Friday, December 31, 2010

Chilean Peso As A Copper Currency

In April 2009, I pointed to the close relationship between the Chilean peso and the price of Copper, Chile's main export good .

Well, now we can read about how the price of copper reaches new highs. And not coincidentally, so does the Chilean peso.
We shouldn't expect a perfect relationship because there are other factors involved, but that there is a strong empirical and causal relationship should be clear.

Booming Estonia Joins The Euro Area

Defying the predictions of a collapse or a break-up, the euro area will tomorrow expand with its 17th official member (in addition, a number of smaller countries like Andorra, Monaco, San Marino and Kosovo use the euro without being formal members): Estonia.

This will have almost no effect in terms of macroeconomic policy since Estonia has pegged its currency to the euro (or the D-mark before 1999) since June 1992, which means that they have already adopted the monetary policy of the ECB (or the Bundesbank before 1999) since then. The difference will be mainly symbolic, but it will also mean that transaction costs will be removed and the credibility of the elimination of exchange rate risks will be strengthened.

Estonia, like Latvia and Lithuania, had a depression in 2008-09 following a long period of rapid growth. Now, like Latvia and Lithuania, Estonia is recovering fast. The recovery is however so far even stronger in Estonia compared to Latvia and Lithuania, with Estonia having at 5% the fastest GDP growth in the EU in the third quarter after only Sweden (and possibly also Luxembourg who hasn't yet published third quarter numbers, but grew by 5.3% in the second quarter). Industrial production is growing even faster than in Sweden (up as much as 35.1% in November compared to a year earlier).

 Meanwhile, its fiscal situation is one of the strongest in Europe, having the third smallest government deficit (after Sweden and Luxembourg) and the smallest public debt.

Thus, while Estonia is still suffering from the after effects of the 2008-09 depression with an unemployment rate which despite  recent declines remains far too high, it has a bright future overall with its strong fiscal situation and high growth rate.

Thursday, December 30, 2010

More On Climate Change Cost-Benefit Analysis

I seems to have struck a nerve with my recent post challenging the supposed damage of "climate change" by pointing out that to the extent it is real it would bring benefits as well as costs. It was a very long time since I got so much response to a post.

Most of the responses deserves no comment as they merely contain insults and personal attacks against me and/or simply repeat the response I mentioned in the original post of merely stating various alleged (and usually exaggerated as in the cases of sea levels and hurricane activity) costs without considering potential benefits. In other words, they don't really answer the question in any serious way.

For a review of the many benefits of global warming, I recommend Thomas Gale Moore's book "Global warming: a boon to humans and other animals" which is available online here. He doesn't really prove that the benefits are greater than costs, but the other side hasn't proven the opposite either. An honest discussion would try to weigh them against each other in a cost-benefit analysis.

There were however a few more reasonable and less emotional arguments, which does deserve responses.

One argument was that we really couldn't tell whether warmer weather would be on balance good or bad, because we hadn't experienced it, and that it wasn't worth the risk. But the right degree of risk aversion is always debatable, and besides, we have in fact experienced warmer weather than now, for example in the Bronze age and (at least in the North Atlantic) during the Medieval warm period. And there were no signs of civilizational decline during these periods.

Another argument concentrated on the supposed danger of carbon dioxide itself, rather than the indirect effect on warming. Yet carbon dioxide levels are currently only 385 parts per million, far less than the 10,000 parts per million where negative health effects are apparent. Even with a really dramatic increase in carbon dioxide emissions is levels going anywhere near 1,000, much less 10,000 parts per million. Furthermore, carbon dioxide is conducive to plant growth something which is good in itself and also limits the increase in carbon dioxide remaining in the air.

Another argument is that only during the last 12 millenia, after the last ice age, did agricultural civilization develop. Yes, but note that if there was a causal relationship, it was a causal relationship from warmer weather, something which Thomas Gale Moore mentions in his book. That would only suggest that the ideal climate isn't colder than right now, not that it's not warmer.

Another argument was that sudden changes in climate will be disruptive to existing ecological systems. This argument is actually partially true in the same sense that any economic change which causes transition problems.

But first of all, we don't know which way the climate would have changed in the absence of human intervention, as climate have changed and would have continued to change for other reasons. Human intervention could potentially counteract otherwise disruptive climate change. And secondly, big changes can be beneficial even if it is short-term disruptive, such as the death of the horse carriage industry following the introduction of cars.

Wednesday, December 29, 2010

Swedish Central Bank As A Role Model?

