Friday, December 28, 2007

Wasn't Rising Prices Supposed to be Good For Japan?

For a long time, we've been hearing how Japan supposedly "suffers" from deflation. As you may remember, less than 3 months ago, some Financial Times journalists declared it bo very bad that the Japanese would get cheaper mobile phone calls and declared that it would "push Japan into deflation". I pointed out that this was not a problem because first of all deflation caused by increased supply is a good thing and secondly, deflation would soon be ended in Japan because of rising oil prices.

I was right, of course. Consumer prices in Japan was up 0.6% in the year to November. While that is a lot less than the 4.3% in U.S. and the 3.1% in the Euro area, that represents a significant increase and it alsos represents an end to deflation. So, according to the ignorant Financial Times journalists, this must have represented a boost to the Japanese economy. But as a matter of fact, it didn't as it meant a reduction in purchasing power and therefore consumer spending (The Japanese consumers aren't as keen as American consumers to increase spending even when their income falls.).

Thursday, December 27, 2007

Flight to Safety-Flight From the Dollar

As most of you have probably already heard, former Pakistani Prime Minister Benazir Bhutto has been assassinated. This was probably the work of jihadists, judging not only from the fact that the assassin committed suicide immediately after he had killed her, but also by the fact that this will leave them as the only real alternative to the present dictator, Musharraf. A jihadist takeover of Pakistan would be troublesome for many reasons, not least because that would mean that jihadists would control nuclear weapons. However, for that to happen, Musharraf would have to be killed to, and that have still not happened.

One interesting economic aspect of this is the fact that the "flight to safety" move in the currency markets, did not involve a flight to the U.S. dollar. Quite to the contrary, this news intensified the dollar sell-off triggered by weak U.S. economic data. This is yet another sign that the U.S. dollar is losing its safe have status-with gold, the euro, the swiss franc and the yen instead serving that role.

Wednesday, December 26, 2007

High Taxes Drive Talent Away From Denmark

Interesting article in the New York Times about how Denmark's high taxes drive away talent from the country, a factor contributing to the fact that Denmark's growth rate is the lowest in Europe. The 3.5% rate for 2006 they refer to was the result of a temporary cyclical peak caused by Denmark's housing bubble. The fact that this bubble has started to burst is of course the second reason for Denmark's underperformance.

Tuesday, December 25, 2007

Environmentalism Creating Misery

Interesting column in The Tennessean by Phil Valentine about how environmentalists are working for misery and therefore in some sense reminds him of Atlas Shrugged villains. He relates this to the latest energy bill, passed by the U.S Congress, which will ban incandescent lightbulbs by 2012 and by 2020 ban vehicles (including SUVs, pickups and minivans) which have a fuel economy of less than 35 miles per gallon (14 kilometer per liter), and also mandate a fivefold increase in the use of ethanol.

Here's the money quote:

"While we marvel at our advanced civilization, they cram into their hybrids to go lobby Congress, all the while claiming to be "progressive.'' News flash: Dimmer lights and less-safe automobiles are not progress."

Sunday, December 23, 2007

Foreign Aid Reduces Poverty!

And to think some of us actually argued that foreign aid does not reduce poverty! Boy, was I wrong about that. We can now read how Uganda's president Moseveni will buy a new £24 million (€34 million, $48 million) Gulfstream presidential jet.

Now that poverty victim will no longer have to put up with the £16m aircraft he bought just 7 years ago. Here is a direct, concrete example of how foreign aid successfully reduces poverty! You'd have to be Scrooge to deny him that.....

In a related breakthrough in economics, the U.K. Department for International Development vehemently denies that the £700 million of British taxpayer's money that they donate to Uganda goes to paying for the jet. I quote:

"All UK aid that goes directly to the Ugandan government is for poverty reduction purposes and supports the national poverty eradication action plan. It is accounted for by the ministry of finance and the Bank of Uganda and donors actively review these accounts."

Many people would of course argue that money is fungible. If someone gives me the money for the purpose of paying the rent, then I can use the rest of my income for other purposes. Similarly, if the government of Uganda receives British money for paying for schools or whatever, this gives the Ugandian government more money for buying Gulfstream II jets. But if the of course highly competent staff hired by the British government says otherwise, then that can't be true anymore.....

