Monday, April 30, 2007

No Pain, No Gain For France?

I see via P.J. Anders Linder, that Matthew Parris has written a article in The Times where he argues that free market advocates should root for Segolene Royal.

A seemingly bizzare idea given the fact that Royal is a radical statist who believes that France's already statist economy should become even more statist with even higher levels of regulations, government spending and taxes.

But the idea that he launches is that as Royal's economic plan will ruin France's economy, this will finally put France in the mood for radical free market reforms, just like the deep British crisis of the late 1970s with 20% inflation and growth far below that of all other countries put Britain in the mood for Thatcherism. This is also why he as a Iraq war opponent rooted for Bush in the 2004 election and is glad that Bush has put the "surge" strategy in action, as its inevitable failure will forever discredit neoconservatism.

There are however, several problems with this reasoning. First is of course the argument from Linder that we don't just live in the long run, but in the short term too and a Royal victory would mean more short term suffering. Secondly, and perhaps more importantly, while the likely crisis after Royal's policies are put in place will strengthen the free market case, statists will certainly come up with excuses for their failure. The ECB will certainly be blamed for not inflating enough (as both Sarkozy and Royal already argues). And Royal supporters will certainly argue that the policies weren't pursued zealosly enough, particularly not after the French general assembly likely stops some of her proposals. As implausible as these excuses might be, the people who want to believe them will believe them.

In 1981, Francois Mitterand pursued similar policies, but after the economy worsened, he was forced to change policies somewhat. But this failure haven't deterred the French from believing in statist policies. Just as the current failure of the "surge" (with more than 100 American soldiers being killed in April) isn't deterring neocons from believing that one day, Iraq can be transformed into a Western democracy.

Sunday, April 29, 2007

India Reaches Trillion Dollar Economy

Of course, a dollar, and by extension a trillion dollar, is gradually less and less worth due to inflation and depreciation, so becoming a trillion dollar economy is far less worth than it was in the past.

Nevertheless, it is still noteworthy, that India's GDP have now surpassed the trillion dollar level. This was reached a lot faster than expected as the Indian rupee has appreciated sharply during the most recent month.

Unlike the Chinese who have been foolishly dragging their feet and refused to allow any significant appreciation, despite the enormous losses this implies, India have allowed a really sharp appreciation during the recent month. As late as March 19, the dollar costed more than 44 rupees. Now a dollar cost just 40.8 rupee. This implies a 7.5% appreciation in less than six weeks. By contrast, the Chinese yuan appreciated a mere 0.3 % against the dollar during the same period. Indeed, during the entire 21-month period since the traditional 8.28 yuan peg to the dollar was loosened, the yuan has appreciated a mere 6.8%, less than the Indian rupee's gain during six weeks.

India's currency policy is much wiser than China's for reasons that I've explained before. Namely, that it achieves a certain level of monetary tightening by means that enables them to buy foreign goods at a lower price. The traditionally argued disadvantage to a stronger currency, namely job losses in the export sector, is not a real disadvantage as alternative tightening measures would have implied job losses too.

While India's wiser currency policy is not -particularly not in the long term- enough to overcome the other structural disadvantages it has to China, it certainly means that in the short- to medium term outlook I have become more bullish on India relative China, than I used to be.

Saturday, April 28, 2007

Stock Market Highs And Recessions

Blogger "Kash" has an interesting post reminding everyone how stock market highs are often followed by recessions. The archived news story he puts up tells of how the U.S. stock market reached record highs in June 1990, just a month before the start of the 1990-91 recession. Then, as now, this was driven mainly by increased profits of the foreign affiliates of U.S. companies, a factor which is even more important today when the share of both revenues and costs that come from within the U.S. for U.S. companies have declined significantly since 1990. This means that the stock market is even more unreliable as a leading indicator of the economy then it was in 1990, when it reached all time highs just a month before the start of a recession.

Update: Here is more, in the New York Post, about how the fortunes of U.S. big corporations (And by extension indexes like the Dow) are increasing reflective of foreign economies rather than the U.S. economy.

About U.S. GDP Report

U.S. first quarter GDP growth, at 1.3% in the "advance" release, came in just as weak as I predicted a month ago, when I wrote it would be 1-2%. As always with the advance number, it could be revised later, but as there is no reason to assume that upwards or downwards revisions are more likely, they can nevertheless be analyzed.

Looking at the specific components, they were mostly in line of what I expected although personal consumption and business investments were somewhat stronger than I had expected, while government demand was seemingly weaker.

However, government demand wasn't really that weak. Nominal growth was in fact much faster than in the fourth quarter. The price index used for government demand accelerated sharply in the first quarter after increasing unusually little during the fourth quarter. As a result government demand increased to their highest proportion of GDP since 1993 (except for the first half of 2003 when the invasion of Iraq temporarily boosted military spending).

Business investments came in above zero. However, they fell as a proportion of GDP, and despite the slight recovery in March, orders for investment goods are still running lower than during a few months ago, meaning that business investments are likely to turn down during the fourth quarter.

