Why China Is Not A Bubble

A reader asked me if I believed that China is the next big bubble. The answer to that question is in short "no".

Why? Well, clearly China has recently had excessive credit- and money supply growth, something that has created a lot of malinvestments. This could cause some local problems in some parts of China, and could even cause the Chinese economy as a whole to suffer a short-term setback.

However, the thing to remember about China is that the structural fundamentals are so good that they will, at least for the coming two decades or so, overcome the problems created by a too inflationary monetary policy.

While the working age population will soon start to stagnate and then decline due to the "one child policy", the fact is that a substantial part of their workers are still tied to rural low productivity jobs. As more and more are employed in more productive urban jobs, the momentum will remain for the Chinese economy in terms of labor supply.

Furthermore, while a all too large percentage of investments are malinvestments, the overall investment rate is so high that "nonmalinvestments", or sound investments, is still high enough to expand productive capacity.

So while temporary slowdowns are likely, the long-term outlook remains good for China at least during the coming two decades-

Yes, Wage Cuts Can Lower [High] Unemployment

Paul Krugman again tries to deny that wage cuts can solve the problem of high unemployment.

there would be no reason to expect a general fall in wages to raise employment.

Why? Don’t demand curves usually slope downward? Yes, but that’s because when you cut the price of something, it normally gets cheaper relative to other things, leading people to redistribute their spending toward the cheaper good.

But when you cut the price of everything — which is more or less what happens when wages fall across the board — there’s nothing else to substitute away from.

Yet as I pointed out in a previous post when Krugman made similar argument, there are two fallacies in Krugman's argument.

First of all, there is no need to assume that the fall in wages have to be the same in all sectors. For example, construction workers should see a big drop given their high level of unemployment, while the low unemployment for workers in the education and health sectors suggest that their pay may not need to be lowered at all.

And secondly, the price of goods and services consist of more than labor costs (you need capital to produce too), so a lower cost of labor would be a relative price cut. For this reason, it is also wrong to assume, as Krugman does, that lower wages would necessarily raise the nominal exchange rate by an equal amount, meaning that relative wages compared to foreign workers would also be reduced.

A John Kerry Foreign Policy

In Afghanistan, the West fights al-Qaeda.

In Libya, the West aids a group whose leader describes al-Qaeda as "good Muslims" and have in fact fought with them in Afghanistan and Iraq.

One starts to think that John Kerry runs the war policies of the U.S., the U.K. and France, because somwthing like "We actually did go to war against al-Qaeda, before we went to war for them" is an accurate description of these policies.

Ireland: Bad News From Bond Market-Good News From Economy

Paul Krugman argues that austerity in Europe has failed because Irish bond yields have reached new highs while British growth has stalled.

Interestingly, he doesn't mention Irish growth. GNP (which is more relevant than GDP in Ireland because of the way that foreign companies use internal pricing for tax planning purposes) increased 2% in the fourth quarter compared to the previous quarter (8.2% at an annualized rate) and 2.8% compared to the previous year.

Meanwhile, the current account surplus improved by €1.4 billion (4% of GNP) causing the overall 2010 current account deficit to fall to less than 1% of GNP.

Thus, while Ireland has more problem than ever borrowing on the bond market (something which really isn't a problem since they can borrow cheaper from other governmemts), its economy is strenghtening and the imbalances it has suffered from is disappearing.

And the point with regard to the effects of fiscal austerity is that if the British experience proves that it reduces growth, just what does the Irish experience prove?

Another Reason Why Inflationary Policies Increase Inequality

I have long argued that while it is not the only factor (immigration for example has also played a role), inflationary monetary policy has been the most important reason why inequality in America has increased so much.

The two main reasons for this are:

1) Because wages/salaries are less flexible than most prices, inflation will lower real wages and increase corporate profits. This will increase inequality because the rich own a far higher proportion of stocks than they receive of labor income.

2) Inflationary policies tend to raise stock prices relative to profits, something that will raise inequality for the same reason as the relative increase in profits.

This article (Ironically from the institution that produces inflation) points to a third mechanism in which inflationary policy will increase: namely the fact that people with low income spends a higher proportion of their income on food and energy than people with high income, meaning that the relative real income of the poor will fall when inflationary policies causes food and energy prices to soar.

