More On The Destruction Leads To Growth Theory

A reader has sent in the following comment and question on my post about the effects of the earthquake/tsunami on the Japanese economy:

Regarding the strange view that Keynesian have on war/disaster/destruction induced booms, I think there are a lot of people that really thinks that there is apiece of truth in this (especially in Sweden (social democrats).

Perhaps that is to some extent due to the fact that e.g. the U.S. only finally came out or their depression in ~1929-1939 when they startedrearmament for World war II. So, how should this actually be understood? Was the positive effect on the U.S

First of all, it should be noted that the situation in Japan is not really comparable to America during World War II as no American cities or power plants were damaged during the war. So even if we accept for the sake of the argument that the war ended the depression, it would not validate the view that destruction of cities are good for the economy.

The comparison one could make is with Japan as well as Germany in 1945, as most of their cities were destroyed to varying extent by American-allied bombings. And while Japan and Germany (especially the Western part) did recover, there is no reason to believe that the bombings had speeded up the recovery. Indeed, the recovery had likely come sooner if the Japanese and Germans had their productive capacity intact.

As for the belief that the war was good for the American economy, I again recommend Robert Higgs' writings on the subject.

In short, Higgs points out that the disappearance of unemployment was fake:

Ten million drafted, and others signed up because they didn't want to get drafted into the infantry; so buildup hinged on coercion of workers. What if today we arrested that many people and put them into prison? We'd have to build the prisons and feed them; the jailed people could work. Gets rid of unemployment, but it's fake.

Higgs also points out that it is very difficult to really estimate the value of military production because the "prices" used were more or less arbitrary estimates. The price controls used likely also meant the private sector production that remained saw deteriorating quality not captured by price indexes as one way to respond to price controls is to cut costs in ways that often reduce quality since it is only the price and not the quality that is controlled.

Moreover,  civilian GDP ( GDP minus military spending) fell sharply even accepting the official price indexes

What World War II really showed was then that the government can initiate a massive military build up at the expense of real prosperity. That doesn't imply that spending binges from the government in general helps the economy, especially not if it is associated with the destruction of productive capacity.

Consumer Spending At Post-Depression High Relative GDP

Stephen Roach discusses U.S. consumer spending and says that it is likely to have to be curtailed in relative as it is near recent highs. Actually, his numbers seems to be outdated, as it did in fact reach a new post-Depression high of 71.2%, slightly higher than the 71.1% high reached during Q3 2009.

National savings is despite this somewhat higher than during Q3 2009 because government purchases fell from 20.8% to 20.2%. The resulting gross savings rate of 8.6% is however still very low historically. While it is higher than the 8.1% during Q3 2009, it is higher than the 11.2% during Q1 2007 and roughly 15% during the late 1990s.

You Would Have Thought That The Soviet Era Should Have Learned The Russian Government Something

Russia, the world's biggest oil producer and the second biggest oil exporter (after Saudi Arabia), is facing increasing gasoline shortages. But how could the world's biggest oil producer have a shortage of gasoline? Because the Russian government in an effort to satisfy voters who don't want to pay higher gasoline prices has created price controls that makes it much more profitable to export oil and gasoline than to sell it in Russia.

This is very similar to the widespread shortages of food and other consumer goods caused by artificially low prices during the time when Russia was part of the Soviet Union. Apparently, the Putin regime hasn't learned the correct lessons from this era.

If they wanted to help gasoline buyers, it would have by the way been much smarter to instead use some of the increasing revenue from oil exports to cut or abolish the excise tax on gasoline. If they had done that, there wouldn't have been any shortages even as prices remained low.

About That Great Japanese Tsunami Induced Boom

Remember how Keynesian Larry Summers said that the earthquake/tsunami in Japan was bad because so many people were killed but that it had the silver lining of stimulating the Japanese economy?

Now we see that industrial production in Japan fell a record 15.3% in March. That's some boom....

U.K. Economy Has Stopped Growing

The U.K. economy grew by 0.5% compared to the previous quarter in the first quarter, according to preliminary estimates. That is in fact worse than it appears at first glance, because roughly the entire increase reflects a weather related bounce back from an unusually cold December.

Taking the weather effect, that likely lowered growth by 0.5% during Q4 2010 and increased it by 0.5% during Q1 2011, into account, Britain thus had two straight quarters of zero growth.

With nominal M1 growth (and M2 and M3) falling below zero and price inflation being high, this means that real money supply is falling fast, something that means that the risk is high that the current stagnation could turn into a double dip recession.

U.S. Housing Sector Is In A Double-Dip Recession

U.S. house prices falls 3.3% from a year earlier in February, reversing almost all of the increases in the preceding year. Meanwhile, residential construction spending is down by 7.8%. The housing sector of the U.S. economy is thus in a double-dip recession.