Personal consumption will likely continue to grow during the second quarter, in part because of the stock market rally. However, it will likely grow a lot slower than the first quarter's 3.8% number, in part because of rising oil prices and a likely accelerated food price increase.

One interesting thing is that $50 billion in bonuses was attributed to the fourth quarter in the national accounts, while in the personal income accounts they were attributed to the first quarter. As a result, the personal savings rate seemingly rose from -1.2% to -1.0%. If they had been attributed to the fourth quarter, as in the calculation of national income, the savings rate would have instead fallen from -0.7% to -1.5%. With the bonuses being ended by March, the savings rate will likely fall during the second quarter.

As for the other components, it is more difficult at this point to say how they will develop. However, the most likely scenario is for a continued decline (albeit at a slower rate) in residential investments due to the continued high inventory level of new homes. Inventories will probably post a small decline, while the trade deficit will likely be more or less flat as a weaker dollar will boost exports while higher oil prices will increase the cost of imports.

Adding it all up, the most likely scenario is for second quarter growth to be even weaker than during the first quarter, but that growth will nevertheless stay above the key zero threshold, as increases in personal consumption and government demand will outweigh declines in investments. Of course, growth driven entirely by consumption is hardly healthy, and certainly implies a risk of growth falling below zero during the third quarter.

Tuesday, April 24, 2007

New Eurostat Report About EU Government Spending Burden

Eurostat reports that Euro-zone budget deficits fell from 2.5% of GDP to 1.6%. Unfortunately though, most of it reflected higher government revenues. The burden of government spending fell from just 47.5% to 47.4%.

Combining it with the 2002 numbers in last year's release, you can see that compared to 2002, Euro-zone spending fell by 0.3%: points between 2002 and 2006, from 47.7% to 47.4%. But the change in different countries has been very different. Two countries, Italy and Portugal have fairly dramatically increased spending, by 2.7%: points and 1.8%: points respectively. Not coincidentally, they have had the weakest economies of the Euro-zone. France, Holland and Ireland have also increased the burden of spending. In the case of Ireland though that is less of a problem since it started (and ended) with the lowest burden of spending while France started with the highest burden.

The biggest cuts in government spending were performed in Greece and Germany, with 2.9 and 2.7% points respectively. Both started with government spending somewhat above the Euro-zone average and ended with government spending somewhat below. Not coincidentally, Greece has seen very fast growth while Germany has gone from being the sick man of Europe to have growth above the Euro-zone average. Other Euro-zone countries with significant spending cuts (above 1%: point of GDP) include Slovenia, Austria and Luxembourg, all of whom have had above average growth. So you can see a pattern here. Countries who have significantly reduced government spending relative to GDP have all out-performed the Euro-zone average, while the countries who have increased it have under-performed, with the sole anomaly of Ireland. But Ireland, as previously noted, still has the by far lowest burden of government spending and it has also been helped by extremely favorable demographics. And furthermore, some of its growth has been driven by a housing bubble and related cyclical excesses.

The same pattern is evident if we look at non-euro zone countries. The biggest spending reduction has occurred in Slovakia, where government spending fell a full 6 5: points, from 42.3% of GDP in 2002 to 36.3% in 2006. Other big spending reducers are the Czech Republic (-4.2%: points), Denmark (-3.8%: points), Estonia (-3.3%: points) and Sweden (-2.4%: points). Not coincidentally, all of these countries have had above average growth.

Sweden and Denmark still have relatively high levels of spending, but particularly Sweden's is exaggerated by some statistical distortions. First of all, Sweden and Denmark tax transfer payments much more (page 192 in the pdf-file) than do other European countries-or the United States. In Sweden and Denmark, taxes on transfer payments are more than 4% of GDP, compared to 1-2% in most continental European countries, 0.5% in the U.S. and 0.3% in Britain. Taxes on transfer payments are really nothing but an accounting illusion since the money never leaves or enters the government sector, and so means that both revenues and spending are exaggerated. Moreover, as Eurostat notes, Swedish interest payments are reported on an unconsolidated basis, which means that for example interest payments from the State to State-owned pension funds are included, which it is not in other countries. Taking these two facts into account, both Sweden and Denmark have now been surpassed by France in terms of government spending. And Denmark has also been surpassed by Italy.

The biggest spending increases have occurred in Cyprus (+3.3%: points) and Britain (+3.2%: points). Latvia, Malta and Hungary have also increased government spending relative to GDP. Cyprus, Malta and Hungary have all fallen behind other new member countries, and Britain have lost its previous status as growth leader of Western Europe and now trails the Euro-zone average in growth. Latvia is the one anomaly among non-euro zone countries from the strong negative correlation between changes in the burden of government and economic growth. This is due in part to similar reasons as Ireland's strong performance, namely that Latvia started and ended with one of the lowest burdens of government spending. Latvia also have arguably the strongest cyclical element in its economic growth, with money supply growth running at nearly 40%, which have resulted in a consumer price inflation rate of 8.5% and a current account deficit of more than 15% of GDP.