Saturday, December 22, 2007

U.K. "Twin" Deficits Grow

The link between budget deficits and current account deficits is a highly disputed topic. The truth on this matter is that they are related. Not in the sense that budget balances are the only thing affecting current account balances, or even that a change in the budget deficit will ceteris paribus affect the current account balance equally. Instead it is true in the sense that an increase in the budget deficit will simply make the current account deficit larger than it otherwise would have been. How much larger depends on the circumstances and so differ between different countries and different periods of time, but it is probably usually something like a 20 to 40 cent increase in the current account deficit for every $1 increase in the budget deficit.

So, while being related, these two deficits aren't identical twins. Indeed, they're arguably not even fraternal twins, but more like half siblings. Half siblings reared in different environments, as there is one key economic factor which moves them in opposite directíon: the business cycle. An inflationary boom tends to reduce the budget deficit, while increasing the current account deficit. It is therefore rare to see them move empirically in the same direction.

However, sometimes we do see that. That is usually during times of moderate growth when the budget deficit increases. This is what we saw in America 2002-2004 and this is what we see now in Britain.

The budget deficit in Britain have so far this budget year (April-November) been £36.2 billion, up from £26.0 billion the same period last year. Thus we have seen an average monthly increase of £1.3 billion compared to last year. As a result, the forecast from The Economist's Intelligence Unit of a budget deficit of 3.1% of GDP looks set to be exceeded. And even that forecast would have made Britain's deficit the largest in the G7, even larger than in Japan, Italy and France.

At the same time, Britain's current account deficit is reaching new highs,with the third quarter deficit rising to £20.0 billion, 5.7% of GDP. Britain's deficit thus actually exceeded America's deficit as a share of GDP during the third quarter. The increase in the current account deficit reflect in part the increase in the budget deficit but also an overvalued pound.

With expanding "twin" deficits and a weakening economy, the pound seems likely to be one of the weaker currencies in the near future, along with the U.S. and Canadian dollars.

Q4 U.S. GDP Looks Stronger-But at the Expense of 2008

The probability of negative GDP growth during this quarter in America fell significantly today after the release on personal consumption expenditures in November. I had expected it to stay flat or even fall considering the decline in real income caused by the sharp increase in oil prices. Instead it rose significantly, 0.5%, and the September and October numbers were both upwardly revised. Although December consumption looks likely to fall for reasons which shall be discussed later, this still means that personal consumption will rise for the quarter. Indeed, assuming no revisions and a complete reversal of the November gain in December, that still implies 2.2% spending growth.

Although residential investments will continue to fall sharply, and business investments likely to fall too while inventories and trade looks likely to be negative, it is dubious whether it will really be enough to pull growth below zero. It seems unlikely on a volume basis and less likely than before even on a terms of trade adjusted basis, although that can still not be ruled out.

What was really remarkable about this 0.5% increase is that it happened at the same time as real disposable income fell 0.3%. And in October real consumption increased 0.1% even as real disposable income fell 0.1%. As a result, the household savings rate fell from 0.5% in September to -0.5% in November.

While this dramatic decline in savings will boost fourth quarter GDP, it represents a dramatic deterioration of the fundamentals of the economy. As long as asset prices rise, a negative savings rate may appear sustainable. But in reality it only is so if the rise in asset prices is due to high level of retained earnings as retained earnings represent a rise in the underlying value of the assets.

But to the extent higher asset prices simply reflect asset price inflation, it does not imply any addition in real wealth but only a reduction in the purchasing power of the dollar. And while retained earnings are still positive, they have decline dramatically in recent quarters due to a combination of falling profits and increase in both stock repurchases and dividends. And in any event, asset prices aren't rising that much anymore. Bond prices have soared, but stock prices have stalled after their previous gain (which still mean they are more overvalued as profits have fallen) and house prices have fallen.

In short, the negative savings rate simply isn't sustainable. That means that consumer spending will have to fall in the coming months. This in turn implies that while the probability of negative growth for the fourth quarter have fallen significantly, this makes negative growth in the first quarter of 2008 appear even more certain.