Higher Inflation, Higher Deficit In Britain

The increasingly stagflationary nature of the British economy was confirmed today as consumer price inflation rose to 4.4% while the government deficit rose despite the austerity policy implemented .

Keynesians might use this as an argument that the austerity policy has failed, but the very high inflation rate is inconsistent with the assertion that insufficient aggregate demand is the problem.

Given the high level of inflation and government deficit, it is by the way a mystery how anyone would want to hold U.K. government bonds at the current pathetically low levels ( 3.60% for a 10-year security, even less for shorter maturities). Does these investors want to lose money to the U.K. government or have they simply become crazy?

Obama's Strategic Dementia

The always perceptive Caroline Glick on Obama's strategic dementia regarding his Middle East policy.

It's almost as if Obama seems determined to surpass Jimmy Carter and George Bush Jr. as the worst president ever. If that is his desire, then he is increasingly successful.

Reported Inflation (And By Extension Real Wages) Isn't The Same Now As In 1980

The Scott Sumner post that I discussed in the previous post had a link to an associated press story claiming that even though inflation has fallen since 1980, it feels worse since wage growth has fallen even more.

Given that 1980 was a year of economic discontent (Reagan didn't just win because the ayatolla Khomeini had humiliated Carter), I am not so sure that workers feel worse off now compared to then.

Related to that is the fact that it's not true that real wages are falling more now than then. Quite to the contrary, if you look at the official numbers real wages are performing much better now. While inflation dropped from 12.5% in December 1980 to 2.1% in February 2011, growth in nominal weekly earnings only fell from 7.9% to 3.0%, meaning that the increase in real weekly earnings rose from -4.1% to 0.9%.

There is however one reason to believe that the perceived improvement is much smaller than these numbers would indicate: namely that since 1980 the consumer price index methodology has been changed several times to incorporate "hedonic adjustment" and similar changes that all have happened to lower the reported inflation rate. But since inflation numbers haven't been changed retroactively in accordance with the methodological changes, this means that today's inflation numbers aren't strictly comparable with the older ones. Older inflation numbers would have been much lower if the new methodology had been used, and newer inflation numbers would have been much higher if the old methodology had been used.

It actually doesn't matter in this context whether the old or new methodologies were more accurate. Either way, the fact remains that the current inflation numbers is associated with a higher cost of living increase than the same number in the past. This explains why workers may not have perceived the alleged improvement.

Scott Sumner Wrong On Monetary Policy & Commodity Prices

Scott Sumner makes the rather astonishing assertion that "In fact, monetary stimulus raises commodity prices if and only if it raises expected future output. There is no other mechanism.".

Actually, there are at least two other mechanisms, First of all, the fact that commodity prices are extremely flexible (they go up and down every minute) whereas many other prices, including the price of labor (aka wages or salaries) are "sticky". This means that commodity prices will react immediately to more "monetary stimulus" while the more sticky prices will react months or years later, causing a relative price reduction of the sticky prices at least in the short term.

And secondly, there is the thing called exchange rate. If what Sumner refers to with the euphenism "monetary stimulus" in the U.S. causes the dollar to drop in value, then the price of commodities in terms of euros, yens, pounds etc. will fall given a certain dollar price. The resulting increase in demand and reduction in supply from outside the U.S. will cause the dollar price of these commodities to increase.

One would have thought that Sumner as an economist would have heard of the flexible/sticky price distinction and of currency exchange rates. And he probably has, but he has failed to realize that they are two mechanisms in which monetary policy can raise commodity prices without raising real output.

No, It's The Other Way Around

Dean Baker argues that the Fed should focus only on "core" inflation because he claims that the Fed can't influence food and energy prices other than marginally.

Not only is Baker wrong about this, but the truth is the opposite of Baker's assertion. Because particularly fuel prices and to a lesser extent food prices (food commodities are as sensitive as energy commodities, but the commodity cost is particularly in America a much higher share of the retail price of fuel than it is of the retail price of food, not to mention the restaurant price of food) are largely determined by the prices set by global financial markets. This means first of all that they are more flexible than other prices and secondly it means that they are strongly affected by the dollar's exchange rate (the weaker the dollar, the higher will the dollar price of commodities be). And through it's monetary policy the Fed strongly influence the dollar's exchange rate.