So, looking at European economies you can see a very strong correlation between economic growth and changes in government spending. The correlation is not perfect, of course, just like all other correlations between causal factors and aggregate social or economic phenomena’s as there are always other factors involved. But given this fact, the correlation is actually unusually strong, with just two real anomalies among 25 countries, both of whom are easily explained. Government spending will hurt the economy regardless of whether it is financed through taxes that reduces incentives or through government borrowing, which has a "crowding out" effect on growth.

Spanish Housing Bubble Bursting?

Well, not yet. But increasingly investors fear it will. And at any rate, the rate of house price increases is certainly slowing. The 12-month increase in house prices was just 7.2% in March, half of the rate of increase in previous years.

I've dealt before with the issue of the Spanish housing boom. Clearly, some of it has been fueled by ECB holding interest rates far too low for far too long. And as interest rates are now rising this implies that a housing bust is a real risk. However, as I wrote then, the strong underlying demand because of a large influx of foreigners means that the severity of any bust will be limited. Renewed strength in other European economies, particularly Germany, also means that the spill-over effect to the overall economy will be limited.

Monday, April 23, 2007

Sarkozy vs. Royal

So now it is clear that it will be Nicolas Sarkozy versus Segolene Royal. Sarkozy has his shortcomings. He has spoken out in favor of affirmative action. He has furthermore embraced a protectionist and populist (in the worst sense of the word) rhetoric. However he has also talked of some badly needed free market reforms of France's statist economy. Many people dislike the fact that he referred to the rioting immigrants as "scum" and advocates tough measures against them, but I think "scum" is a rather appropriate description of thugs who burn cars and riot for no good reason (and no, the fact that 2 thugs fleeing police were so stupid that they electrocuted themselves to death is not a valid reason). And most importantly of all, his opponent stands for a disastrous policy of not only protectionism but also sharply increased minimum wage, higher government spending and more government regulation. That is more of the policies that have made France Europe's second slowest growing economy after Portugal. So, while he is imperfect, Sarkozy is clearly preferable to Segolene Royal.

On the Other Hand

As a mirror image to the previous post about how profits of U.S. companies are rising in their foreign subsidiaries while falling in domestic operations comes this observation from Michael Mandel of Business Week that investment spending from U.S. companies are much stronger than government statistics of U.S. investment spending indicates. The reason for this is that they are in fact investing a lot more-only they do so outside of America. This makes of course perfect sense. The main reason why corporate profits affect investment spending is because they make it more plausible in the mind of management that there is a strong incentive for additional investments. And if previous investments outside of the U.S. are more profitable, then this means that U.S. corporations will tend to invest more outside of the U.S. This means that U.S. stock prices will be increasingly disconnected to the strength of the U.S. economy.

Sunday, April 22, 2007

Could Rest of World Strength Save U.S. Economy From Recession?

As most readers know, I recently wrote a article about why a U.S. recession is likely in 2007, an assessment I haven't changed. However, then as now, I emphasized that it was only likely, not certain. The reason is that it is possible that the U.S. could be as lucky as Australia was in 2005 and be helped by some positive shock. I mentioned one of these possible shocks, falling oil prices, and this is in fact a factor which has helped the U.S. economy already quite a bit as oil prices -in sharp contrast to other commodity prices- is in fact down more than 10% compared to last year.

There is however, another factor which could and are indeed helping the U.S. economy. That factor is cyclical strength in the rest of the world. The other two large power centers of the world, Europe and East Asia is enjoying strengthening growth. While this will limit the decline in oil prices and is contributing to the rally in other commodity prices, the overall net effect of this on the U.S. economy is clearly positive for several, related reasons.

First, because this will increase U.S. net exports, something which will limit the downside to GDP growth when investments decline. The 3 month moving average of the trade deficit is in fact down by $5 billion compared to last year, and so net exports is already strengthening growth.

With the U.S. dollar falling and with domestic demand being far weaker than in the rest of the world, it seems likely that the trade deficit will continue to fall.

But it is not just through higher net exports that rest of the world strength will limit the downside in the U.S. economy. Almost as important is the effect on income flows and balance sheets. We are often told by the financial press that profits of U.S. companies remain strong. Well, actually profit growth isn't really that impressive at 6-7%, but it is nevertheless much stronger than what one would have expected from a economy poised to go into a recession. But the fact is that profits are in fact falling for the domestic operations of non-financial companies. That aggregate S&P 500 profits are up 6-7% reflect booming profits of financial companies and more importantly booming profits of foreign subsidiaries of U.S. companies. Companies like Coca Cola and McDonald's have reported that their profits remain strong mainly because of their foreign operations. This in turn reflects both the high economic growth outside of the U.S. and also currency effects of a falling dollar. The dollar profits of a U.S. company operating in Europe will be increasing at double digit levels even if the profits in euros are flat.

This will in turn also help strengthen U.S. stock prices, and this is one of the reasons why U.S. stocks rallied the previous week. Moreover, as stock prices outside of America also rise, particularly in dollar terms, the value of foreign stocks held by U.S. companies and households also rise, thus helping U.S. households to afford to spend more than their disposable income.