This is ominous since housing is usually a leading indicator of the economy, though there are exceptions from this such as the 2001 recession when the housing sector continued to boom despite the slump in the rest of the economy. So far, a strong manufacturing sector has counteracted the weakness in housing, but it remains to be seen whether this can continue.

Who Is More Important-Luxembourg Or Germany?

This editorial by Investor's Business Daily at first seems to dispute the conclusion that China will soon surpass the United States as the world's biggest economy, only to later argue that it almost certainly will, but that China's per capita income will never surpass America's, and per capita income is the only relevant issue.

But that is not really true. It is true that per capita income is what matters for living standards. But total GDP is what matters for economic power of different countries. That is why the government of Luxembourg has almost no influence while the German government is very influential, despite the fact that per capita income is significantly higher in Luxembourg than in Germany. And that is because total GDP is far bigger in Germany as the higher Luxembourgian per capita income is more than outweighed by the fact that Germany has 82 million people while Luxembourg only has 0.5 million people.

Note that this is not just important for the geo-political power of governments. It is also relevant for businesses in terms of where to invest in marketing (at a given cost of marketing, it is better to do it in a big market) and in many cases also where to invest in production, as artificial (like tariffs) and natural (shipping costs) trade barriers  makes it better all else being equal to produce close to where potential customers are. Since they are neighbors and have no artficial trade barriers, this has little relevance for the cases of Luxembourg and Germany, but it does for example have relevance for the cases of the United States and China.

Who Benefits From Silver Rally?

Silver today reached $50 per ounce, touching for the first time the level reached during the brief 1980 super spike, and representing a triping of the price during the latest year. But who benefits from this rally (aside from speculators that holds silver or silver contracts)? Well, you get a pretty good idea from this list of top 10 silver producers:

Ranking 2006	Country	Production in mio. Oz
1	Peru	111,6
2	Mexico	96,4
3	China	75,4
4	Australia	55,6
5	Chile	51,5
6	Poland	40,4
7	Russia	39,6
8	USA	36,7
9	Canada	31,2
10	Kazakhstan	26,1

Note however that given their large silver consumption, China and the USA might not as a whole benefit from higher prices, though the parts of their country where the silver mines are will, similarly to how for example North Dakota benefits from higher oil prices while America as a whole loses.

Malaysian Ringgit Up-Or Down?

For the first time since 1997, it costs less than 3 Malaysian ringgits to buy a U.S. dollar. But like in the case of the Chinese yuan, this gain reflects U.S. dollar weakness to a much higher extent than ringgit strength. The ringgit is down by roughly 2% against the Singapore dollar this year, and even more against for example the euro, the Norwegian krone, the Russian ruble and the Swedish krona

North Dakota's Commodity Driven Boom

Carla Fried argues that North Dakota is "America's best state". Well, at least it has America's best labor market. The unemployment rate was just 3.6% (the 3.8% number she quotes is outdated) compared to the national average of 8.8% and employment increased as much as 4.2%, more than in any other state and way above the national average of 1%.

Also, houses are still cheap, the violent crime rate is the fourth lowest in the country (with only Maine, New Hampshire and Vermont being less violent) and overall economic growth is very high.

What can be learned from this? Well, as a personal advice to unemployed or underemployed Americans, they should try to look for jobs in North Dakota, where it is a lot easier getting jobs than elsewhere.

On the political level, the lesson that can be drawn from North Dakota's success isn't related to issues of taxation and regulation in general, but rather that if your state or country is lucky enough to have oil in the ground, you shouldn't try to inhibit its extraction for environmentalist reasons. Because the main factor driving North Dakota's boom is increased oil extraction. With oil prices reaching new highs and with oil production increasing as much as 43% in the latest year alone (and 200% during the latest 5 years), oil is bringing in far more money than ever before to North Dakota.

Another partially related key factor driving North Dakota's boom is the high prices of wheat and many other grains, enriching local farmers.

The Ruble Rally

Mark Thoma noted that Russian prime minister Vladimir Putin characterized U.S. inflationary policies as "hooliganism" and argued that if Russia wants to shield itself from the inflationary consequences it should allow the ruble to appreciate.

But as it happens, Russia has done so. Since the beginning of the year the ruble has appreciated from 3.27 cents to 3.58 cents, a 9.4% gain. Only the Swedish krona has gained more (+10.1%), while the Norwegian krone has also gained 9.4%.

Russia, like Norway but unlike Sweden and America gains in the short term from the great rally in the prices of oil and other commodities fueled by the war in Libya and Fed policy. However, the Russians are likely worried that the negative effects on oil importers could in the medium to long term cause another economic downturn, something that in turn could cause a big collapse in commodity prices like during the second half of 2008.

Has The Yuan Appreciated Or Depreciated?

There is talk that Chinese policy makers will to a higher extent use currency appreciation to fight inflation. That would be a good idea, but the problem is that so far there hasn't been much of it. Indeed, there has been none against most currencies.