This article hails the Swedish central bank as a role model in fighting the Swedish housing bubble. I wouldn't be too sure about that because credit growth remains excessive despite not only rate hikes but also new rules requiring more money down for home buyers. In part this is because of the limited effectiveness of monetary policy in a small country, and in part this is because the rate hikes have in fact been very timid so far. Still, most of the Riksbank board deserves credit (Lars E.O. Svensson, former Princeton colleague of Paul Krugman and Ben Bernanke, being the big exception) for recognizing that inflation isn't simply something which means higher consumer prices, it could also take the form of asset price bubbles.

Monday, December 27, 2010

Krugman's Upside Down Use Of Inflation Indicators

Paul Krugman, as usual, misses the point about commodity prices: it is not that overall consumer prices, particularly not the hedonically and otherwise thoroughly "adjusted" official consumer price index will in the short term rise as much or even close to as much as commodity price indexes. It won't, for reasons thatI explained last week.

No, the point is that they are the first symptom of more inflationary conditions (usually caused by you know which institution) and that they are leading indicators of higher consumer price inflation. When they drop, they are similarly leading indicators of deflation or at least disinflation.

Krugman's example of the big commodity price drop in the second half of 2008 is in fact a good example of this as consumer price indexes then turned negative in the United States.

Needless to say, this leading indicator isn't perfect, but what leading indicator is?

Normally, people value leading indicators a lot higher than lagging indicators. That's why people care about the Conference Board's leading indicator index, while very few if any cares about its lagging indicator index. Something which is perfectly rational, since we know what has happened, while we don't know what will happen, and therefore wants indicators of what is likely to happen.

Yet in Krugman's, and many other leading economist's upside down "logic", the lagging indicator known as "core inflation" is all important, while the leading indicator of commodity prices should be ignored.

Swedish Krona Vs. Danish Krone

A reader wondered what I thought of the outlook of the Swedish krona vs. the Danish krone.

Well, since the Danish krone is pegged to the euro, and will likely remain so, and since I think the Swedish krona will continue to appreciate against the euro, it follows that I believe it will also appreciate against the Danish krone.

The Swedish krona is at historically high levels against the euro (and therefore also against the Danish krone), something which limits the upside potential, but since ECB rate hikes are out of the question as long as the debt panic persists and since the Riksbank looks set to hike rates a few times during 2011 (despite the objections of "arch-dove" Lars E.O. Svensson), the krona will likely appreciate against the euro and the Danish krone.

Saturday, December 25, 2010

Why America's Trade Deficit Is Smaller Than It Looks

For the latest 30 years, America have had a constant current account deficit, and often a quite large one. This means that America have had constant net borrowing from abroad. One would have expected then that it would have to give up now some of its production (or at least borrow more) to cover the interest (or profits in case the deficit was paid for by selling stocks). Except that it hasn't.

During the first 3 quarters of 2009, America had a net factor income surplus of $191.6 billion, at an annual rate. That is a dramatic increase from 1980, when the surplus was just $34.2 billion. Even if you adjust for inflation, it represents a dramatic increase as the 1980 surplus was $79.1 billion in 2010 dollars. Indeed, it is an increase even relative to GDP, as the 1980 surplus was 1.23% of GDP, while the 2010 surplus was 1.31%.

But how is it possible for America to pile up more and more debt and yet still receive more and more net capital income?

There are two explanations:

One is that some of this capital income really isn't capital income-it is the result of tax planning by U.S. companies. Many U.S. companies decides to attribute profits to Ireland and other low tax countries. The result is that Irish trade statistics falsely shows that Ireland has a really large trade surplus-but also a really large factor income deficit. The flip side of this is that the U.S. trade deficit is overestimated while the factor income surplus is also overestimated.

A second reason is that U.S. investors in foreign assets have had higher returns than foreign investors in U.S. assets. U.S. investments has largely been direct investments and stocks that over the long run produces a higher return than government bonds in most countries. Furthermore, U.S. government bond have over the long run had much worse return than just about all other government bonds.

But why do non-American investors keep investing in U.S. government bonds when they both have lower expected return and a higher risk (due to the exchange rate factor)? As I pointed out here, this is likely in some cases the result of some private investors being unaware of this or thinking (in some cases correctly, in others incorrectly) that the U.S. dollar is temporarily significantly undervalued. In other cases, it is the result of foreign governments in the form of sovereign wealth funds or central banks actively trying to hold down the value of their currency for usually mercantilist motives.