All of this means that the Fed particularly in the short term have a very strong effect on food and fuel prices, indeed the short-term effect is often even greater than the long-term effect.

By contrast, most "core" prices are more or less "sticky", meaning that Fed policy at least in the short-term have little or no influence over them.

While there are other factors influencing food and fuel prices, such as the civil war turned international war in Libya because of a recent ill-advised decision, that doesn't change that the Fed can and does change them in whatever direction way they want, which in practice have tended to be upward. And besides, "core" prices are also influenced by other factors.

A Canada Bubble?

As Canada has had a much stronger job market (the employment rate is down by less than two percentage points compared to five percentage points in the U.S.) pre-crisis levels, compared i and stronger recovery than its southern neighbor, and with its GDP per capita at current exchange rates now also exceeding the U.S. level (though only slightly, but in the past the U.S. has always been ahead usually with a wide margin)), Canada's economy is receiving a lot of praise both from foreigners and from Canadians.

However, while Canada have relatively strong growth now, Canada's boom has been largely driven as this article points out by two cyclical sectors, commodities and housing, a story not dissimilar to that of Australia.

The fact that Canada's current account deficit unlike Australia's (its deficit has fallen significantly) have risen despite the increased revenue from commodity exports however indicates that the potential problems facing Canada are greater than Australia's.

If these two sectors were to experience dowmnturns at different times, Canada might get away with a "soft landing". If however they go down simultaneously, then Canada will face a deep slump.

EPI Greatly Exaggerates Wage/Productivity Divergence

The left-wing Economic Policy Institute (EPI) claims that despite an increase in productivity by more than 60% between 1989 and 2010, real compensation per hour rose by only 20%, quoting "their own analysis of Bureau of Labor statistics data".

I don't know how they made their analysis, but I do know that the numbers are extremely misleading. If their numbers had been correct, the percentage share of national income going to compensation of employees would have fallen by more than a fourth.

In reality, the share of gross domestic income going to compensation of employees fell from 57.7% in 1989 to 56.1% in 2009 (2010 numbers aren't available yet). The drop was even lower in relation to net domestic income (which excludes capital consumption), from 65.6% to 64.8%.

The share of income going to labor tends to be counter cyclical (decrease during booms, increase during slumps) and 2009 was a year when the economy was still in effect in a slump while 1989 represented the peak of the Reagan boom, but even in 2006, it had only fallen to 54.9% of gross domestic income and 62.5% of net domestic income.

Thus, while wages and other forms of labor compensation have fallen behind productivity somewhat, the divergence is much smaller than the EPI claims. I am again not sure just how they have come up with their misleading numbers, but most likely they have ignored some forms of compensation of labor and used different price deflators for productivity and labor compensation.

G7 Intervenes To Weaken Yen

Following the sharp spike the value of the yen caused by the tsunami related problems of the Japanese economy, the G7 last night intervened to lower the yen's value.

Currency interventions are often costly and/or ineffective, but given how much damage the perverse yen rally inflicted on the already damaged Japanese economy, this move was justified.

No Fly Zone Could Create Worst Case Scenario

Somewhat surprisingly (I had expected Russia and China to veto, instead they abstained, as did India, Brazil and Germany) the UN Security Council passed with a 10-0 vote a so-called "no fly zone" as well as other measures short of ground troops againt the Qadaffi regime.

While the authors behind the resolution may have good intentions, the effects could be to greatly aggravate the problems.

Given that the Qadaffi regime appears to have the upper hand against the rebels, the direct effect of actions against Qadaffi will be to prolong the civil war. That will both mean more civilian deaths and a more severe blow to the world economy because oil supplies will be disrupted for a longer time.

Meanwhile, while it is possible that this action could help the rebels win, it is also possible that Qadaffi may still prevail in the end. And given his anger over Western action against him, this could put him back in the terrorism sponsoring business, just like the 1986 American-British bombings led Qadaffi to blow up a plane over Lockerbie, Scotland.

So, the short-run effect of this half-measure could very well be to prolong the civil war, damaging both Libya and the rest of the world and the medium to long term effect could be to again make Libya a sponsor of Islamic terrorism like Iran.

The best solution would have been to stay out of this civil war, just like we stay out of the countless other civil wars around the world. But if we are to intervene, we should make sure that it leads to the total defeat of the group we're attacking. The kind of half-measure now proposed runs a high risk of leading to the worst of both worlds.