Most early indicators for December, including regional surveys from Chicago, New York, Philadelphia and Richmond, reports on retail sales and jobless claims indicate that the economy is indeed weakening already in December.

Tuesday, December 18, 2007

Good Review of U.S. Economic Numbers

Paul Kasriel, director of Economic Research at Northern Trust, has an excellent and well-written review of the U.S. economic situation and the key statistics describing it. Read it here.

Commodity Price Boom Alive And Well

In my previous post, where I argued against Nouriel Roubini's views on monetary policy, I pointed out that his belief that commodity prices would fall and so lower consumer price inflation is wrong for several reasons.

First because we are in a structural commodity price boom, as Jim Rogers pointed out in his book Hot Commodities which I reviewed here. Second, there are reasons to believe that the U.S. crisis won't spread as much as Roubini thinks. And third, while some highly cyclical commodities may fall, there are many noncyclical commodities which will continue to rise.

The most cyclical commodities are of course industrial metals, such as nickel, zink and copper. They have in fact already started to fall, even in U.S. dollar terms and even more so in terms of other currencies.

However, some commodities are not cyclical. This includes gold, but also agricultural commodities, such as wheat, corn and coffee.

And these noncyclical commodities have continued to rise in value. The Economist's commodity price index is up 1.2% in the latest month and 15.6% in the latest year. If you disaggregate this number you see some interesting details. While industrial metals is down 9.4% in the latest month and 12% in the latest year, food commodities is up 8.8% in the latest month and 38.8% in the latest year.

Now we see wheat reaching an all time high of $10 per bushel(a bushel is 35 liter) while soybeans and corn also reached new highs. So, the U.S. recession will not end the commodity price boom nor solve the problem of inflation. Instead, we're facing stagflation, a concept which may be difficult to accept for Keynesians like Roubini but is nevertheless very real.

Sunday, December 16, 2007

Why Rate Cuts Are Definitely Not Justified

In his latest blog post, Nouriel Roubini argues the case for agressive interest rate cuts. I of course, completely disagree with that and think interest rates should be raised, particularly in America but also in most other countries. Roubini's post is mostly centered around replying to three valid arguments against rate cuts, namely:

a) such monetary easing will not prevent a hard landing and will only postpone the necessary restructuring after a reckless credit-boom driven asset bubble;

b) it will cause moral hazard and possibly create future bubbles;

c) it may lead to higher inflation.

I will comment on and respond to his replies to these arguments.

His reply to the first argument is that while a recession may be unavoidable, agressive rate cuts can reduce the severity and length of it and that is the right thing to do to avoid inflicting unnecessary pain on Main Street.

But this overlooks that first of all, the claim that monetary policy easing can reduce the severity of a recession is overrated. Perhaps the short-term effect is still positive, but the effect is very small as such move tends to boost the price of oil and other commodities and so reduce the purchasing power of Americans.

Secondly, Roubini does not even adress the point of necessary restructuring. The underlying problem is the overvalued asset prices and the insufficient savings of Americans caused by 20 years of inflationary monetary policies by Greenspan and Bernanke. By giving the American economy more of the same, we will see a long period of stagnation and/or more recessions.

With regard to the second argument, Roubini asserts that investors are already punished as it is and so moral hazard is not a problem.

But that argument does not hold simply because the losses are much smaller than they otherwise would have been. And with the gains sharply boosted during the boom while limited during the bust, it becomes rational for investors to create asset price bubbles, even though it is damaging to the economy.

Roubini then tries to deny that his policy would create more bubbles using two arguments. The first is that he advocates a symmetric approach to asset price bubbles, that is tightening policy during the boom as well as easing during the bust, new bubbles wouldn't be created. But that doen't change the fact that as long as central banks accomodates bubbles during the boom phase, which is what we've seen now and is likely to continue to see, policy would be very assymetric if the Fed cuts rates now and so create more problems.

The second argument is to try to minimize the role of monetary policy in creating the problem. I've already dealt with that argument when being made by Alan Greenspan and Sebastian Dullen so I won't repeat it again.

With regard to the third issue, inflation, Roubini admits that inflationary pressures are "elevated" right now, a statement of the all too obvious with the CPI up 4.3% and the PPI up 7.2% during the latest 12 months, but he argues that inflationary pressures will "fizzle away in short order once the US hard landing is in full swing".