All of this illustrates a fact I discussed last month: that globalization is a factor which have contributed to reducing cyclical swings in the economies of the world.

Will it be enough to prevent a recession? Time will tell. I regard as unlikely, but certainly possible. And even if it doesn't prevent a recession, it will certainly make it a lot milder than it otherwise would have been.

Friday, April 20, 2007

Leftist Defeated Big in Debate

From Larry Kudlow's TV-show:

KUDLOW: All right. Don Luskin, let me go to you. I'm looking at some of the distributional aspects of our current tax code. The top 1 percent now pays 37 percent of income taxes. Back in 1980, they only paid 19 percent. The top 5 percent pays 57 percent. That's up from--that's up from 37 percent back in 1980. And if you make over a million bucks, 181,000 people, they pay 19 percent of the income tax. Your thoughts, Don Luskin.

Mr. LUSKIN (Trend Macro Chief Investment Officer): Well, I'd like to borrow a word from Jared Bernstein, unfair. I'd like to know what's fair about getting one class of people to pay all the bills for another class of people, be they rich or poor. I'm sick and tired of hearing the word fairness used in this discriminatory way. It's a one-way use of a word, where it's fair if the rich pay more and it's unfair if the poor pay their fair share.

Mr. BERNSTEIN (Economic Policy Institute Senior Economist): You're breaking my heart here. For the rich...

Mr. LUSKIN: And I'm tired of it.

Mr. BERNSTEIN:'re breaking my heart here, Don. I mean, corporate profits are at 56-year high. Who here feels sorry for rich people?


Mr. LUSKIN: No one is feeling sorry for anybody, Jared. I'm talking about fairness. I'm talking about equality. I'm talking about egalitarianism...

Mr. BERNSTEIN: So you want--so you want everybody to pay...

Mr. LUSKIN: ...the kind of thing that people like you spend your whole careers raving about. All I know is that it doesn't make any sense for a taxi driver who is willing to work two shifts to pay a higher tax rate than a lazy taxi driver who only works one shift. Now, you explain to me what is fair about a tax code that punishes enterprise.

Mr. BERNSTEIN: Well, you want to talk about fairness, let's talk about the Bush tax cuts. The reduction in tax liability...

Mr. LUSKIN: Well, why don't you answer my question first before we talk about the Bush tax cuts?

Mr. BERNSTEIN: The reduction--I think I am answering your question.

Mr. LUSKIN: What about those taxi drivers?

Mr. BERNSTEIN: I am answering your question. The reduction...

Mr. LUSKIN: Why is it fair for a hard-working taxi driving to pay a higher tax rate than a lazy taxi driver?

Mr. BERNSTEIN: Well...

Mr. LUSKIN: Answer that question.

Mr. BERNSTEIN: Certainly that's not fair. The...

Mr. LUSKIN: Thank you.

New York Times Wrong About Chinese-U.S. Dependence

The New York Times has a story about how Chinese dependence on U.S. have supposedly decline in recent years. As evidence, they use the fact that America's share of Chinese exports have declined. The fallacy here should be apparent. While it is true that the U.S. now receives a smaller share of total Chinese exports, Chinese exports relative to Chinese GDP have increased even more. This in turn means that Chinese exports to the U.S. relative to Chinese GDP have done up, not down. And this is of course what matters in terms of the dependence of the Chinese economy of exports to the U.S.

The simplest and least painful way for the Chinese government to reduce this dependence would be the same policy move that would most effectively reduce excessive money supply growth: i.e. allow the yuan to appreciate faster.

Lucky Aussies-Except With Regards to Weather

Of the major currencies this year, the Euro and the British Pound have been the big winners, while the U.S. dollar, Chinese yuan and Japanese yen have declined. However, two currencies have been even stronger than the European currencies: the dollars of Australia and New Zealand. The main reason for this strength is of course the so-called carry trade and the fact that Australia and New Zealand have high interest rates.

Another, although much less important, factor is the steady improvement in Australia's terms of trade. And the latest figures indicate that this trend continues. Import prices fell 1.7% compared to the previous quarter and 3% compared to the year before. Export prices were unchanged compared to the previous quarter and is up 5.8% compared to the year before. The reason for this improvement in terms of trade is of course the rising price of exported raw materials caused by increased demand from China.

It is because of this that Australia has been able to have the longest expansion in history and shows no sign of a immediate downturn, despite the existence of similar imbalances as in America. However, if the Chinese economy turns down, either because of an American recession or internal problems, than the Australian boom will be cut short. For now though, the Aussie economy continues its lucky ways.

However, I see now that with regard to the weather, Australia is not lucky. An extreme water shortage due to an ongoing drought means that agricultural production will fall which in turn will push up food prices.

Thursday, April 19, 2007

New Numbers Again Illustrate Foolishness of China's Currency Policy

Chinese GDP growth for the first quarter came in at 11.1%. While that was higher than most so-called professional analysts had expected it was roughly what I had expected. A month ago I said a 12% growth rate would be the result if the trade surplus had increased as fast in March as in January-February. But as the trade surplus actually fell somewhat, a 11% growth rate was more likely.