This year, the yuan is up by 1.7% against the U.S. dollar (and currencies pegged to the U.S. dollar, like the Hong Kong dollar). However, because of the weakness of the  U.S. dollar, the yuan is down by 1.9% against the South Korean won,  down by 3.3% against the Canadian dollar , down by 3.8% against the Australian dollar, down by 4.6% against the British pound, down by 6.9% against the euro and down by as much as 7.7% against the Swedish krona.

The only other major currency apart from the U.S. dollar and currencies pegged to it that the yuan has appreciated against is the Japanese yen (up by 2.5%). But appreciating slightly against the dollar bloc and the yen is not good enough if the Chinese policy makers want to limit inflation, especially at a time when the U.S. dollar and the yen is declining sharply against most other currencies. As long as the U.S. dollar is as weak as it is now, the yuan must appreciate a lot faster against it to prevent further depreciation against currencies. Only then will the exchange rate be effective in limiting inflation.

Obama & Bernanke-Not Speculators- Responsible For High Gas Prices

Knowing that many Americans are angry about the high prices of gasoline and other oil-derived products, the Obama administration is trying to blame it on "speculators".

Now, it is theoretically possible that speculation can raise gasoline prices, namely if they buy oil products and keep them away from the markets. However, this theoretical mechanism isn't applicable here. During the latest year, aggregate inventories of oil products (crude oil, gasoline, distillates) in the U.S. is in fact down by nearly 5%.

The reason for the high cost of gasoline can instead be found in Ben Bernanke's monetary policy and Obama's own Libya policy.

While blaming speculators for high gasoline prices may be more politically convenient for the Obama adminitration, it is nevertheless factually incorrect. Instead it is the Obama adminitration and its appointee Ben Bernanke that everyone angry about high gasoline prices should blame.

Egyptian Economy Remains Depressed

The unrest in North African nations in recent months have affected Arab economies very differently. Saudi Arabia and the Gulf states (with the possible exception of Bahrain) have benefited because of the higher oil price. On the other extreme, the Libyan economy has been devastated because of the civil war and foreign bomb attacks.

Somewhere in between, but closer to Libya's fate, is that of Egypt. While its economy have recovered some of the damage inflicted during the worst unrest, both tourism and foreign investments and therefore allover economic output remains well below pre-unrest levels.

If political stability continues and relatively secular forces gain power, then the Egyptian economy will likely soon make a full recovery. If however unrest breaks out again and/or the islamic fundamentalist Muslim brotherhood gains power, then recovery will take a very long time, if it is ever achieved.

An Interview With Sweden's Finance Minister

An interesting interview with Swedish Finance Minister Anders Borg can be found here. I don't agree with everything he says, but I agree with most of it, and even when he's not entirely right he discusses interesting points about particularly Sweden but also the rest of Europe and America.

Gold Rally Confirms Message From TIPS

Recently I discussed how the spread between the yield of regular 5 Year U.S. Treasury securities, and inflation-protected ones (TIPS) reached the highest levels ever during the existence of TIPS. Though the spread has gone down a few basis points since then, the spread remains higher than during for example the big spike in inflation during the first half of 2008, and it is more than 160 basis points higher than before QE2.

Confirming the picture that inflationary expectations is one the rise, the classic inflation hedge gold has now risen above the $1,500 per ounce level for the first time ever. Another precious metal sometimes viewed as an inflation hedge, silver, has gained even more and is now at its highest level since the great 1980 spike in the price of silver.

It is thus as clear as it can get that inflationary expectations are rising. Such expectations can be partly self-fulfilling because it reduces money demand, something that has a similar effect as an increase in money supply.

And because the United States unlike certain European countries has a rising money supply, this means that U.S. inflation will likely continue to rise.

Hong Kong Unemployment Below Pre-Crisis Levels

Hong Kong's level of full-time unemployment fell to 3.4% in the first quarter, meaning that it is now below the pre-crisis level of 3.6%. During the crisis it rose at most to 5.4%. Part-time unemployment/underemployment is at 1.8%, also slightly below the pre-crisis level

Hong Kong's boom is mostly sound, reflecting its laissez faire policies and the structural boom in mainland China. However, the pegging of the Hong Kong dollar to the super-weak U.S. dollar has also created strong inflationary tendencies that have only partially been counteracted by for example taxes on property sales. That is one of the reasons why the peg to the U.S. dollar should be ended.

Inflation Increasing Interest Rate Hikes?

The Ernst & Young Item Club argues that interest rate increases from the Bank of England could actually increase inflation because employers might want to compensate employees for higher mortgage interest costs and thus raise their wages.

But that is hardly how rational employers would set wages. The proper level of pay is instead determined by two factors: 1) The net revenues the company receive, as a company can't afford to pay workers more than they earn 2) The risk of losing workers and the ability to find substitutes, as they need to pay workers what is necessary to persuade them to work for them.

