared to 0.28 U.S. cents in the 1970s (inverted terms, 360 yen per dollar), yet Japan still posted a $23.5 billion (¥1.96 trillion ) monthly current account surplus in September, which translates into an annual surplus of nearly $300 billion.

Thus, there are good reasons to believe that quantitative easing will not reduce the trade deficit despite weakening the dollar. It will raise nominal domestic demand, but it might not increase real domestic demand because prices will be higher.

And this also illustrates why there is an overbelief in how much yuan appreciation will really reduce the Chinese trade surplus, when the same hasn't achieved it for Japan.

Intention Of Binge Drinking Isn't To Get Drunk

The Fed now claims that the purpose of "quantitative easing" isn't to lower the value of the dollar.

That's sort of like claiming that the purpose of binge drinking isn't to get drunk-or that the purpose of pushing on the accelerator of a car isn't to increase it's speed.

Government Stupidity At Work

As I try to limit this blogg to issues related to economics, I haven't written until now about the new ultra-intrusive "security measures" that the U.S. government is imposing on U.S. airports, but after reading this article, I can't resist doing so anymore.

Apparently, the U.S. federal government, in the form of the so-called Traffic Security Administraton (TSA) is even insisting that pilots go through this. This is absurd beyond belief. If a pilot really wanted to crashland a plane, would he really need any explosives or weapons. All he needs to do is use his control of the plane to crash land it. But that's hardly the only problem with the full body scanners.

First of all, they are intrusive and humiliating as they allow government employess to view everyone nude, something which can and will be (and already have) abused.

Secondly, the radiation involved in these scans create a health risk. While the health effects are probably very low for people who travel only occassionally, it is nevertheless a negative.

And thirdly, it won't stop people who are really determined to blow up planes. I of course have absolutely no such desire (in fact, I'm of course strongly opposed to it), especially if I'm on that plane, but if I wanted to do it it would be quite easy to do so. In case you don't realize yourself how the scanning could be circumvented, let's just say it involves places where the sun don't shine. As Rafi Sela, a security expert of the arguably safest airport in the world, the Ben Gurion airport in Tel Aviv, Israel, puts it:

"I don't know why everybody is running to buy these expensive and useless machines. I can overcome the body scanners with enough explosives to bring down a Boeing 747"

Given that Israel is arguably the country that Islamic fundamentalists hate the most in the world, and given that Israel still unlike the United States and several other other countries have still prevented terrorists from entering their planes for several decades, amd the fact that it has done so without the kind of gross violations of people's privacy, one can wonder why it hasn't been emulated. Is it political correctness (yes, one (but not the only) part of the israeli security strategy is to view 24-year old Muslim men as more likely to be terrorists than non-Muslim 4-year olds or 84-year olds), stupidity or ulterior motives, or a combination of the mentioned factors?

Well, I'll leave that up to you to decide. We can only hope that resistance against this intensifies, because if it is established, it is likely to spread to for example Europe as well.

A Few Interesting GDP Comparisons

If you go to different national and international statistics bureaus and check GDP for different countries at current exchange rates, you will find some interesting facts. To take just a few examples:

Israel with 7.6 million people has roughly the same GDP as neighboring Egypt with 79 million people. It also has a larger GDP than that of Pakistan, with 171 million people.

Singapore with 5.1 million people has roughly the same GDP as Malaysia with 28.3 million people. And it also has a bigger GDP than the Philippines, with 92 million people.

Sweden with 9.4 million people has a GDP that is nearly 4 times bigger than that of the other European country with a blue and yellow flag, Ukraine, who has 45.9 million people.

Australia with 22.5 million people has a GDP that is nearly as big as that of India, with 1.19 billion people.

Norway with 4.9 million people has a GDP that is roughly 2.5 times bigger than that of another oil rich country, Nigeria who has 158 million people.

Japan with 127 million people has a GDP that is nearly as big as that of China, with 1.34 billion people.

---- Many people would perhaps object to these comparisons as the general price level is a lot lower in the poor countries due to the Penn effect. And they've got a point in the sense that the difference in living standards isn't as big as these numbers suggests.