At the same time, consumer price inflation heated up to 3.3%. That the consumer price inflation rate is so high despite the massive increase in the supply of goods is clearly troublesome, as are the likely high rate of malinvestments. Both are symptoms of excessive money supply growth, which in turn, as Iäve explained repeatedly here, is caused by the irrational refusal of Chinese leaders to allow a significant yuan appreciation, and instead hold the yuan exchange rate down by accumulating massive foreign exchange reserves.

One worrisome sign is the deceleration during the latest month of the rate of yuan depreciation. A month ago, it costed 7.728 yuan to buy a dollar. Yesterday it costed 7.7208 yuan, a appreciation of just 0.1%, much lower than in previous months. Unless the rate of yuan appreciation quickly re-accelerate, China's imbalances will be significantly aggravated, regardless of what other actions (One thing that might work though would be to do away with tax rebates on export companies and/or to reduce import tariffs. That would have a similar effect as a higher exchange rate) the Chinese government use to reduce excesses.

Tuesday, April 17, 2007

About U.K. & U.S. Inflation Reports

Today numbers for consumer price inflation for both the U.K. and the U.S. was released.

The U.K. inflation numbers were really bad. According to the EU-harmonized index, inflation rose to 3.1%-the highest ever since that index was introduced in 1997. According to the traditional (and wider) British consumer price index, the Retail Price Index, inflation rose as high as 4.8%. This forced Bank of England governor Mervyn King to write to chancellor Gordon Brown and explain why it has failed to keep inflation at 2%. According to the BBC News account it blamed the rise on rising oil prices. Which is actually pure BS. Because while oil prices did rise between February and March, they actually fell between March 2006 and March 2007, particularly in pound terms.

Anyway though, this makes a May interest rate increase by the Bank of England a near certainty, which is why the pound rose through the psychologically important $2/£ barrier for the first time since 1992.

By contrast, U.S. inflation numbers were unexpectadly low. While a 0.6% monthly increase isn't low in absolute terms, I had expected a higher number given the surge in both energy and food prices. But while energy prices in the CPI did indeed rise sharply, food prices rose a mere 0.3% and the so-called core index rose just 0.1%.

What is particularly puzzling is the weak food price increases. According to the PPI, food prices at the wholesale level rose 5.7% in the latest 4 months. Yet according to the CPI, food prices at the retail level rose just 1.8% in the latest 4 months. Even if you exclude restaurants, the increase of prices in food stores was just 2.3%. This seemingly implies that retailers have significantly reduced their gross margins. Something which is hardly sustainable. That in turn implies that retail food prices should start increasing faster in coming months, as food stores realize that the increase in input prices isn't temporary.

Monday, April 16, 2007

Now Even Larry Kudlow Acknowledges Inflation

When even people who have a vested interest in denying something acknowledges it, you know the case for it is really overwhelming. For example, today, even people who supported the Iraq war acknowledge that Iraq is a mess. Indeed, even some people who still think the Iraq war was a good idea feel compelled to admit that Iraq is a mess.

Similarly, as a sign that the inflation outlook is really bad, now even arch-dove Larry Kudlow feel compelled to admit there is strong inflationary pressures in the U.S. economy. Kudlow has been a master in denying it, constantly changing standards and definitions as to what predicts and measure inflation. As every indicator around points to rising inflationary pressures, he no longer has any choice but to acknowledge that there really is strong inflationary pressures. Now, I suspect Kudlow won't stay hawkish for long. As soon as just one of his indicators turns dovish, he will too, even if all the remaining indicators support the hawkish position. But the fact that even Kudlow feels compelled to acknowledge inflation clearly illustrates that it is a big problem.

Saturday, April 14, 2007

Spain vs. Portugal

Two countries share the Iberian Peninsula (unless you count the tiny areas of Andorra and Gibraltar), Spain and Portugal. Both have been counted as the poorer countries of Western Europe-and both still are, but to wildly varying extent. As the graph (taken from this story of The Economist) below illustrates, while Spain's per capita income during its entry to the Euro-zone has risen from 92.1% to 97.7% of the EU25 average, Portugal's per capita income has fallen from 80.3% to 70.4% of EU25 average. The gap between Spain and Portugal has in other words risen from 15% to 39%.

Portugal's growth is the lowest in Europe and as a result, Portugal has fallen behind not only the one member state of the original 15 which was poorer than them (Greece )in per capita income, but also three of the new member states ( Slovenia, Czech Republic and Malta). While the title "the sick man of Europe" has been given alternatively to Germany, France and Italy, Portugal's economy is sicker than any of these.