This argument seem mostly based on his Keynesian notion of aggregate demand determining inflation as well on his belief that the U.S. recession will produce a global economic downturn which in turn will reduce commodity prices.

The Keynesian aggregate demand notion is of course complete B.S. as it does not explain the phenonema of stagflation, which is what we're seeing now.

As for the global effects, while the U.S. recession and the fear factor will certainly reduce growth in other countries, it will certainly not be enough to end the commodity price boom and turn it into a bust, especially since many commodities are noncyclical. China, the most important commodity consumer, still struggles to contain rampant inflation and will so easily be able to maintain growth in demand by simply abstaining from further increases in interest rates and reserve requirements.

So, contrary to Roubini, more of the thing that caused today's problem of excess debt, inflation and falling production will only produce more of excess debt, inflation and falling production.

Saturday, December 15, 2007

TIPS Yielding Higher Than Other Bonds

I have long argued that if -a very big if, since I really don't think you should- you feel you must invest in U.S. government securities then you should choose the TIPS, the treasury inflation-protected security which gives you a pre-determined real yield plus compensation for inflation, and recently I pointed out how the unbelievably low yield spread between the TIPS and regular bonds provided an arbitrage opportunity. That spread is only about 2.3%:points, meaning that inflation only has to be 2.4% to make it more profitable to own TIPS and inflation has to be as low as 2.2% in order for regular bonds to be more profitable. With the historical average inflation rate being 3% and the most recent inflation number 4.3% and with the Fed doing everything it can to increase inflation further, TIPS is a certain winner compared to regular bonds.

It is a mystery why the yield spread is so low. This is a clear example of markets behaving irrationally. That people who invest in the U.S. bond market are irrational is not really new either. As pointed out in this speech by William Dulley, it has historically been the case that bond investors have underestimated future inflation. He points to studies that show that the government's cost for TIPS has been much higher than its cost for other bonds. The mirror image of the higher cost for the government is that TIPS have given investors much higher return than other bonds.

Dulley however tries to dismiss the notion that TIPS will provide higher return for investors in the future too by saying that most economists share bond investors low inflation forecasts. But since those economists didn't predict the high inflation numbers that we've seen in recent years, why should we trust them now? All this shows is how incompetent most economists are as forecasters

Another implication of this is that the TIPS-regular bond yield spread is not a reliable guide of inflationary pressures.

Friday, December 14, 2007

Did Industrial Production Rise or Fall?

Financial web sites tell us the seemingly bullish news that industrial production rose in November compared to October. That it did, but only compared to the revised October figure. If you look at the actual report, you can see that reported industrial production in November was actually 0.1% lower than the initially reported October figure (113.9 vs 114.0 in initially reported October number). Industrial production is also 0.2% lower than 4 months earlier.

Finance Madness

Kevin Duffy has a great and hilarious article on that I recommend. It discusses the madness of countless deserving targets, including Ben Bernanke, Alan Greenspan, certain fund managers like Ron Insana, Warren Buffet, Larry Kudlow and last but not least, Jim Cramer whose show "Mad Money" certainly has an appropriate name.

After reviewing these madmen of finance, Duffy makes this conclusion:

"Beam me up, Scotty. There are still no signs of intelligent life."

Worse Than That

Paul Krugman describes Alan Greenspan as being:

"like a man who suggests leaving the barn door ajar, and then - after the horse is gone - delivers a lecture on the importance of keeping your animals properly locked up."

Actually that's not really an accurate description of Greenspan. Greenspan has been much worse than that. A more accurate description would be that Greenspan is like a man who explains to people the importance of keeping the animals locked up in order to avoid having the animals running away, only to proceed to open the door of the barn and then after the horse is gone tell everyone that the fact that he opened the door had nothing to do with the loss of the horse.

Thursday, December 13, 2007

Inflationary Wild Fire in America

Now even official government statistics starts to display the inflationary tidal wave in America. The import price index rose 2.7% in November 2007 from October 2007 and 11.4% from November 2006 while the producer price index rose 3.2% from the previous month and 7.2% from 12 months earlier. That the sharp increase in import prices does not merely reflect deteriorating terms of trade but is also reflecting general inflation is illustrated by the fact that export prices rose 0.9% from the month before and 6.1% from 12 months before.