However, the numbers are still striking. And when it comes to economic influence, GDP at current exchange rates is what matters. Why these differences exists is a complex story usually involving differences in culture and current and/or past economic system that varies between the different cases. Only in the cases of Norway and Australia is it related to natural resources-but as Nigeria and India also has that, this only explains a small part of it. And in the cases of Singapore vs. Malaysia and to a lesser extent Israel vs. Egypt amd Japan vs. China, the richer country actually has less natural resources.

In the case of Singapore vs. Malaysia, former Malaysian leader Mahathir Mohamad gave this explanation:
 
""""""Singapore will overtake Malaysia because its focus is just on economic growth. There is no social restructuring goal such as fair distribution of wealth between races as we have in Malaysia.

Blame Norway

Usually when surplus nations are blamed for global imbalances, it is China and/or Germany that are criticized. But now I see via Scott Sumner that Sweden is attacked for having a too high surplus (Sweden's annual surplus was SEK 232 billion in 2009, or somewhat below $35 billion). Its recommendations for reducing the surplus are the following:

"Its fiscal policy should be more expansionary; it should encourage currency appreciation; and it should open its domestic market to foreign goods."

Yet regarding the first point, fiscal policy is already relatively expansionary with both tax cuts (on pensions) and spending increases promised for next year. While it would be possible to do even more, too radical moves would endanger fiscal soundness.

Regarding currency appreciation, it is not clear how this should be done since Sweden's government has almost no foreign assets. It could increase foreign currency debt, but too much of that is risky. Raising interest rates would work, but that would also reduce credit demand, meaning that the trade surplus might not drop.

And as for the point about trade policy, that would be nice if it was possible, but it isn't since Sweden is part of the EU and the EU has a common trade policy.

If you want to criticize a Scandinavian nation whose government pursues a policy of artificially creating a massive external surplus, Sweden is not the appropriate target.

Neighboring Norway had a surplus of NOK 311 billion in 2009, or roughly $52 billion, about 1,5 times as much as Sweden. And unlike in Sweden, this surplus was largely the result of the massive purchases of foreign assets by its sovereign wealth fund, who holds assets of more than $500 billion. Relative to GDP, that is much more than China's foreign exchange reserves.

Norway's government should, both to reduce global imbalances and give its people a break stop or at least reduce its purchases of foreign assets and instead reduce the tax burden of the Norwegian people. Unfortunately, that is not likely to happen as only the "populist" semi-libertarian Progress Party advocates this and they unfortunately only got 22.9% in the latest election.

The politicians and pundits bashing China and Germany should devote some of their attention to Norway to pressure its government to stop or at least reduce its purchases of foreign assets, so that global imbalances can be reduced and incidentally the Norwegian people can have increased freedom.

Budget Cuts Not Behind Slowing Growth In Europe

Euro area economic growth slowed from 1% to 0.4% on a quarterly basis, something which is blamed by some on budget cuts.

Yet quarterly growth in Latvia which has applied the toughest cuts in Europe held firm at 0.8%, with the annual change turning positive (2.4%) for the first time since the crisis started.

The real story is that the high quarterly growth in Germany in particular during the second quarter was just a temporary spike. Fiscal austerity has only lowered growth to the extent they involved marginal tax rate increases and/or provoced disrupting strikes.

Yes, Gold Is At A Record High Against The Dollar

David Leonhardt has an odd article in the New York Times where he criticizes those of us pointing to how gold has reaced a new all time high:

"Gold is at a record only if you fail to adjust for inflation. And you should almost always adjust for inflation. Otherwise, you end up with meaningless records — Gold reaches record high! Oil reaches record high! Lettuce reaches record high! — that depend on the fact that a dollar in 2010 does not have the same value as a dollar did in, say, 1980.

More than a month ago, Ryan Chittum of The Columbia Journalism Review noticed the epidemic of supposed gold records and urged those of us in the news media to stop. The actual record was set 30 years ago, when the price of gold, in today’s dollars, hit $2,387, or 71 percent higher than it closed on Tuesday.