Foreign investments in one of the worst possible investments in the world, U.S. Treasuries, represents intentionally in the case of sovereign wealth funds and central banks, or unintentionally in the case of private investors a rebate on their exports and extra payments on their imports from America. Or in other words, Americans really don't pay as much for their imports as the trade statistics suggests and they similarly get paid more for their exports than the trade statistics suggests.

The implication of this is also that the trade deficit is actually exaggerated-while the factor income surplus is also exaggerated and is in fact probably an illusion alltogether.

Friday, December 24, 2010

The Limits Of Monetary Policy Independence II

Posting will be limited during Christmas, both because I have other things to do and also because I can imagine that most of my readers will at any rate be focused on other things than hard-hitting economics commentary. However, for those of you who are nevertheless interested, and for the rest when they check in after Christmas, I will at least offer you this post, which are a follow up to my post "The Limits of Monetary Policy Independence". Bloomberg reports that many in South Korea points out that higher interest rates will fuel foreign capital inflows, which in turn could fuel asset bubbles. More specifically, the capital inflow will push the won higher something which will increase imports and divert the production of exporters into the domestic market. Meanwhile, many South Koreans will circumvent the higher domestic interest rates by borrowing in foreign currencies, something which will further push the won higher. Thus, while higher interest rates is effective in holding down consumer price inflation, it will only have a limited effectiveness in stopoping asset price bubbles. South Korea is however unlike for example Iceland probably big enough for the net effect to be positive, though it won't be as positive as some people think.

Wednesday, December 22, 2010

How Inflation Creates Commodity Mini-Cycles

As Jim Rogers persuasively argued in his book Hot Commodities, most commodity prices goes through long super cycles because commodities have a low short term price elasticity of supply and demand., while having a lot higher long term price elasticity of supply and demand.
If there is a big increase in demand (or decrease in supply), supply (from new sources) can increase only slightly in the short term because it takes a lot of time both for natural reasons and political (environmentalist, bureaucratic etc.) reasons to find more of for example oil and metals, and even when new resources are found, new obstacles of both natural and political nature prevents them from being actually extracted.

As a result, the increase in demand from some or decrease in supply must in the short term be met by a decrease in demand (from others) through higher prices.

Moreover, the required short term price adjustment is further elevated because most people find it too difficult or expensive to adjust in the short term. If they have an SUV and gas prices go through the roof, they still might not switch to a hybrid car because the switch would be very expensive.

For these reasons, sudden increases in demand or decreases in supply will cause dramatic short term price increases and these increases will usually stay for a while.

However, after several years, new wells or mines will be found and after several more years, commodities will be extracted from them. As a result, supply will start to significantly increase. Moreover, after several years with elevated prices, people will have been able to reduce their use or perhaps even entirely substituted it. As a result, demand will significantly decrease.

As a result of the increase in supply and decrease in demand, a dramatic price decline will occurr. This will cause a new period of low prices, because supply and demand also responds slowly in the short term to low prices.

I agree fully with the above described analysis, but as I wrote in my review of Rogers book I felt it was incomplete because it left out how inflation affected commodity prices. Both because commodity prices, being traded on markets, are more flexible than others and also because commodities are very far from the final consumers (and thus in accordance to Austrian theory making them extra sensitive to real interest rate changes) and also because of the above mentioned low short term elasticity of both demand and supply, inflationary policies will raise commodity prices a lot more than consumer prices in general.

One answer as to why Rogers left it out suggested by an Austrian leaning friend of mine is that Rogers felt that he was only interested in the long term super cycles created by the analysis he described, and wasn't interested in the more medium term effects caused by inflation. And it seems unlikely that inflationary policies will affect the two decade or so long cycles that Rogers described as they have little affect omn the long term fundamentals.

And that is probably correct. But while Rogers wasn't interested in it, it should be interesting to anyone who thinks that price fluctuations on a shorter term than two decades or so are relevant. The three reasons I described is in fact why inflationary policies will create mini-cycles over a few years.

Because inflationary policies have little or no effect on the long term fundamentals of commodity prices relative to other prices, while having strong positive (in the sense of increasing) effects on commodity prices in the short term it follows that whenever central banks starts to pursue more inflationary policies, commodities and other assets that benefits from higher commodity prices are good investments. However, as this also means that commodity prices will fall later, investors should when it looks like the inflationary policies will have to be ended or reversed should go short on such assets

5-Year TIPS Yield Spread Reach 2%

The spread between regular U.S. 5-year treasury securities and inflation-indexed ones reached 200 basis, as the regular security had a 1.97% yield and the inflation-indexed one had a -0.03% yield, implying an expected inflation of 2% per year the coming 5 years. This spread is up about 80 basis points since the Fed started to warn about QE2, reflecting a drop of about 25 basis points in in the inflation-indexed yield and a 55 basis points increase in the regular yield.