What is Portugal's problem? To some extent it is bad luck. Like Italy, Portugal's exports are to a large extent composed by goods (like textiles) which competes directly with super-competitive China. The inflow of cheap goods from China have benefited countries which had no textile industry to begin with, like Sweden and Britain, but hurted countries that previously exported textiles to Sweden and Britain, such as Italy and Portugal. But the main factor is that while Spain have had budget surpluses and a falling burden of government, Portugal's government have been on an unprecedented spending spree, quickly increasing the burden of government.

As they put it in this report from 3 years ago:
"Why have the two countries diverged? The answer lies in Portugal’s budgetary policy. During its cycle of expansion, Spain adjusted its public accounts and cut its taxes, spending and indebtedness. Portugal expanded its public spending, but did not reduce its deficit. In 2001, Portugal broke with the European Pact of Stability and Growth by recording a budget deficit of 4.1%, above the 3% limit stipulated by the Pact. Last year, Portugal engaged in a major belt-tightening effort and managed to reduce its deficit to 2.8%.

According to Das Neves, the current setback in public finances “was not created by a revolution or cyclical crisis or external shock, as in earlier cases. It was the result of feudal interests, who forced their priorities on the public good. Pressure groups satisfied themselves at the cost of [higher] public spending, and they created a budgetary hole. A significant portion of the elite appears to have stopped producing; it dedicated itself to dividing what already existed. That’s why there was a slowdown.”

If you look at numbers from Eurostat, you can see that the already large difference in burden of government between Spain and Portugal have widened further in recent year. While government spending in Spain fell from 38.7% to 38.2% of GDP between 2002 and 2005, Portugal saw government spending rise from 44.3% to 47.8%. And while Spain had a budget surplus of 1.1% of GDP, Portugal had a budget deficit of 6.0% of GDP.

This latter fact illustrates that while some people have feared that in the European Monetary Union, countries would gain and shift the negative effects on others by running budget deficit. In fact, the empirical pattern is in fact the opposite: countries with budget surpluses, like Ireland, Spain and Finland to be successful, while countries with large budget deficits like Portugal, Italy and France have big troubles.

Friday, April 13, 2007

Global Fallout From U.S. Recession

Many people have recently asked me -especially after my latest article- about what the global repercussions from the likely U.S. recession will be. That depends of course on just how deep it will be and how U.S. politicians will respond to it, but at any rate it will certainly be noticed elsewhere because America is still the world's largest economy and the number one importer.

The countries that will be hurt the most are first and foremost the closest neighbors of the United States, such as Canada and Mexico. Both Canada and Mexico exports about 25% of their GDP into the U.S. and so a downturn in demand there will have a significant negative effect on their economies, possibly even pushing them into a recession too.

Another highly vulnerable economy is China. China has foolishly pursued a policy of holding down the value of the yuan. This have not just resulted in a slower growth in real income as vast sums have in effect been given away, but it has also significantly increased their vulnerability to a U.S. recession. China's goods export constitutes more than 10% of GDP, which while being far less than Canada and Mexico, is dangerously high.

Moreover, as sentiment in the U.S. Congress is quite sinophobic, it is a virtual certainty that China will be blamed for the recession. Meaning that there is a significant risk that the relatively mild anti-Chinese trade restrictions passed recently could quickly turn much more draconian. At that point, the Schumer-Graham 27.5% across the board tariff bill could actually be passed. This would cause considerable damage to Chinese exports. And unlike the export limiting effects of a stronger yuan, there is no positive side in the form of cheaper imports to compensate for the damage.

As China is the biggest export market for many Asian countries (And Australia, Chris should note!), the dramatic weakening of the Chinese economy caused by this will further add to the direct damage from the U.S. slowdown (and will in fact perhaps be a bigger factor than the direct effect). Therefore, if U.S. politicians respond to the recessions by draconian restrictions on Chinese imports, this means that the Asia-Pacific region could suffer at least as much as Canada and Mexico.

The mayor economic region that would suffer the least from a U.S. recession would be Europe. The European Union exports less than 2.5% of its GDP to the U.S. and its trade with indirectly damaged regions is likewise relatively limited. And with the momentum in European domestic economies being fairly strong, a U.S. recession will probably not have a significant negative effect.

And with strong domestic demand driven by housing bubbles in large parts of the Euro-zone as well as Britain, Sweden, Denmark and the Baltic states, falling demand in the rest of the world combined with a likely continued appreciation of the Euro and other European currencies, Europe will likely experience a dramatic weakening of its current account balance. Europe will therefore likely take over America's role as "consumer of last resort" during the coming year.

In short, the effects of a U.S. recession will be greatest in Canada, Mexico and other countries in Latin America and smallest in Europe. For Europe the effect on growth will be only marginal, although it is likely to have a significant effect on its current account balance. The outlook for China and the rest of the Asia-Pacific region depends on whether or not U.S. politicians introduce draconian restrictions on imports from China. If they don't the effect will not be particularly dramatic, if they do, it will have dramatic effects.

The Economist's Commodity Price Index Above 200

The Economist's commodity price index rose above 200 this week. It is upp a full 5.6% on the month and 23.9% in the latest year. And with 100 being the level for the year 2000, this means that commodity prices have more than doubled since that year. All confirming what regular readers of this blog knows I've been saying all along: that the coming recession in America will be a case of stagflation, not some kind of Keynesian "lower aggregate demand pushing down both inflation and growth"-recession.