Neither point is affected the least by higher mortgage costs in any way which would argue for higher wages as it wouldn't mean higher net revenue nor make it harder to recruit more workers. Indeed, to the extent it does affect it would argue for lower wages because if people have less money they will spend less and so reduce net revenue and because of the income effect on labor supply it could make it easier to recruit workers. Not to mention the fact that the reduction in money supply caused by the interest rate increase will deflate net revenues, also strengthening the case for lower wages in response to higher interest rates.

At this point I can imagine that some readers will object by arguing that "you're thinking of what rational employers will do, but employers aren't always rational". That is of course true, but first of all irrational employers that raise wages when there's no reason to do so will tend to be out-competed. And secondly, they are unlikely to be able to pass on the price increases because a lower money supply means that nominal demand will also be lower, increasing pressure to lower rather than raise prices.

The most likely effect of some employers irrationally raising wages to compensate workers for higher mortgage costs is therefore likely to be higher unemployment, and not higher price inflation, as they go bankrupt or are forced to fire employees to avoid bankruptcy.

Clarifications About Monetary Policy & Oil

In hindsight, I realize that I unintentionally might have given a partially misleading impression in the preceding post.

I quoted Steve Hanke's estimate of the effect of a move in the euro/dollar exchange rate on the dollar price of oil and then treated it as correct or assuming that the real effect is at most the double. Let me then clarify that Hanke's estimate could very well be true if we are talking about exchange rate movements in an isolated or ceteris paribus context.

However to the extent that the drop in the dollar is caused by "loose" Fed policy, I do believe that the effect on the dollar oil price is a lot higher because it not only raises it through the exchange rate mechanism but also because the price of oil, like prices of other commodities, is much more flexible than other prices. Indeed, it could in fact be even higher than 1, which is to say that "loose" Fed policy could very well increase the dollar oil price more than it lowers the dollar's exchange rate against other currencies including the euro, and so increase the price of oil even in terms of euros and other currencies.

On the other hand, it should be noted that the 7% appreciation of the euro since mid-February doesn't just reflect  "loose" Fed policy, but also a "tight" ECB policy. Because since mid-February, the British pound has appreciated less than 1.5% against the U.S. dollar, the yen only about 0.5% and the Canadian dollar only about 2.5%.

Thus, even if we say assume that a weakening of the dollar caused by the loose Fed policy increases the value of oil compared to U.S. dollars by 3 times the amount it increases value of foreign currencies compared to U.S. dollars (an assumed effect which thus is 6 times Hanke's estimate), we would still at most only be talking about a 5-7.5% effect, something that pales in comparison with the overall 30+% increase in the dollar price of oil since mid-February.

Furthermore, just as "loose" Fed policies has a price increasing effect, so does "tight" ECB policies have a price reducing effect. Considering that, it should be clear that monetary factors account for a much smaller part of the oil price increase than the war in Libya that has been prolonged by foreign intervention.

Role Of The Fed & Libya In More Expensive Oil

Steve Hanke claims that:

The biggest single contributor to oil price increases in recent months is not located in Libya, but at the headquarters of the Federal Reserve in Washington, D.C.

I disagree. While the Fed's dollar weakening QE2 has certainly played a role in the increase in oil prices since mid-February, it is less important than the war in Libya. If Hanke's own estimate that a 1% drop in the dollar's value against the euro causes a 0.5% increase in the dollar oil price is correct, then the weak dollar has only raised the dollar oil price by 3.5% as the dollar has dropped by 7% against the euro during that period ( from €0.74 to €0.69, which in inverted terms means that the euro has appreciated from $1.35 to $1.45).

Contrast this 3.5% with the total dollar oil price increase of more than 30% . Indeed it should be noted that the oil price in terms of euro is more than 20%, from about €62 per barrel to about €76 , despite the fact that for example the ECB's tightening measures and the disaster in Japan has helped hold down the euro oil price. Even if we assume that the effect is twice (7%) of what Hanke estimates, it still pales with 20-30% effect of the war in Libya.

The Total Cost Of The Intervention In Libya

So far, the intervention in Libya has cost the U.S. government more than $600 million, a number that keeps increasing as it continues to participate in the intervention despite formally hand over command to NATO. In addition to that comes the costs for France, Britain and other participants

However, this number greatly underestimates just how much the intervention costs most of the countries involved in this. As I pointed out earlier, the intervention by prolonging the civil war has caused a sharp increase in oil prices.  I estimated the effect to $25 per barrel, but let's say this is an exaggeration and the effect is only $20. Let's also assume that in the absence of the intervention, Qadaffi's forces would have ended the civil war on Monday March 21. How much has the total cost then been? 