The consumer price index that will be released tomorrow will probably rise a lot less than 3.2% on a monthly basis, but it also seems likely to rise a lot more than the 0.6% estimate of most analysts.

So, at a time when inflationary pressures are getting worse and worse, what does the Federal Reserve and "Helicopter Bernanke" do? They take more measures to increase the already abundant liquidity, including interest rate cuts, ensuring continued debasement of the dollar. That is why I think everyone who can should get out of the dollar ASAP. That currency is going to hell in a hand basket.

Wednesday, December 12, 2007

Japanese Current Account Surplus Soars-Again

Again illustrating how undervalued the Japanese yen is the latest statistics showing how the Japanese current account surplus soared 46% to ¥ 2.22 trillion in October ( roughly $20 billion or €13.5 billion). This despite the sharp increase in oil prices. All 4 mayor economies of the world, the U.S., Japan, China and Germany has all seen their trade surpluses increase dramatically or decrease significantly compared to last year. But the sharp increase in oil prices meant that for the U.S., China and Germany, the improvement dramatically slowed in October. In Japan, however, the surplus continues to grow rapidly.

This is a result of how the structurally lower price inflation in Japan have meant in combination with a falling yen that the real exchange rate of the yen has fallen dramatically. The yen is still 10% lower against the U.S. dollar than in early 2000. And during that time cumulative price inflation have been some 25% higher in America than in Japan. At least. And the real depreciation against the euro has been even greater. Meanwhile, as Japan have had price deflation and as loan demand has been weak, monetary conditions in Japan have been relatively tight, holding back domestic demand.

The result is that the Japanese current account surplus is at a record high, both in absolute terms and as a share of GDP or GNP. The main reason why this haven't started the same kind of political outcry in America as in the 1980's is that most Americans are focused on that other, younger, demographically 10 times bigger and more rapidly growing "Yellow peril", China.

Tuesday, December 11, 2007

Swedish Inflation Rises Sharply

As was predicted by me, but few other analysts, Swedish inflation rose sharply in November. There are several different gauges of inflation in Sweden. The traditional Swedish measure rose from 2.7% to 3.3%,the EU-harmonized index rose from 1.9% to 2.4% and the Swedish version of core inflation (excluding interest rates and taxes, instead of food and energy) rose from 1.4% to 1.9%. Although they differ in level, they are all in a clear upward trend.

The analysts who failed to predict this now tries to explain this with the global trend of higher food and energy prices. There is some truth to that, but what they miss is that in the absense of significant monetary inflation the price of food and energy in terms of Swedish kronor would have risen a lot less. And other prices would have been lower. Another very important reason for the rise in inflation is a lagged effect of the significant monetary expansion that started in the second half of 2005. Until now, the effect of this was mostly seen in asset prices. But ultimately some of it will spill over into consumer prices, a trend accelerated as the previous disinflationary factors are losing strength and being replaced by factors helping to push up goods prices, such as the global commodity price boom and high union wage settlements. This trend will probably continue and help push Swedish consumer price inflation even higher.

Sunday, December 09, 2007

Of Course the Fed Did It

That the Federal Reserve caused the housing bubble seems like a statement of the obvious to me and really anyone with even superficial understanding of sound economics. I've already discussed the denial of Alan Greenspan, a man with an obvious personal interest in denying it.

Sebastian Dullen of Europe EconoMonitor may not like Greenspan have a personal interest in denying the role of the Fed, so presumably his denial is based on lack of understanding of sound economics. He advances somewhat different arguments than Greenspan, yet his arguments if anything makes even less sense.

His first argument is a repetition of Fed governor Frederic Mishkin's absurd argument that high interest rates encourages risky investments. The idea, it seems, is that by
making it more expensive to borrow, only risky investments will provide sufficiently high return to make it worthwhile, and so risky investments will increase.