Wednesday, April 11, 2007

The Economic Policy Institute's Misleading Use Of Statistics

After my post on income inequality, monetary policy and leftists, a Italian fan of my blog that calls himself Libertyfirst asked me about a chart in a text from the leftist ( union funded ) Economic Policy Institute that I had linked to. I hadn't thought much about the chart and linked to the text simply to provide a source for my claim that the left is pro-inflationist.

But when I looked at it after LibertyFirst:s question, I was really amazed by it. It showed that productivity supposedly increased 75% while real compensation to non-managers allegedly was nearly flat since 1980. While corporate profits have indeed increased, I knew for sure it hadn't increased anywhere near as dramatically as it would have done had real compensation really been flat in the face of a 75% increase in productivity. And there simply aren't enough CEO:s around to account for more than a fraction of this discrepancy.

My answer at the time was that it was misleading because 1) The numbers for productivity included all private sector workers, while the number for real compensation included a more limited group of workers that excluded not just CEO:s 2) The compensation number probably (I wasn't sure exactly what number they used so this was just a hypothesis) excluded non-wage benefits which has increased faster than wages 3) The productivity number was deflated by product price indexes while the compensation number was probably deflated by consumer price indexes which increases a lot more (and if a price index increases more, any real number derived from nominal numbers deflated by it will be lower).

I see now that another leftist group, Center for Economic and Policy Research, has quantified the exact extent to which the third factor is responsible for the distortion in the EPI chart (not that the paper was in anyway intended to refute EPI, it simply did so unintentionally):

"When a consumption deflator is applied to economy-wide net output [instead of smaller output deflator due to higher depreciation rates of investment goods such as computers], cumulative productivity growth since 1973 has totaled just 47.8 percent, instead of the 81.6 percent figure reported for gross output in the non-farm business sector."

This means that more than a third of the divergence between productivity and real compensation in the EPI chart is explained by using different price indexes when calculating productivity and real compensation. The rest reflects mostly the two other distorting factors, with a small portion reflecting the real relative increase in corporate profits compared to compensation of labor.

Recession 2007

Today on I officially forecast a recession in America. Or actually, what I'm, saying is that it is the most likely scenario. There is a small possibility that a dramatic decline in oil prices or some other positive shock could avert, but that seems less likely than not to happen. Instead a recession is the most likely scenario.

I see BTW on Bloomberg News today that the IMF disagrees with me. A majority of Americans however, agrees with me in this poll.

Monday, April 09, 2007

U.S. Government Spending Growth Decelerating?

According to preliminary numbers from the Congressional Budget Office, the budget deficit continued to decline during the first half of fiscal 2007 (October 2006-March 2007). This happened despite the fact that tax revenue growth decelerated significantly. After rising 14.6% in fiscal 2005 and 11.8% in fiscal 2006, revenue growth fell to 8% during the first half of fiscal 2007. This is still faster than nominal GDP growth, presumably reflecting rising inequality (If the tax system is progressive, higher inequality will mean a higher tax revenue to GDP ratio). Revenue growth in March decelerated even more dramatically, to just 1.2%. This is probably to some extent a calendar effect, but it likely also reflects a slowing economy.

What is particularly noteworthy was that spending growth fell to a mere 2.8% (or 2.0% in calendar adjusted terms). This could mean that despite slower growth, fiscal 2007 could be the second fiscal year (the previous being 2004, where it fell from 20.0% to 19.9%) during Bush's term where spending to GDP actually fell. However if you look at the fine print, you can see that something fishy is going on. Military spending increases fairly rapidly, 7%, and Medicare increases a full 20.2%, and Medicaid and Social Security also increases fairly rapidly, more than 5%. With nominal GDP growth running at just 4-4.5%, this would seemingly indicate that the burden of spending is rising.

So how come aggregate spending increases just 2.8%? Well, because of a 9.8% decline in "Other Programs And Activities", which fell from $435 billion to $392 billion. Excluding this, aggregate spending rose 8.8%, from $906 billion to $986 billion.

Part of the decline in "Other Programs And Activities" was due to the fact that last year, the Federal government spent a lot of money on hurricane relief in wake of the devastation caused by Hurricane Katrina. The fact that this is absent this year certainly should count as a spending cut, albeit only a one-time one. However, the second explanation for the decline was that the government received higher revenues from auctions of licenses for the use of electromagnetic spectrums and Medicare premiums. In other words, this "reduction in spending" is really revenues counted as some form of negative spending.

So, this apparent slow increase in government spending is just an aberation caused by a temporary factor and dishonest accounting from the government.

Friday, April 06, 2007

U.S. Jobs Report Strong-But It Doesn't Contradict Recession Scenario

Today's U.S. job report was quite strong with employment up fairly strongly according to both the payroll and household surveys. Meanwhile hours worked and hourly earnings also posted significant gains.