QE2 has certainly been a success in terms of raising inflationary expectations. Whether that is really desirable is however questionable to say the least.

Tuesday, December 21, 2010

Is Warmer Weather Necessarily Worse?

What has always troubled me the most with the view that we needs to stop "climate change" in the form of "global warming" is the idea that it would be bad if the Earth became warmer.

Sure, that could be negative in some areas for some reasons, but it would also be beneficial in other areas for other reasons. Suppose for example that Antarctica, or at least parts of it, would become habitable due to a warmer climate, wouldn't that be a good thing that could possibly outweigh possible problems elsewhere?

So what is there to say that the pre-industrial  era climate is really the optimal climate? That the benefits of a possible warmer climates wouldn't outweigh the disadvantages? I have asked that many times to Al Gore supporters and either gotten no answer at all, or some list of alleged (and exaggerated) disadvantages that completely overlooked the benefits.

If one needs an example of why cold weather is bad, the current problems in the European traffic system is a good example.

Note that some "climate change" theories argue that "global warming" could lead to colder weather in for example northern Europe. But even assuming that this is really true, it begs the question of why colder weather is bad there but good everywhere else. And this cold weather will largelly undo the initial warming effect, leaving us with little to worry about, assuming "global warming" is bad.

Monday, December 20, 2010

Latvia & Fiscal Austerity

Leftist blogger Matthew Yglesias express horror at the fact that Klaus Regling, chief executive of the European Financial Stability Facility, held up Latvia as a positive exampel, by pointng out that Latvia has gone through a severe depression.

Now, quite clearly, Latvia's performance during the latest 3 years is a dissster. Neither me or Klaus Regling denies that.

The point of Regling's statement was instead that Latvia first of all proved all of the people who now considers a massive Greek and Irish (and others) debt writedown inevitable, as those same people usually regarded a Lavian devaluation as inevitable, something which clearly won't happen.

And secondly, while Latvia due to its previous sins has gone through a depression, it is now clearly in a recovery path, "despite" the fact that it hasn't debased the value of its currency and "despite" the fact that it has pushed through a fiscal austerity program more radical than anywhere elsewhere. In fact, recovery began in the very same quarter that it's nearly 5% of GDP austerity program began to be implemented (much more than in any other country), which is to say the first quarter of 2010.

After having fallen for seven straight quarters, GDP has increased 3.1% in the first 3 quarters of 2010.

Friday, December 17, 2010

In Case You're Wondering

In case you're wondering why there hasn't been any posts in the last few days, then it is because the response to last day's appeal has unfortunately been disappointing. If you wish continued open access, then more of you must be willing to reciprocate the value that this blog gives you. Do so now, by clicking the "donate"-button on the right side bar and donate in relation to the value you receive and to your ability to pay.

Wednesday, December 15, 2010

Supporting This Blog

The time has come again for fund raising. As I wrote last year:

Like many other sites recently, I am now starting a fundraiser. Blogging is a very time and effort consuming activity. And while advertising provides some revenue, it is nowhere near enough. As The Economist and many others have discovered, Internet advertising generates surprisingly little revenue.

So, to enable this blog to continue at the current rate of activity or to expand, readers really need to start donating. I am letting future activity depend on this. No donations means no blog. Few and/or little donations means little activity.Many and/or large donations means unchanged or more activity. The future of the blog is in your hands.

Donate according to how much value this blog gives you and your ability to donate. So, press the "donate"-button in the right side bar, and donate now (or as soon as possible)!

If the response is deficient, then the content available for everyone will be restricted. Either by drastic reduction of blogging or  restriction to it for only subscribers. If the latter happens by the way, then those who contribute now will get a rebate or if the contribution is high enough, be considered automatically eligilible.

If on the other hand, the response is better than expected, than I will increase my activity in general and more specifically in the subject areas that contributors want me to focus on.

BTW: If you still haven't done your Christmas shopping and plan to order books (or some of the other items offers) for that purpose, or if you want to order books (or again other items) for other reasons, do order them through the widget you can see in the left.side bar. That way you'll support this blog at no extra cost for you!