The United States imports about 9.5 million barrels per day, so the daily cost is $190 million. In the 25 days of extra war that has surpassed, the cost for the U.S. economy is thus $4.75 billion, a number that increases by $190 million every day. France imports 1.7 million barrels per day, so the extra cost per day is $34 million (€24 million), and the total cost is $850 million (€ 600 million) so far. Britain used to be a net exporter but is now because of a big drop in domestic oil production a net importer of about 400,000 barrels per day, so the extra cost per day is $8 million (£5 million) and the total extra cost so far is $200 million (£125 million).

Of the other 14 participating countries only 4 (Canada, Norway, Qatar and the United Arab Emirates) are net exporters and thus short-term winners from this.

Among the participants is Greece, who one would have thought would realize that given their current fiscal predicament really can't afford to participate. I don't know what the direct fiscal cost for Greece is, but the cost for the Greek economy of the higher oil price is $7 million (slightly less than €5 million) per day given its net import of around 350,000 barrels per day, with a cumulative cost so far of $175 million (€120 million).

Because price elasticity of demand from higher prices is a lot higher in the long run than in the short run, the price increasing effect will likely fall as time passes if (as there is a high risk of because of the stalemate created by the intervention) the war drags on for months and years. However, because this demand reduction is a associated with lower levels of output and the need to use other energy sources that are really more expensive, the reduction in the extra cost for oil will be offsett with other costs, so the total economic loss might not fall as time passes. However, as the non-oil sectors of their economies weaken and as the price gain for oil falls, the gains for oil exporters like Canada and Norway will fall and perhaps evaporate as time passes.

Singapore's Strong Boom Continues

According to an advance estimate ,Singapore's GDP growth accelerated during the first quarter to 5.4% or an annualized 23.5%. Yearly growth slowed to 8.5% because growth was even stronger in Q1 2010, but as yearly growth was 16.4% in Q1 2010, this means that in 2 years, GDP is up 26.3%.

While this boom is partly a cyclical rebound from the deep 2008-09 slump, it is mostly a result of Singapore's structural economic strength.


The high level of growth together with the high level of inflation (5%) means that Singapore's central bank will likely allow a faster rate of appreciation of the Singapore dollar against the U.S. dollar. As the exchange rate is controlled by the central bank and as it needs to make it stronger, the Singapore dollar's continued appreciation is one of the safest bets around. Just how great those gains against the U.S. dollar will be however depends on how the U.S. dollar performs against other currencies.

Inflation Higher According To Old Measure

A reader wants me to comment on a CNBC article that argues that inflation according to the old measurement is 9.6% rather than the expected 2.6% according to the new methodology.

This is an unplausible estimate as it suggests that real growth is and has been during the last few years as bad as during the worse parts of the recessions of the 1970s and early 1980s.

Still, while John William's numbers exaggerate inflation, it is probably true that the official numbers underestimate inflation. And regardless of whether the old or new methodology is right, there can be no doubt that the revision in methodology has lowered official inflation, something that given a certain nominal growth means that it has increased official real growth. This in turn means that the slowdown in growth is even worse than the official numbers suggests.

U.S. Import Prices Up 22% In Two Years

The super-weak U.S. dollar is having a predictable effect on import prices, as they rose 2.7% in March 2011 from February 2011, 9.7% from March 2010 and 22% from March 2009. These increases are mostly driven by higher fuel prices, yet even non-fuel import prices are up at an accelarating rate, by 0.6% ( 7.4% at an annualized rate) from February, 4.2% from March 2010 and 7% (3.4% at an annualized rate) from March 2009.

Export prices are also increasing at an accelarating rate, mainly due to higher prices of agricultural products, but at a slower rate than import prices.


Another redistributive effect from QE2 is thus from the vast majority of Americans who aren't farmers and are hurt by higher fuel and food prices to the minority of farmers who benefit from higher food prices. Given this fact, and the fact that the federal budget is being cut, this is a good opportunity to end farm subsidies. However, given the strength of the farm lobby, I wouldn't bet on it happening even under the current conducive conditions.

The Problem With Choosing An Affirmative Action Candidate

There is an increasing anger and frustration among left-liberals in America over President Obama's increasingly obvious incompetence. Paul Krugman and others points out that Obama seems to fail to understand how to win negotiations, which is why Republicans are able to get Obama to agree to their policies, despite controlling only one (the House of Representatives) out of three decision making government institutions. By contrast, when Republicans in 1995 controlled two out of three decision making government institutions, they were outmaneuvered by the far more politically savvy Bill Clinton.


In all likelihood, Obama will similarly surrender almost completely to Republicans in the fights over raising the debt limit and next fiscal year's budget, even though the Bill Clinton example showed that isn't necessary.

To clarify, since I agree with Republicans about the need to cut spending, I think that Obama's weakness and incompetence is good. But I can certainly understand why left-liberals are angry since Obama's incompetence causes their cause to fail again and again.