This was interpreted by the bond market as a sign that the danger is over with regards to the U.S. economy and that the risks of a recession is diminishing. However, this overlooks that the job market is completely worthless as a leading indicator. It is in fact not even a good coincident indicator. Instead it is a lagging indicator of economic strength.

If you look at data from the Bureau of Labor Statistics, you can see that employment continued to rise during by on average more than 100,000 per month during the second half of 2000, even though GDP growth turned negative in the third quarter. By contrast, job growth remained weak -indeed negative according to the payroll survye- some two years after the 2000-2001 recession ended.

Instead this report indicates that corporate profits -which is a leading indicator of economic activity- probably fell during the first quarter for domestic nonfinancial companies as the 1.5% increase in hours worked indicate that productivity growth was probably near zero. And with wages posting strong gains, this implies a significant increase in unit labor costs. Which in turn is likely to indicate falling profits.

Thursday, April 05, 2007

China-The World's Largest Foreign Aid Donor

Today, the Chinese government, for the sixth time in just 10 months decided to raise reserve requirements by 0.5%:points, to 10.5%. If they keep this up, fractional reserve banking will be ended in China by 2033!

Seriously though, that is of course not likely to happen. The background for this policy action is one that I've explained to regular readers of this blog repeatedly. Namely, that China's irrational decision to keep the yuan grossly undervalued requires it to amass such enormous amounts of foreign exchange reserves that creates massive excess liquidity.

The natural response to this problem would of course be to stop accumulating more foreign exchange reserves and so allow the yuan to appreciate in value. This would solve the problem and reduce both monetary inflation and price inflation, while at the same time reducing both the risk of and the vulnerability in case of more protectionist measures from America or the EU. The traditional counterargument is that it would cost Chinese jobs, at least in the short-term, but that is no different from the effects of for example increased reserve requirements.

Thus, it would produce only advantages with no negative sideeffects at all for China to allow a significant yuan appreciation. Which makes it really puzzling to me why the Chinese government won't do it. Interestingly, many China-haters are also calling for a massive yuan appreciation, even though it would strengthen China.

China's irrational monetary policy mix is in fact in effect a massive foreign aid program. If China decided to reduce excess money supply growth by the more effective mean of yuan appreciation it would not in fact reduce output even in the short-term, it would only shift it from the export sector to domestic sectors. Meanwhile, it would significantly reduce its cost of imports and so in effect increase its terms of trade. A 10% increase in the value of the yuan compensated by less of the clumpsy tightening measures currently used would directly reduce the cost of imports by the equivalent of $60-70 billion, while not reducing nominal output. The fact that the Chinese uses their current approach thus in effect constitutes a $60-70 billion foreign aid program.

But the total implicit foreign aid cost is actually more than that. Both becuase the yuan is likely undervalued by a lot more than 10%. So just looking at trade directly, we're talking about more than $100 billion a year. And also, because the undervalued currency are achieved by investing in foreign assets denominated in currencies which eventually will fall in value, China are in effect giving away a lot of their export revenues. Assuming the very modest estimate (It will likely be even more) of $300 billion in additional foreign exchange reserve accumulation and assuming a 20% undervaluation of the yuan, we're talking at least $60 billion of Chinese export revenues in effect being given away. All in all, China's currency policy probably cost the country at least $160 billion, probably more like $200 billion per year.

Being a beneficiary of China's foreign aid program myself, I'm not really complaining. But I can't help being puzzled as to why the Chinese government would want to squander so much of the poor citizen's hard earned earnings and give it away to wealthy Westerners.

It might be that they're just as confused as China-bashers like Charles Schumer and don't understand the absurdity of their policy. Because of the structural strengths of the Chinese economy, the well being of their citizens are growing rapidly despite the governments' irrational policies. However, as their policy leaves them overly dependent on exports to the U.S., Charles Schumer and his friends could get turn out slowing the Chinese economy a lot more than what the Chinese government is comfortable with, when China inevitably gets blamed in Congress for the likely coming U.S. recession. At that point, the foolishness of China's monetary policy will be so apparent that not even the Chinese leaders will be able to ignore it.

Wednesday, April 04, 2007

ISM Indexes Confirm Stagflation Scenario

While the suprising release of the 15 British hostages kidnapped by Iran will push down oil prices somewhat and so increase growth somewhat and lower inflation slightly, other news seem to confirm the stagflation scenario. Of particular interest are the ISM indexes over economic activity. The ISM manufacturing index released monday showed a drop in the overall index from 52.3 to 50.9 and the key new orders component dropping to 51.6 from 54.9. However, the prices paid component showed a rise from 59.0 to 65.5. Similarly, the non-manufacturing index showed a decline in the overall index to 52.4 from 54.3, with the key new orders index falling from 54.8 to 52.8. However, the prices paid component rose from 53.8 to 63.3.

Factory orders data also indicated weakness. Job growth according to the private ADP survey was a bit firmer, but it is well known that employment is a lagging indicator. Meanwhile, a leading lender of subprime mortgages have gone into bankruptcy.