Tuesday, December 14, 2010

U.K. 3 Year Inflation Average Above 3%

The Bank of England is supposed to keep consumer price inflation at 2% per year, with failure being defined if it deviates more than a percentage points from it. It is now clear that it is failing in a systematic way as consumer price inflation rose to 3.3% in November.

Considering that consumer price inflation was 1.9% in November 2009 and 4.1% in November 2008, the 3 year average inflation rate was 3.1%. According to its own standards, the Bank of England's monetary policy has thus been a great failure.

End Of Obamacare?

A federal judge has ruled that the requirement of all individuals to buy health insurance violates the constitution. I am not enough of a legal scholar to determine if that assessment is correct, much less if it will be held up in the Surpreme court.

But what is clear is that if this component is killed, then this will eventually mean the end of the other components, including the ban on refusing insurance on "pre-existing conditions". Because if health insurance is voluntary while insurance companies can't deny it on the basis of "pre-existing conditions" then healthy people will choose to go uninsured until they need it, causing a drop in the number of contributors of the system, something which will raise premiums, something which in turn will cause even more healthy people dropping drop out.

So while the battle is formally only about the individual mandate, it is really about the entire Obamacare scheme.

Monday, December 13, 2010

Men's Unemployment More Cyclical

Nancy Folbre highlights that male employment fell a lot more than female employment during the recession, and argues this is structural. There is arguably some truth to that in the sense that for various reasons discussed below the labor force participation rate between men and women has converged over the last few decades, something which has caused a convergence in employment rates.

Yet in the same numbers that she references, you can see that during the latest shallow recovery, male employment has in fact risen relative to female employment. The male employment rate only fell from 63.5% in November 2009 to 63.4% in November 2010, while the female employment rate fell from 53.7% to 53.3%, thus increasing the gap from 9.8% to 10.1%. And if you look at unemployment rates, this is even more clearer as the male unemployment rate fell from 11.2% to 10.6%, while the female unemployment rate rose from 8.6% to 8.9%.

This is nothing new. Between 1979 and 1982 (annual averages), male unemployment increased by 4.8 percentage points, while male unemployment rose by only 2.6 percentage points. Between 1982 and 1989, male unemployment fell by 4.7 percentage points, while female unemployment fell by 4 percentage points.

Then between 1989 and 1992, male unemployment rose by 2.7 percentage points while female unemployment rose by 1.6 percentage points. Between 1992 and 2000, male unemployment fell by 4 percentage points, while female unemployment fell by 2.9 percentage points. Between 2000 and 2003, male unemploymet rose by 2.7 percentage points, while female unemployment rose by 1.6 percentage points.

And between 2003 and 2006, male unemployment fell by 1.7 percentage points while female unemployment fell 1.1 percentage points. Thus in all recessions, men's unemployment rose more than women's while men's unemployment fell more during the boom's.

One can also note that with the exception of 2006 (the peak of the by far weakest recovery except for of course the one we've had during the lastest year) men's unemployment rate was always lower during cyclical peaks, while women's unemployment rate was always lower during recessions.

In short, the difference in changes between men and women thus reflects two components: a long term trend of a reduced gap in the labor force participation rate, probably mostly caused by decreased will of women to be housewives as well as an increase in the number of single mothers, but in some cases perhaps also problems for more people ta make ends meet on only one paycheck. And secondly, a much more cyclical unemployment rate for men caused by the fact that they work in more cyclical industries like manufacturing and construction. If one is concerned about high male unemployment then, the solution lies in having a more vigorous recovery.

Saturday, December 11, 2010

Bernanke & Money Printing

Ben Bernanke says that "we're not printing money. The amount of currency in circulation is not changing. The money supply is not changing in any significant way".

Actually, according to his own statistics department, currency in circulation is up by 6.4% in the latest 52 weeks and by an annualized rate of 10.1% in the latest 13 weeks.

Overall money supply,  is closer to the truth in terms of yearly change, as it is only up by 1.7% in the latest 52 weeks. During the latest 13 weeks however, it is up by an annualized rate of 9.1%.

So while Bernanke's statements was partially true with regard to earlier this year, they are inaccurate with regard to the last few months.

Finally, don't miss the below clip where Jon Stewart demolishes Bernanke and his money printing statements and actions in a very effective and hilarious way:

The Daily Show With Jon StewartMon - Thurs 11p / 10c
The Big Bank Theory
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Krugman Criticizes Implementation Of His Policies

Paul Krugman attacks a Tea Partu-backed candidate in Nassau county for having reduced taxes without offsetting spending cuts. But isn't tax cuts unmatched by spending cuts a form of fiscal stimulus, which is to say what Krugman have spent the last few years saying we should have? So Krugman is actually here criticizing someone for pursuing the same form of policy that he advocates.