However, with some exceptions such as Krugnan that already during the 2007-08 Democratic primaries saw through Obama and saw how incompetent he was, this is actually a case of poetic justice.

When you think about, just why did Democrats choose Obama in the primaries over the much more savvy and (initially) well-funded Hillary Clinton? Well, it basically comes down to two points.

1) Obama sounds good when reading from a teleprompter.
2) Obama is "black" (actually he is just half-black, but never mind that now).

While it may be true that a few white racists who otherwise would have voted for him might have abstained because he was "black", he likely received far more votes (particularly in the Democratic votes) because he was "black", both from black voters and from some academic leftist whites who were under the illusion that a "black" president would heal America's racial conflicts and/or be just compensation for past mistreatment of blacks. 

And given how close the Democratic primaries were, it is basically certain that Obama would have lost -and lost big- to Hillary Clinton if he had been white and had a similar background and views and abilities.

So for all of the Democrats that chose Obama entirely or partly because of the fact that his father was black despite the fact that it was obvious that he wasn't competent, their current frustration with Obama's failures is really a case of poetic justice punishing them for choosing a candidate on an affirmative action basis.

Biggest Drop In British Disposable Income Since 1921

The Telegraph has a headline that claims that "UK disposable income falls to lowest since 1921", but actually that's not really true. The level of real disposable income is far higher than in 1921, but the yearly decline is forecasted to be the biggest since 1921, and that's of course bad enough.

It would be interesting to see a measure of real disposable income excluding taxes and transfer payments. That would give us an idea of to which extent this drop reflects the government's austerity measures and to which extent it reflects economic weakness.

Icesave Deal Myths

The Icelandic people again rejected a deal on the Icesave issue in a referendum. This decision is supported by many usually sensible people, yet I am afraid that they have overlooked some important aspects.

First of all, it is not all that clear that it will benefit Iceland as this will cut Iceland off from some economic relations with the outside world until a settlement is reached. And once this is decided in the courts, the outcome might be worse for Iceland than this deal.

And secondly, it is not really true that this deal would have in the misleading depiction by some of this issue meant that "the Icelandic people would have bailed out bankers". After all, the shareholders in these banks have already (quite rightly so) seen the value of their shares wiped out. And while some of the responsible Icelandic banking executives have gotten away far too easily, this deal wouldn't have affected them in either a positive or negative way.

Nor is it even a case of the British and Dutch savers being bailed out, since they have in fact already been compensated by the British and Dutch governments.

So what is at issue here is which governments  (of Iceland, Britain and Holland) and thus by extension which taxpayers should take the hit. And since the banks were Icelandic and since the Icelandic government have bailed out Icelandic savers it is not unreasonable to demand that they should treat savers from foreign countries, especially fellow EEA countries given that Iceland by signing the EEA treaty pledged to treat other EEA citizens in the same way as Icelandic citizens.

If Iceland had refused to compensate Icelandic savers in the failed Icelandic banks, then there wouldn't have been a case against them, but now that they have there is a case for keeping their obligation to treat other EEA citizens equally.

Thus, while I am for punishing the responsible Icelandic bankers even more by doing more to retrieve more of the money they unjustly got away with (until enough has been taken back to pay the bill for compensating savers, they shouldn't be allowed to keep any assets for the rest of their lives), this is not the issue at stake here.

The issue is whether Iceland's government will take responsibility for its incompetent supervision of banks whose desposits they've chosen to guarantee and follow its obligation to treat all EEA citizens equally.

U.S. Inflationary Expectations Continue To Rise

The accelerating inflation in the United States suggested by the big drop in the dollar against almost all currencies and the big commodity price rally is also evident in inflationary expectations.

When QE2 was first hinted in the beginning of September last year, the yield on the regulary 5-year Treasury security was about 1.4% while the yield on the 5-year inflation-protected Treasury security was about 0.2%, implying expected inflation of 1.2%

Yesterday, the yield on the regular security was 2.31%, while the inflation-protected yield was -0.58%, implying an expected inflation of about 2.9%.

Inflationary expectations has thus risen 170 basis points, or 1.7 percentage points, which is a lot in the Treasury bond market. Noteworthy is that this also represants an the highest ever since inflation protected securities were introduced in 2003 and that the spread even surpasses the highs reached in the first half of 2008, when official inflation had risen above 5%.

Note that the expectations of inflation will help create it, since demand for money will fall, something that has a similar effect on price inflation as an increase in the supply of money.

Danish "Flexicurity" Failing The Test Of Recession

A few years ago, there was a lot of praise for Denmark's "flexicurity" labor market strategy of flexible hiring and firing combined with generous unemployment benefits (particularly for people with low income) and "activation" policies. This was understandable as Denmark in early 2007 had the lowest unemployment rate in the EU, only 3.4%. By comparison, Denmark's souther neighbor Germany had an unemployment rate of 7.1% and its northern neighbor Sweden had an unemployment rate of 6.7%.