UPDATE: New surprise as Qadaffi announces cease fire. However, unless he is willing to resign, this will mean at most a temporary end to violence since the rebels won't accept a continued Qadaffi rule and Qadaffi son't accept rebel control over large parts of the country.

Yen Reaches New Record High On Devastated Economy

Because of the somewhat perverse logic that I described a few days ago, the devastation of the Japanese economy caused by the earthquake/tsunami and its effects on Japan's nuclear power plants, Japan'cs currency continues to appreciate dramatically in value, reaching a record high 1.3 U.S. cents per yen (77.32 yens oer dollar in inverted terns) up from 1.2 cents (83 yen oer dollar in inverted terms) before the natural disaster.

Such a dramatic currency appreciation will cause further damage to an economy already severely damaged by the massive deaths, destruction, radiation fear and power outages.

Should We Destroy All Buildings In New York?

After every natural disaster we have to put up with Keynesians telling people of the "silver lining" is that the economy will be boosted by rebuilding. Now we have Larry Summers saying just that, while of course deploring the loss of lives.

This is of course just another example of the "broken window fallacy" where it is ignored that the rebuilding spending means less money available for other spending, not to mention the fact that the value of the previously existing buildings goes lost.

One wonders BTW why Summers and others don't take this to its logical conclusion and advocate an orderly evacuation of some large American city, say New York, and then destroy all the buildings. If really the destruction of buildings from natural disasters are so good for the economy, why wait for "Mother nature" to cause this in a way which kills people? Why not simulate this in a way where no one is killed.

The logic of this argument means that we should, after having avacuated all the people, destroy all buildings in New York and perhaps a few more cities, and then rebuild them. Does that sound like a sensible idea to you? Well, that's Keynesianism for you.

Electricity Wasting Time

I have never liked so-called "Daylight savings time" as I only thinks it is unnecessary trouble with no real benefits.

Now a new study find another drawback with "Daylight savings time": it increases electricity use.

Perhaps it should be renamed to "electricity wasting time"?

Let Them Eat Ipads

Great post by Yves Smith on the cluelessness of Fed officials and others who focus solely on so-called "core" inflation.

The only thing I could add is a link to my own post explaining why Fed policy is in fact partly responsible for the great increase in food and fuel prices.

The Difference Free Market Reforms Makes

Tino Sanandaji has a good post where he compared the performance of France and Sweden. France has had slower growth than the United States since the 1980s while Sweden has had higher growth than the U.S. since 1993.

Part of the story for the Swedish boom was a cyclical rebound from the deep Swedish 1990-93 slump, but free market reforms have also helped. By contrast, France hasn't had any free market reforms, contributing to its weak performance.

Oil & GDP Growth

Many people worry that the oil price increase caused by the civil war in Libya will hurt the global economy and perhaps push many economies into a recession.

However, the truth is more complex for that.

In Libya, the economy is certainly suffering, and had GDP statistics been compiled (which I really don't think they are during this civil war) they almost certainly would have shown that the civil war has caused a severe depression.

For other oil exporters however, the oil price increase will benefit the economy as their terms of trade improve, increasing their real income. However, as terms of trade improvements aren't visible in the headline volume GDP numbers, the headline GDP growth rate may not increase.

For net oil importers, the oil price increase will hurt the economy as their terms of trade worsens, reducing their real income. However, like with net oil exporters, net oil importers may not see the official GDP growth rate changed because the prevalent volume GDP methodology ignores terms of trade changes.

For the world economy as a whole, real income will fall as the price increase reflects lower oil output in Libya. Oil exporters except for Libya will benefit, but their gains will be smaller than the losses for Libya and net oil importers. However, the headline GDP statistics may not show much changes, because in Libya it is unlikely that any statistics will be collected and because the gains or losses for others is ignored by the prevalent volume GDP statistics.

Country Damaged By Tsunami-Currency Gets Stronger

The somewhat strange logic of currency markets was illustrated today as they reacted to the news of Japan suffering large damages caused by a tsunami by bidding up the value of its currency, the yen, by more than 1%.