And These Are The People Who Wants To Run Our Lives

Delegates at the UN Climate conference are persuaded to ban the "dangerous greenhouse gas" called di-hydrogen monoxide. This greenhouse gas is better known as H20 or water. And these are the people who wants to run our lives in the name of "science"!

Case For Yuan Appreciation Strengthens

While higher interest rates would be counterproductive in terms of reducing China's excessive trade surplus, it probably would be helpful in reducing China's excessive inflation.

Of course, a common solution to both problems would be to resume appreciation of the yuan, something which would also ease trade tensions.

Friday, December 10, 2010

Higher Interest Rates Would Increase Chinese Trade Surplus

Bloomberg news reports that China's trade surplus in November was larger than expected and argues that this underscores the case for higher interest rates. Yet higher interest rates is in fact something which all other things being equal increases a trade surplus since it encourages higher domestic savings while discouraging domestic investments. And when a country has higher savings while lower investments this will mean higher net exports, or in other words a higher trade surplus (or more strictly current account surplus). The effect is theoretically ambiguous for countries with floating exchange rate since the direct effect of higher interest rates are counteracted by the indirect effect of a stronger currency. However, if the exchange rate is fixed yet the central bank is still able to set interest rates more or less independently because of the existence of capital controls, as is the case in China, then higher interest rates have an unambiguous trade surplus increasing effect. So, if Chinese leaders wants to reduce China's trade surplus higher interest rates (or for that matter higher reserve requirements) is definitely not something they should do.

Thursday, December 09, 2010

Japan's Deflationary Boom

Japan's GDP surprised on the upside, with real GDP increasing 1.1% (4.5% at an annualized rate) in the third quarter compared to the previous quarter and by 5.3% compared to the third quarter 2009.  Adjusting for terms of trade has no impact on the quarterly number, and lowers yearly growth by only one percentage point.

This growth is much higher than in most other advanced economies. Yet this strong growth happened "despite" the fact that Japan "suffers" from deflation. The domestic demand deflator fell by 1.5% in the latest year, and by 0.5% (2% at an annaualized rate) compared to the previous quarter. The private consumption deflator (a gauge of consumer price inflation) fell even more.

This shows again that it is in fact possible to have price deflation and high economic growth at the same time. Some Keynesians would perhaps object that Japan had a severe slump the previous year, so that real GDP is in fact still lower than in the third quarter of 2008 (and 2007). That is true (and this suggests that the boom is a cyclical rebound, meaning that current growth rates are likely not sustainable), yet Japan's working age population shrinks by nearly 1% per year, and unemployment is therefore very low by Western standards, only 5.1%. There is therefore not much "unused capacity"

The Effect Of Extended Jobless Benefits

Good editorial in Investor's Business Daily pointing to evidence that extended jobless benefits increases unemployment as the share of long-term unemployed have increased dramatically even as job openings have increased. They also point to empirical studies and the positive experience of Sweden's supply-side policies of reduced unemployment benefits and marginal tax rates.

Wednesday, December 08, 2010

Inflationary Expectations Continue To Rise

As I noted yesterday, the tax and spending deal between Obama and the Republicans have caused a significant increase in the yields of long-term U.S. Treasury securities. If you combine yesterday's and today's increases, we have a combined 30 basis point increase. Judging by the movements of the inflation-indexed securities, roughly half of that increase reflects higher real interest rates and half reflects higher inflationary expectations.

What few had noticed moreover, was that even before the deal, nominal yields had actually risen above the level before the Fed started to warn about QE2. By contrast, real yields was, and remains despite the last two days, below the levels before QE2.

So the real story is about how inflationary expectations have increased dramatically. For 10-year securities, the nominal yield is nearly 65 basis points above the level in early September while the inflation indexed yield is 10 basis points lower, implying an increase in inflationary expectations of 75 basis points. The implied 10-year inflationary expectation is roughly 2.3% now.

For 5-year securities, the nominal yield is about 45 basis points above the level in early September, while the inflation indexed yield is about 20 basis points lower, implying an increase in inflationary expectations of 65 basis points. The implied 5-year inflationary expectation is roughly 1.85% now. (For current values see here, for historical values see here).