Already then, the strategy wasn't really as successful as it seemed because there was a lot of "hidden unemployment", but then again that was true of Germany and Sweden as well.

Yet during the recession in 2008-09, Denmark saw a much greater decline in employment than both Germany and Sweden and while both Germany and Sweden are now experience robust job growth (so robust that in both countries employment is now higher than before the recession), Denmark continues to experience a decline in employment.

As a result, despite the fact that "hidden unemployment" has declined in Germany and Sweden but not in Denmark, Denmark (7.9%) now has a higher unemployment rate than both Sweden (7.6%) and Germany (6.3%).

While employment is up 3% in Germany and 2.6% in Sweden  since 2007, it is more than 2% lower in Denmark (hours worked is down 4%).

Note that the German gains are a lot more impressive given that it has had a slight population  decline while Sweden's population is up by 3%  and Denmark's population is up by 2.1% since 2007.

The main reason for the poor Danish performance is that while both Germany and Sweden has improved incentives, Denmark's government has failed to do anything useful in this aspect.

ECB Interest Rate Hike Is A Mistake

This may surprise some readers, since I am normally very "hawkish", but I believe that today's ECB interest rate increase is a mistake. The reason for that is that while inflationary policies are bad, so are deflationary ones. And this is clearly a deflationary move. 

Even before this interest rate increase, money supply growth has become virtually flat and in fact slightly negative., with annualized M1 growth being -0.8% during the latest 6 month period. This interest rate increase will likely push it further into negative territory.

Not surprisingly given this fact, the euro has increased in value this year by as much as 8% against the U.S. dollar. While this in part reflects general U.S. dollar weakness caused by QE2, it also reflects the current deflationary euro area conditions, as the euro has appreciated against almost all currencies (with one exception being the Swedish krona, as the Riksbank is also pursuing deflationary policies).

Yet even as the euro exchange rate is soaring, bond yields are also rising especially in troubled countries, also suggesting deflationary monetary conditions. 

It is true that prices of many commodities have risen, even in terms of euros. Yet that reflect foreign (manily Fed) monetary policy and negative supply shocks like the war in Libya.

The increasingly deflationary monetary policy is one partial explanation for why Portugal was forced to seek an EU rescue package similar to the ones that Greece and Ireland have gotten.

The ECB has in the past pursued far too inflationary policies. It now risks erring in the opposite direction.

Australian Job Growth Returns

After a temporary setback following the recent floodings, job growth returned in Australia, with 37,800 new jobs, (the equivalent of about 500,000 in America), pushing the unemployment rate down to 4.9%.

As I have stated before, this boom will likely continue as long as commodity prices remain at a high level.

Following the news, the Australian dollar rose to a new high of US$ 1.048.  This reflects in part general U.S. dollar weakness, but also that the news means that the probability of more interest rate increase by the Reserve bank of Australia.

Robert Reich On Inequality, Monetary Policy & Other Things

A reader asked me to comment on this lecture by Robert Reich.

Well, first of all I can say that he is a great public speaker, better than I am. But that is probably the only good thing I can say about it.

Secondly, as a tall person (see picture) I am offended by his anti-tall comments.

Thirdly, he misleads somewhat by not explaining that population growth is a partial explanation for why median income growth has trailed GDP growth.

Fourthly, when he correctly notes that income inequality reached highs during the recent bubble as well as the 1920s, he is confusing cause with effect. The reason why income inequality was so high was also the reason why there was asset price bubbles, namely inflationary Fed policy.

Fifthly, related to the previous point, Reich fails to note the reason why inequality has increased, namely Fed policy. And moreover, he explicitly endorses this very policy that causes inequality during this speech! It's sort of like endorsing the policy of turning off the lights during nights and then deploring the fact that it is dark.

The reader also asked a question of why inequality dropped so dramatically during the 1930s, but not after the recent slump. The explanation is simple: in the 1930s there weren't no large scale bail-outs of banks and monetary deflation during the slump. This time, the Fed bailed out Wall Street bankers and continued to provide them with free money.

U.K. Recovery Continues To Be Weak

Industrial production in the U.K. fell by 1.1% in February from the previous month, and as a result it is only 0.1% higher than 5 months earlier and only 2.4% higher than 12 months earlier. This confirms that the recovery in the British economy remains very weak.

What is noteworthy is that one key reason for this weakness is a continued big drop in oil and gas extraction, something that aggravates the increase in oil prices caused by Prime Minister David Cameron's Libya policy.

China Raises Interest Rates, Yuan

For the third time since Christmas, China raised interest rates. It has also repeatedly raised reserve requirements. Meanwhile, it has allowed the yuan to rise to a new record so that a dollar now only costs 6.5375. This however only implies a 1% appreciation since the beginning of the year.