This isn’t simply a question of math. Anyone who says gold is at a record high (or who said oil was several years ago) is getting the story wrong. Why? Because $10 today is not more valuable than $9 a few decades ago. Claiming otherwise is tantamount to saying that 10 rupees is more valuable than $9 because 10 is a bigger number than 9.

The notion that gold is more expensive than ever happens to fit with a larger narrative that also does not square with the facts — namely, that inflation is an imminent threat. This can be a bit confusing, I realize, because inflation plays two roles in the story: past inflation distorts our view of record highs, while future inflation is the concern of some of those people making a big deal out of gold. "

Note his strategy to confuse. The point is that gold is at a record high against the U.S. dollar. No one has ever talked about record highs against lettuce or a basket of consumer goods. The point is that the Fed has, and continues to debase the dollar.

And his argument becomes even more absurd if you consider that he lashes out against the notion of considering past inflation. Yet as he acknowledges later in the article, the entire decline in the inflation-adjusted gold price since the brief 1980 peak happened in the 19 years that followed. For the last 11 years, including the latesty year, gold has soared regardless of whether you adjust it against the CPI or not.

What gold's drop in particularly real but also nominal terms between 1980 and 1999 reflected was decreased inflationary expectations. It's rise since then reflects primarily higher inflationary expectations but also actual inflation and lower interest rates. And this is the story that Leonhardt in a very unsuccessful way tries to refute.

He later attributes gold's rise to increased industrial demand from China and other emerging economies. But that is hardly applicable to gold which has almost no industrial use.

That an article of such a poor quality could get published at a leading newspaper is disheartening. But then again, I guess this is what you should expect from the newspaper that hires Paul Krugman as a columnist.

Why Gold Rose Above $1,400

As a semi-followup to the previous post, it should be noted that the effect on the price of gold is even stronger than the effect on prices in general for three reasons:

1) Because while the reduced opportunity cost of not holding long term bonds will increase demand for money (and thus reduce the dollar price of things which aren't assets), it will also increase demand for alternative assets such as gold.

2) Because of gold's special reputation as an inflation hedge, increased inflationary expectations will increase demand for gold even more than most other things.

3) Because it is a good that is traded on financial markets and therefore has especially flexible price, it will react faster than most goods and services on the increase in inflation.

Not surprisingly given the above points, gold reached today yet another all-time high. rising for the first time above the $1,400 mark.

How Does QE2 Generate Inflation?

It is generally assumed, and rightly so, that the new round of "quantitative easing" will generate higher inflation in the United States. But it is rarely explained just why it will do so. After all, QE2 will not be conducted by dropping dollar bills from helicopters.

Well, there are essentially three mechanisms by which it happens: higher money supply, lower money demand and lower supply of goods and services.

1) Regarding money supply, it should be noted that by lowering interest rates, QE2 will boost demand for loans. Higher demand for loans will in a fractional reserve banking system generate a higher money supply. Given a certain level of money demand and supply of goods and services, a higher money supply will result in higher price inflation.

2) Regarding money demand, higher inflationary expectations will cause people to be less willing to hold money (as its real value is expected to drop), thus reducing money demand. And lower money demand has a very similar effect on prices as a higher money supply.

It should be noted though in this context that to the extent that QE2 lowers nominal interest rates, this will increase money demand as the opportunity cost of holding money drops.

So the net effect of Fed bond purchases on money demand depends on to what extent it raised inflationary expectations more than it lowers nominal interest rates.

And it seems that the increase in inflationary expectations is this time somewhat bigger than the drop in nominal yields.

As of this writing, the nominal 5-year yield has dropped 21 basis points since August 31 (from 1.33% to 1.12%) while the inflation indexed 5-year yield has dropped 72 basis (from 0.14% to -0.58%) points since August 31, implying that inflationary expectations has increased 51 basis points (from 1.19% to 1.70%) during that period.

Thus, QE2 has likely reduced money demand somewhat.

3) Regarding the issue of reduced supply of goods and services, it should be noted that to the extent that QE2 reduces the value of the dollar and to the extent that companies adjust prices, it will raise import and export prices, causing a reduction in the inflow of foreign goods and services and increase in the outflow, reducing the supply of goods and services available to Americans.