So, if the purpose of QE2 was to increase inflationary expectations, it has certainly succeeded, aided in part by the tax-and spending deal. If however the plan was to lower nominal interest rates, then it has certainly failed, in part because of the effects of the tax- and spending deal.

Another thing to note about the big increase in interest rates is that it to the extent it reflects higher real interest rates is bearish for gold (and silver) as it increases the opportunity cost of holding gold (and silver).

Tuesday, December 07, 2010

Bond Market Reaction To Tax Deal

While as usual the actual yield changes constantly changes, so that it will probably be different when most readers read this, the changes now are still significant enough to report on. The yield on regular Treasury securities are up 21 basis points on both the 5-year and 10-year security. Meanwhile, the yield on inflation protected Treasury securities are up 12 basis points for 5-year securities and 13 basis points for 10-year securities.

Thus bond investors anticipate both higher inflation and a "crowding out" effect in the form of higher real interest rates from this deal of cancelled tax increases, tax cuts and cancelled spending cuts. While bond markets often react in an irrational way, this reaction is in fact very rational. A more "stimulative" fiscal policy will in fact increase consumer price inflation, and to the extent that Ricardian equivalence doesn't hold (and to the extent the trade deficit doesn't increase), it will also raise real interest rates.

Mixed Tax Deal

The issue over extending the Bush tax cuts has long been a game of chicken: both the Democrats and the Republicans wanted to extend them for families earning less than $250,000 per year, but they disagreed on the tax cuts for families earning more than that.

Since they are (and will in the Senate remain even next year) a minority and since Obama would otherwise at any rate veto it, the Republicans knew that the only way that they could preserve the tax cuts for high income earners was to vote no to any separate bill extending them only for people with lower income. And while they are a minority, they can (especially with the help of more conservative Democrats like Ben Nelson) block it using filibuster.

If neither side yielded, then there would have been an outcome neither side wanted, namely tax increases for everyone. Would that become the case or would either side yield.

While many hard core leftist pundits and politicians like Paul Krugman and Bernie Sanders called on Obama to refuse to give in, and blame possible tax increases on the middle class on the Republicans, Obama ultimately caved in and agreed to extend them for 2 years.

The absence of such a tax increase is of course good. Furthermore, they seems to be part of a larger deal that has other good elements, particularly a reduction in the payroll tax and a change in the rules for business expensing.

Yet, the fact that payroll tax reduction and the extensions are supposed to be only temporary limits their usefullness. Most businesses base most of their investment decisions on long term considerations as it is not always easy or costless to undo them, this means that if it is not certain that tax cuts will be there for at least several years, then they will abstain from many activities that will be made profitable the first year.

Furthermore, allowing companies to write off the entire cost of capital equipment the first years, means that they can't use depreciation the coming years to reduce their tax bills, limiting its usefullness.

Also, the agreement doesn't just mean tax cuts and cancellation of tax increases, it also mean some spending increases, such as extending unemployment benefits and "refundable tax cuts" (which are actually transfer payments since they don't pay income tax).

Furthermore, it should be noted that all of these things will expand the deficit compared to the alternative.

So, it's a mixed bag with some positive and some negative aspects. I'll leave it to you to decide whether the good outweighs the bad or not.

Monday, December 06, 2010

Silver Price Nearly Doubles In A Year

While most commodities, including oil and gold, have increased in value the latest year both in terms of euros and U.S. dollars are at or near the highest levels since the summer of 2008, silver actually stands out as the commodity that has increased the most.

It is in U.S. dollar terms up by roughly 70%, from less than $18 per ounce to more than $30. By contrast, gold is "only" up about 20% in terms of USD. And since the euro has dropped by more than 10% in the latest year, the gain is even more impressive in terms of euros, up from €12 per ounce to $23, a 90% gain.

What then is behind this big rally. The most important factor is that it benefits from inflationary trends, something which increase highly flexible commodity prices in general and precious metals in particular, as they are demanded as inflation hedges.

Another reason is that the price of silver has long been, and arguably still is, more  depressed than the price of gold. Silver is actually still 40% below its brief 1980 peak even in nominal dollars, while gold is trading 75% higher than its 1980 peak. So silver's stronger rally is arguably to a large part simply a case of catching up with gold's stronger performance.

Example Of How Tax Increases Promote Tax Planning

Does higher tax rates really increase tax revenues? At current rates in the United States and most other countries, I would say "probably yes, but not by as much as a static analysis (one that assumes no effect on the tax base) would suggest".