There is of course an explanation for this, namely that because currency movements are to a great extent determined by interest rate differentials and because Japan is closer to the zero bound barrier than others and because this will weaken global economic activity, this will reduce the yield advantage of other countries and so make Japanese bonds more attractive given a certain exchange rate. The increased demand for Japanese securities this creates causes in turn an appreciation of the yen.

Howervr, while this can be explained, it illustrates why floating exchange rates do not always reflect "economic fundamentals" as advocates of that system often asserts.

The Problem With Democracy

While democracy is a lesser evil compared to dictatorship, it is nevertheless a flawed system because voters often don't understand the reality they are going to decide upon.

Case in point is the latest Bloomberg poll.

It says that a majority of Americans believe that the deficit can and should be reduced substantially without raising taxes (except for households earning more than $250,000) yet even greater majorities oppose cuts in most major programs.

The only spending they support reduction in is for foreign aid and the wars in Iraq and Afghanistan, yet ending these things would eliminate less than $200 billion of the $1.5 trillion deficit. And even with a static analysis (with a dynamic analysis where behavioral effects is considered revenue gains would be even smaller), repealing the Bush tax cuts for households earning more than $250,000 would only increase revenue by $70 billion per year.

The inescapable conclusion is that to reduce the deficit to sustainable levels, it will be necessary to raise taxes for the middle class and/or to cut popular programs like Social Security and Medicare. Yet the public say they oppose such moves while at the same time favoring a dramatic reduction in the deficit.

While Krugman is wrong most of the time, he once in a while gets it right, and he was quite correct in describing the position of the majority of Americans as wanting to "repeal the laws of arithmetic".

The Recurring January Depression

David Beckworth argues that current ECB monetary policy is "tight". I actually agree with that euro area bond yields have risen together with the euro exchange rate and the fact that M1 money supply growth has dropped to zero.

However, one of his arguments, that consumer prices fell in January compared to the previous month is not valid.The monthly change number he quotes is seasonally unadjusted. By contrast, both the all-items and "core" consumer price inflation 12 month change rates increased slightly during that month.

The reason for that is that Eurostat do not seasonally adjust monthly changes. And because seasonal factors does affect monthly changes greatly, the unadjusted monthly inflation number tells us little by itself.

To view this monthly drop in consumer prices as proof of deflation is thus as misleading as viewing the always reoccuring drop in unadjusted retail sales in January as proof of a new depression-or viewing the always reoccuring increase in unadjusted retail sales in December as proof of a strong boom.

Estonians Reaffirm Support For Free Market Policies

The elections in Estonia was a success for the relatively free market oriented government, with its support increasing from 45.7% to 49.1%, increasing the number of seats from 50 to 56 (out of the total of 101).

Though the recently experienced depression in Estonia certainly was bad, Estonia is now recovering surprisingly fast. Moreover, voters realize that the problems they experienced wasn't due to the basic free market strategy pursued by the current government.

Education Level, Degrees & Unemployment

One of the things that strikes you with U.S. unemployment statistics is the large gap between the unemployment rate of the highly educated and those with little education.

For high school drop outs, the unemployment rate was 13.9%, for people with only a high school diploma, the unemployment rate was 9.5%, for people with "some college" the unemployment rate was 7.8% and for people with bachelor's degrees or less, the unemployment rate was 4.3%.

The difference is even more dramatic if you look at the employment rate, suggesting that there is a lot more "hidden unemployment" for people with little education. For high school drop outs, the employment rate was only 39.2%, for people with only a high school diploma, the employment rate was 54.6%, for people with "some college", the employment rate was 64.1% and for people with a bachelor's degree or more, the employment rate was 73.6%.

But must such large differences exist? No.People with a lot of education may appear to have an advantage over those with little education because they can both work within their field and take low skilled jobs. A person with a college degree are capable of working as a hotel cleaner or "flip burgers" at McDonald's, but a high school drop out can't take a job as a plastic surgeon. However, people with a long education might not be willing to apply for low skilled jobs. Furthermore, some employers within sectors where little education is needed might view them as "over-qualified" and fear that they will soon quit, and therefore they might prefer people with only little education.

That the large unemployment gap between different educational levels isn't a law of economics is confirmed by the fact that it doesn't exist in all countries. Most countries don't have statistics over educational differences in unemployment, but many of those that do have little or no such differences.