A lower supply of goods and services will given certain levels of money supply and demand increase the dollar price of goods and services.

In conclusion we can clearly see that by a combination of a higher money supply, a reduction in money demand and a reduced domestic supply of goods and services, QE2 will clearly increase price inflation. The only uncertainty is just how big this effect will be.

The Limits Of Monetary Policy Independence

The economic case for floating exchange rates is based mainly on the supposed desirability of monetary policy independence. Yet there are two problems with this.

First of all, it is not necessarily the case that independent monetary policy will really be sounder than the policies of some other central bank. Particularly in many third world countries, adopting the policies of some sounder Western central bank is probably better.

And secondly, particularly for smaller countries, monetary independence is partially or entirely illusory.

The best example of this was the case of Iceland, that raised interest rates really high to contain its speculative boom. Yet that only helped push the Icelandic krona to increasingly overvalued levels, increasing the current account deficit and borrowing in foreign currencies.

Iceland is of course a really tiny country (the population is only about 300,000 or 1,000 times smaller than that of the United States or the Euro area) with high dependence on foreign trade, so for larger economies, national monetary policy will usually not be quite as ineffective as in Iceland. Generally speaking, national monetary policy will be more effective the bigger the country is. Yet even for larger countries the exchange rate movements caused by interest rate changes will constrain the effectiveness of attempts to contain bubbles and imbalances.

One example of this is the effects of the Fed's "quantitative easing". This has caused the U.S. dollar to dive against just about all currencies. Given this, other central banks face the choice of either easing too so as to limit the appreciation of their currencies, or accept a really dramatic appreciation of their currency. Regardless of what they choose, the Fed's policy will increase imbalances and bubble tendencies in their economy. Thus, even if they have a floating exchange rate, other countries will feel the effects of the Fed's policies, meaning that their monetary policy independence is more limited than many people think.

Another Mixed U.S. Employment Report

Yesterday's employment report was a mixed bag. More specifically, the household survey was weak while the payroll survey was strong.

The household survey saw a reversal of the gains of the previous months, as employment fell by 330,000. It was only because the participation rate fell that the unemployment rate didn't rise. The employment to population ratio fell tp 58.3%, the second lowest employment rate(Only in December 2009 was it lower, at 58.2%) during the latest decade.

By contrast, the payroll survey showed relative (at least for being this recovery) strength, as not only did it show an increase in private sector employment of 159,000, it also showed an increase in the average work week. Average hourly earnings also gained by 0.2% in nominal terms, but after inflation this number might be negative.

So we have in short a household survey that indicates recession and a payroll survey that indicates growth. Since they are supposed to describe the same thing, they can't both be right. The payroll survey is usually considered more reliable by most economists, including me, when it comes to mothly fluctuations so the truth is probably closer to it than to the household survey. But the household survey indicates that it might exaggerate labor market strength somewhat.

Why "Multipliers" Aren't Infinite

Nick Rowe at "The Worthwhile Canadian initiative" writes that he is unable to explain why the effect of economic growth of fiscal stimulus isn't infinite given the existence of a "liquidity trap" (which is to say zero nominal interest rates).

While given the existence a "liquidity trap" under massive deflation may perhaps create some positive short term effects from deficit spending, it is in fact very easy to explain why there isn't an infinite effect of it, and why it usually isn't any positive effect at all..

First of all, even aside from the below mentioned problems, it takes time for people to engage in economic transactions, something which alone is sufficient to rule out an infinite effect.

And secondly, there is of course the issue of Ricardian equivalence. To the extent that people expect current deficits to result in future austerity, this will reduce their spendng. And do note that this is not just applicable to households but also companies.

And thirdly, higher nominal spending will mean higher prices, limiting the increase in real output from a higher nominal demand.

And fouthly, deficit spending will in any open economy cause the trade deficit to increase. This is one factor that Rowe recognizes, but he doesn't seem to realize that this alone explains deviations from infinity. And by recognizing only this, he misses the Ricardian equivalence and time factors.