That is in part because it leads to less productive activity which both reduce the tax payments for the individuals who react as well as those that would have benefited from these actions, and in part it is because it will lead to increased tax avoidance activities, both in the form of legal tax planning and illegal tax evasion.

The New York Times now reports of an example of tax planning activities in the form of Wall Street firms moving bonuses that would have otherwise been paid next year to this year, because there is a risk that the Bush tax cuts won't be extended.

Saturday, December 04, 2010

Euro Oil Price At New High

This week was mostly an inflationary one in America, as the prices of commodities, stocks and foreign currencies in U.S. dollar terms rose, while however bond prices fell.

Most commodity prices including oil,.gold and silver, are now after this week's rally close to or at the highest level since the Fed started to hint at QE2.

What few have noticed however, is that in terms of euros they are now much than during the previous week's highs, because while the dollar price of commodities are close to their highs, the dollar price of the euro at $1.342 is still, despite Friday's rally, well below the November 4 peak of $1.424. As a result. for example the price of oil in terms of euros is about 6% higher than a month ago. By contrast, the price of oil in terms of dollars is roughly unchanged.

The big drop in demand for euros because of the debt woes thus seems to be more than outweighing the recent stagnat euro area money supply growth.

Friday, December 03, 2010

Weak U.S. Employment Report

The November U.S. employment report was considerably weaker than that for October.

While the drop in employment according to the household survey was smaller than in October, with a job loss of 173,000 compared to 330,000, the fact that employment according to that survey continues to drop is ominous.

The employment to population ratio therefore fell to 58.2% in November, matching the previous low reached in December last year. Unlike the previous month, the drop wasn't concealed by a drop in the participation rate, and the unemployment rate rose from 9.6% to 9.8%.

The only strong part of the household survey was that part-time unemployment (aka underemployment) fell from 5.9% to 5.7%, and as a result the broader unemployment rate that includes the part-time unemployed and discouraged job seekers was unchanged at 17%.

The payroll survey was considerably weaker in all aspects compared to the report for October. Payroll employment rose only 39,000 compared to 172,000 in October. Unlike in October, the average work week didn't increase and average hourly earnings rose only 1 cent (0.04%) in November compared to 6 cents (0.27%) the previous month.

In the previous report, the household and payroll surveys contradicted each other with the former showing weakness and the latter showing strenth. Now both show weakness, though the household survey is again weaker.

Thursday, December 02, 2010

A Conservative Case For QE2?

David Beckworth argues that "conservatives", by which he means advocates of lower government spending should support the Fed's "quantitative easing" because he argues that the stimulative effects of it will reduce the need for fiscal stimulus, which in turn he argues will result in lower government spending.

Yet aside from making the dubious assertions that government spending and QE2 really boosts real growth (at least QE2 certainly boosts nominal growth, but that could mean higher inflation), he seems to be missing that deficit spending is encouraged if the cost of borrowing is lower. And as QE2 lowers real interest rates, it will reduce pressure on the politicians to reduce spending.

The big spending cuts we are seeing in for example Ireland and Greece as their cost of borrowing increased dramatically is a good example of how politicians respond to the cost of borrowing for the government.

Wednesday, December 01, 2010

Explaining A "Libertarian Contradiction"

Johan Eriksson points to a contradiction between two arguments made by certain prominent libertarians-namely the argument that all countries benefit from specialization from other countries through free trade and the argument that EU farm subsidies hurts poor countries.

He is in fact right to note that there is an inconsistency. True, one could argue that there is a difference because the advantage of EU countries in farm products isn't the result of a natural comparative advantage, but government subsidies. But whether the advantage is natural or artificial is irrelevant for the developing economies. If EU countries can for whatever reason offer a product for a lower cost than the dometic cost of production, than it is good for them. So, the argumemt that EU farm subsidies is bad for developing economies is clearly wrong.

The case against these subsidies rests instead on the fact that they are bad for the people living in the EU. Both because domestic production is diverted from more productive causes and because subsidies of farm exports in effect represents a give away from the EU to others. The case against EU farm subsidies thus doesn't rest on the in fact non-existing harm to others. It rests on the harm it does to EU tax payers and consumers.

Irish Unemployment Falls Again

Statistics released today shows that unemployment in Ireland fell for the third consecutive month in October. Along with other statistics showing gains in real retail sales and industrial production this illustrates that contrary to the myth spread by some, Ireland's problem isn't a weak economy.

Instead, the problem is in part a banking system which was reckless in the past as well as a self-fulfilling panic among investors.