Yet that makes no sense at all. Making it more expensive to borrow will reduce lending growth overall and not shift in any particular direction in terms of low and high risk. The risk in risky investments is a perceived cost for investors, for which they demand compensation. Therefore, they will not consider high risk investments more attractive just because the cost of borrowing is high. The level of risk free interest rates have really nothing to do with this at all. Instead, the effect of higher interest rates will simply be to reduce investments in general, and investment projects with a pay off far into the future in particular. But there is no reason to believe it will cause any shift in investments of different risk levels.

He further argues that the 1983-1986 housing boom is an example of a housing boom under tight monetary conditions. Which is completely misleading. Paul Volcker's monetary tightning was in 1980-82, and the housing boom followed after he implemented dramatic interest rate cuts in 1982. The housing boom followed just after that, with an increase in residential investments of 41.4% in 1983. That year, the MZM measure of money supply rose a full 24.8%, confirming the theory that looser monetary policies creates housing bubbles.

He then argues that the stock market bubble of the late 1920s is another example of a bubble supposedly not caused by the central bank. Which is complete nonsens as the 1920s had a significant monetary expansion, as Murray Rothbard showed in his book America's Great Depression. Dullen argues that real interest rates were high in America in the late 1920s, so monetary policy couldn't be loose. Yet the high real interest rates reflected structural factors related to the positive supply shock to production and profits. The fact remains that real interest rates were lower than they otherwise would have been due to Fed policy.

Saturday, December 08, 2007

Job Report Much Weaker Than It Seems

The employment report supposedly showed according to some commentators that the expansion is continuing, albeit at a more moderate pace, with the payroll survey showing a 94,000 increase in jobs. The household survey reported extremely fast job growth, but this survey is extremely erratic and unreliable with regard to monthly changes. The more reliable year over year change also picked up, but it is still a lot lower than the payroll survey annual increase and it seems likely to drop sharply next month. The truth however, is that the 94,000 number greatly overstate employment growth, particularly private sector employment growth.

Of the 94,000 new jobs, some 30,000 was government jobs, meaning that private sector employment growth was a weak 64,000. However, even this assumes that a lot more new jobs were created in new businesses than destroyed in bankruptcies. These assumptions of the so-called "birth/death model" were made based on conditions in the height of the housing bubble and no adjustments have been made for the fact that the economy has turned down. During the latest year, some 1,128 million new jobs have simply been assumed and not derived from the data. That is a full 92 of private sector employment growth the latest 12 months (As government isn't started or ended, the model only applies to the private sector).
Thus while actually reported private sector employment growth have nearly disappeared and fallen to a mere 98,000 for the latest 12 months, job creation through the start and death of new businesses are assumed to be constant.

Even in the badly hit construction sector, some 140,000 new jobs are simply assumed. As it would be more natural to assume that more businesses have been knocked out than started in the construction sector, this illustrates the misleading nature of the "birth/death model" during cyclical downturns such as the current one.

Many who criticize the "birth/death model" make the mistake of comparing the monthly number to the monthly payroll number. But that is misleading as the monthly "birth/death" is not seasonally adjusted, while the payroll number is. It is more fair to instead derive the seasonally adjusted "birth/death" number by taking the average adjustment of the latest 12 months, which is to say 94,000 (1,128,000/12).

If you then make the reasonable assumption that net job creation through new and ended businesses has developed the same way as actually reported job creation, this means that we can basically zero job creation through that process. Subtract then from the 64,000 number the 94,000 simply assumed jobs, and we get a private sector job loss of 30,000. Even counting in government jobs, and job creation was zero.

A stagnant to negative number is more consistent with the various other indicators of the job market, including the ISM employment indicator, the jobless claim numbers and most importantly, the sharp downturn in tax revenue growth.

Friday, December 07, 2007

Bush Bailout Plan Will Only Create More Problems

As most of you have probably already heard, Bush has proposed a new plan to supposedly save the U.S. housing market. The plan is that mortgage lenders will "voluntarily"(Which is to say, under the threat of legislation if they don't agree to it) freeze interest rates which were supposed to rise in coming months from the initial low "teaser" interest rates. My old friend Antony Mueller comments this plan with the words

"A plan that could have equally come out of the head of Chavez"

That is perhaps a slight exaggeration as [Hugo] Chavez would have probably proposed even more radical bailouts, and America's own "wanna be Chavez", Hillary Clinton, have indeed proposed even more radical measures, including a temporary ban on foreclosures. Yet certainly the Bush plan is still in the spirit of Chavez.