Yes, Gridlock Is An Improvement

As expected, the Republicans made massive gains particularly in the House of Representatives, but also the Senate. As a result, they now have a mojority in the House, and has reduced the Democratic majority in the Senate to a level way below the needed 60% majority needed to overcome filibuster.

Is this good or bad for the U.S. economy? Historically, divided government has often been associated with economic strength, such as in the period of 1995-2001, so most economists believe that this is a good outcome, as bad decisions will be blocked.

But some argue that since this also means that good decisions are blocked, this is nevertheless bad news. However, this alternative view presumes that under the old majority, good policy changes would have been implemented. And as it happened, they weren't. Instead, only bad decisions like the "stimulus" and the flawed healthe care reform were passed.

While no policy changes is worse than positive changes, it is less bad than negative changes. And since a re-election of the old Congress would have meant more negative changes, the new gridlocked Congress is an improvement.

Difference Between Reagonomics & Obamanomics

I previously pointed out that during the first 5 quarters of this so called recovery, real per capita personal income actually fell.

One can compare this to what happened after another deep recession, that of 1981-82 ended.

In the 5 quarters after the supposed end of this recession in Q2 2009, real per capita disposable income developed this way including and excluding transfer payments (Social security, unemployment benefits, welfare etc.) from the government:

Including transfer payments: -0.7%
Excluding transfer payments: -1.4%

By contrast, when the 1981-82 recession ended in Q4 1982, we this development of real per capita disposable income in the 5 quarters that followed:

Including transfer payments: +6.3%
Excluding transfer payments: +6.0%

This difference illustrates just how failed Obama's government expansion strategy has been compared to Reagan's marginal tax rate reduction strategy.

Aussie Is Now King Of Dollars

After having recently come very close, and later fallen back somewhat, the Australian dollar today achieved parity and is off this writing trading very slightly above the U.S. dollar, who in turn is trading slightly above the Canadian dollar. As a result, the Australian dollar is now for the first time since July 1982, the highest valued dollar in the world.

The reason for today's rally is of the interest rate increase by the Reserve bank of Australia (RBA). And the reason why the Australian dollar is going better than the others is that the RBA is gradually tightening monetary policy, while the Bank of Canada is more passive and the Fed is planning "quantitative easing".

How long the Australian dollar will remain strong depends in part of course on just how much the RBA will continue to tighten, and how large the Fed's "quantitative easing" will be. It also depends on how much the prices of Australia's mining exports rise-or decline.

Democrats Will Lose Because Their Policies Have Failed

Tomorrow is election day in America. I obviously don't know what the exact outcome will be, but just about all polls shows that the Republicans will win a majority in the House of Representatives, and maybe also the Senate. The pick-up in seats is likely to match or exceed those in 1994.

There are many reasons for this likely Republican surge, including the fact that a new President's party usually loses seats in mid term election and the fact that Obama has pursued such a radical agenda, presiding over an unprecendted surge in federal spending, something which has created a counter-reaction in the form of the so-called Tea Party movement.

But the most important factor is that Obama's policies have been a big failure. This was confirmed in today's personal income report.

In the second quarter of 2009, the first when Obama started to implement his policies and also the quarter when the recession supposedly ended, real (2005 dollars) disposable income was $10,193 billion (all of the numbers mentioned here are annualized). In the third quarter of this year, real disposable income had risen to only $10,237 billion. And if you factor in the increase in population, real per capita disposable income dropped from $33,191 to $32,976, a 0.7% decrease. If you look at September number alone, real per capita income was even lower $32,916.

Note also that the numbers would have been even worse if you exclude transfer payments. Excluding that, real income is lower even before adjusting for population, and after adjusting for population, it is lower by 1.5%.

Most Americans have thus seen their real incomes continue to drop even after the recession supposedly ended and after Obama's policies have been given a long time to "work its magic". The policies of Obama and the Congressional Democrats have thus been a big failure, and for that the Congressional Democrats will now receive a well-deserved punishment (it is however more dubious whether the Republicans deserve to win). Obama can be grateful that only Congress is up for election this time and that he has got two more years before he has to face an election.