In South Korea for example, people with less than a high school education actually have a lower unemployment rate than those with only a high school diploma (3.8% versus 4.4%). And while people with college education have a lower unemployment rate, it is only slightly lower (3.2%). These differences are so small that they are within the statistical margin of error. Indeed, the previous month, people with less than a high school diploma had a slightly lower unemployment rate than those with a college diploma.

And in Taiwan, there seems to be a weak and opposite relation between education and unemployment. People with college education had a 6% unemployment rate compared with 4.9% for those who only finished senior high school, 5.3% for those who only finished junior high school and 2.8% for those classified as "illiterate and self-educated".

But why does the United States have this large gap when it doesn't exist in South Korea and Taiwan and probably many other countries as well? I'm not quite sure, actually. One reason is probably that wage flexibility is lower in the United States preventing the adjustment needed to get people with little education into work.

Another reason could be that in America formal education levels is for various reasons deemed more important when choosing workers, with the rule being that the higher level the better, while in other countries employers focus more on other indicators of how qualified people are for jobs.

Still, the gap in America seems too large to be explained by these factors alone, so part of it remains a mystery.

The Spectre Of Price Flexibility Clearing Markets

David Leonhardt notes that while employment has improved in the United States in recent months, real wages have begun to fall.

What he fails to note is that there is partly a causal connection between the two: job seekers are finally accepting lower pay, something which makes it profitable for more employers to hire.

It should be noted though that to the extent the reduction in real pay is due to a worsening terms of trade because of for example higher oil prices, then it will not help boost employment. As long as we have a situation of high unemployment however, real wage reductions that don't reflect a weakening terms of trade will boost employment.

By contrast, if the problem had been labor shortages, then higher real wages would boost employment.

U.S. Dollar Now Second Lowest Valued Major Freely Traded Currency

For long, the U.S. dollar was the second highest valued currency among the 7 most traded among the freely traded currencies, after only the British pound. However, since its creation in 1999, the euro has most of the time also had a higher value, usually a lot higher value, though the dollar had a higher value briefly during the 2000-2002 period.

Since then, the currency debasement policy pursued by Greenspan and Bernanke has caused it to have a lower value than more and more currency. The Canadian dollar in 2007-08 and the Swiss franc in 2008 briefly had a higher value than the U.S. dollar but both again became lower valued after the great U.S. dollar rally of late 2008 and early 2009.

Now however both the Canadian dollar and the Swiss franc has regained a higher value than the U.S. dollar. Furthermore, the Australian dollar has also gained a higher value than the U.S. dollar.

As a result there are now 5 major currencies with a higher value than the U.S. dollar, namely the British pound, the euro, the Swiss franc, the Canadian dollar and the Australian dollar. Only the yen has a lower value, and given the fact that its value is still more than 80 times lower, it will be a very long time, if ever, before its value surpasses that of the U.S. dollar. However, the yen has actually increased its value more than the others (except for the franc which has increased similarly), with its value being more than 4 times higher relative to the U.S. dollar compared to the early 1970s, about 3 times higher compared to the mid 1980s.

By contrast, the one currency that has always had a higher value than the U.S. dollar, the British pound, has actually lost value against the U.S. dollar compared to the early 1970s and 1980s and it is the only najor currency to have a lower value against the U.S. dollar compared to early 2000. That is because Mervyn King and his predecessors at the Bank of England has been just as, or even more, inflationist than Greenspan and Bernanke.

China To Reduce Military Spending Relative To GDP

There is some concern over how China increases nominal military spending by 12.7%.

Yet it could be noted that since nominal GDP growth in China is over 15%, this actually means that the Chinese are reducing the proportion of its resources that goes to the military. Much of the apparent increase thus reflects inflation and higher real pay for those in the military.

One can argue that they should reduce the proportion even more, but despite technical upgrading it is misleading to talk of a massive military buildup.

ECB To Raise Interest Rates?

Somewhat surprisingly, the ECB signals that it might raise the official short-term interest rate next month. Given its measures to help struggling countries like Ireland and Greece I didn't think that they would make such a move since that would make the situation for the weak countries worse.

However, if the ECB wanst to tighten monetary conditions generally while helping the striglling countries then general rate hike combined with a switch of assets from financial corporate assets in countries like Germany to government bonds in countries with debt problems would make sense.