For several reasons, including the need to diffuse international tensions, it would have been wise to use exchange rate appreciation more in the fight against inflation, but it appears that the political influence of exporters prevents this.

How Libyan Intervention Damages Global Economy

As I expected (to the extent I was wrong, it was because I underestimated how bad it would be), the intervention in Libya increasingly seems to create a worst case scenario where Qadaffi remains in control over western Libya while jihadist rebels are in control over eastern Libya and where the two sides continue to fight in an endless civil war.

In addition to being clueless about the nature of the rebels, the axis of Obama, Cameron and Sarkozy naively thought that they could destroy the Qadaffi regime through air raids alone. Yet as the Qadaffi forces have begun to disguise themselves to look like the rebels, it becomes exceedingly difficult for bombers to bomb them without risking to bomb the rebels. (something that they have already mistakingly done).

This means that the Libyan civil war, which would likely have ended two weeks ago without the intervention, could go on for a very long time. This means that oil prices will remain high, something that will benefit a few oil exporting countries, but greatly damage oil importers and damage the world economy as a whole.

With oil (WTI) reaching $108 today, it is about 30% higher than when the civil war started in mid-February. While other factors like QE2 could have contributed to this continued increase, other factors such as the disaster in Japan have counteracted the increase, so it is not far feched to attribute almost the entire increase to the Libyan civil war.

A short-term spike would have only created limited damage to the world economy, but the longer this persists the worse will the global economy be damaged.  The half-measure policy pursued by the Obama-Cameron-Sarkozy axis has already prolonged it by two weeks. While it can't be ruled out that somehow the civil war will be quickly ended, it looks increasingly likely to be prolonged, to the detriment of the global economy.

Putting Recent U.S. Job Growth In Perspective

Catherine Rampell puts the recent employment gains in perspective. It is in short, way below what could be viewed as sufficient given how much was lost:

Real Wages: Ends & Means

It might be confusing to some that seemingly discuss real wage cuts as something positive here, yet describe it as negative here. Isn't that inconsistent?

No, because in the first post I described it in terms of being a mean to reduce unemployment, in the other I described it in terms of being an end result given a certain level of employment.

Or in other words, in the first post I described the causal effect of real wage cuts in periods of high unemployment, in the second I described it as an end result given a certain level of employment.

As an end result, lower real wages is something negative. Just about everyone wants their real pay to increase, and not decrease, so all else being equal, lower real wages is something negative.

However, most people would also view being unemployed as being even worse than being employed at a lower real pay, and because lower real wages can reduce unemployment if unemployment was high initially, lower real wages is arguably a lesser evil compared to high unemployment. It is however still a negative, so given a certain level of unemployment and employment, news of lower real wages are bad news.

I Don't Know How Anyone Could Have Gotten Such A Crazy Idea

The Taleban condemns Pastor Terry Jones for burning a Koran, saying that:

According to this Satan, the Holy Quran teaches murder and terrorism in the world.

And so to disprove this, followers of that book goes on to murder 20 people, people who didn't even have anything to with Pastor Jones' burning.

I don't know how Pastor Jones could have gotten the crazy idea that a book whose followers are willing to murder 20 people because some unrelated person in another continent burned some paper would encourage violence, but I'm sure that this incident will discredit this idea.......

Great German, Small American Employment Progress

The German labor market continues to strengthen, with employment up by 1.3% compared to the previous month. Given the fact that the German population is stagnating and the fact that Germany had almost no job losses during the recent slump, this is quite good. Germany is thus one of the very few countries to have a significantly higher employment to population ratio compared to 2007. The reason for this is mostly the free market labor policies implemented in recent years.

Meanwhile, employment is picking up in the U.S. as well, with the household survey showing a 291,000 gain (slightly more than 0.2%) and the payroll survey showing a 216,000 gain (slightly less than 0.2%). However, unlike in Germany, the employment to population ratio is despite the gain in the most recent month actually slightly below (58.5% versus 58.6%) year ago levels. The alleged drop in unemployment during the latest year thus simply reflects a lower labor force participation. And because the employment to population ratio fell so much during the slump, it is unlike in Germany significantly below 2007 levels.

With both the average work week and nominal average hourly earnings unchanged, real wages likely also fell.

That Just Makes Another Fact More Depressing For India

India's population have increased to 1.21 billion, up by 180 million or 17.6% compared to a decade earlier. Though this means that the potential for economic growth is better, this also means that India is trailing China in per capita growth (the relevant indicator in terms of reducing poverty) even more than the total growth numbers suggest.

It also makes the fact that India's GDP was just $1.52 trillion in the fiscal year 2009/10 even more depressing, as this means that India's 1.21 billion people produce less at current exchange rates than the 37 million in California (California is 13% of the U.S. $14.8 trillion economy, or $1.92 trillion). It also means that India despite now having almost as large population as China, it's economy is only slightly more than a fourth of China's $6 trillion economy.