Notwithstanding me and Antony Mueller, almost everyone ,including the stock market, seems to think that this will somehow save the U.S. housing market.

However, it won't. There are several reasons for this. First of all, even if this is universally implemented and they somehow manage to neutralize law suits from bond holders who lose from this, it will only mean status quo. The deterioration in the housing market that we've seen so far occurred with those lower rates that will stay unchanged. This only means that the problems of sub-prime borrowers won't get worse still, not that they will decrease.

Second, the value of the loans for bond holders and others who have financed these mortgages were based on the assumption that these subprime borrowers would pay higher interest rates. If they don't, then the value of these holdings must be written down significantly-at least assuming honest accounting is used. And whether or not honest accounting will be used, this will impose significant losses for the lenders.

Proponents of the plan, like Nouriel Roubini, answer this argument by saying that the plan will limit defaults, and rising defaults would have also inflicted losses on the investors, losses that according to Roubini is higher than the losses from the lower interest rates. Yet Roubini merely asserts this without providing any statistical evidence of this claim. The same thing goes with his other assertion that the plan bails out people who are merely illiquid rather than insolvent. The massive increase in debt levels that I discussed in the previous post directly contradicts this claim. And as Roubini himself concedes, bailing out insolvent borrowers only postpones the problem of defaults.

Moreover, even if it were true that the losses would have been even greater assuming the plan hadn't been implemented, then it still remain the case that the value of these holdings is much lower than its current book values, meaning that there is a need for massive write downs.

And while perhaps the plan will limit the decline in the housing market in the short term, the long term consequences will be very negative as this first of all slows down the adjustment to a more sustainable level of house prices and construction activity. Moreover, it will encourage irresponsible borrowing and so create more problems in the future as people learn that politicians will bail them out if. The plan will thus in the long term create a lot more problems than it solves.

Flow of Funds Report Show Record Burden of Debt

The latest flow of funds report show a record level of debt burden. Private sector debt rose to a record 168.2% of GDP, up from an upwardly revised 166.4% the previous quarter, 135.5% in the fourth quarter of 2000 and 98% in 1980. Both household debt and business debt increased faster than GDP, but business debt is now increasing faster.

Even mortgage debt is actually increasing, and increasing faster than GDP (rising from 74.3% to 74.5%) as well as disposable income (rising from 101.3% to 101.4%) reaching new all time highs relative to both. Although housing values strangely increased slightly according to this, mortgage debt relative to housing value increased from 48,9% to 49,6%.

While household debt increased in both absolute and relative terms, business debt increased much faster, and rose from 69,0% of GDP to a record 70.2%. The reason for this surge in lending is a significant decline in the financial savings rate of companies, particularly nonfinancial companies. Undistributed profits -Net profits minus paid dividends- of nonfinancial companies fell from $259.1 billion to $232.1 billion, leaving it at less than half of its 2005 peak. At the same time, business investments increased to new highs in absolute terms. All of this have financed by sharp increases in debt.

All of this confirms what I've been saying all along: the so-called "credit crunch" is a hoax with regard to the overall financial system. The "credit crunch" is only applicable to a limited number of financial instruments, something which is more than compensated by the fact that bank lending is soaring, increasing by 5% between August 1 and November 21, which corresponds to an annual rate of 17%.

U.S. Budget Deficit Increasing Again

Confirming the view that the U.S. has dipped into a recession is the latest budget numbers from the Congressional Budget Office. These numbers are preliminary and is often revised, but the final numbers usually differ by only little, and can differ both ways so it is meaningful to look at them. The numbers show that during the first two months of fiscal year 2008 i.e. October-November 2007 the budget deficit increased by $35 billion from $157 billion to $192 billion.

Some of this increase reflects calender effects as December 1 fell on a weekend this year, meaning that payments that last year were made in December were now made in November. However, it should be noted that the effect this had in temporarily boosting spending were also reflected in a boost to revenues, so the net effect of adjusting for this isn't as big as the $17 billion effect on spending the CBO refers to.

Revenues for the first two months rose less than 5% in nominal terms before adjusting for the aforementioned calendar effects. The November reveneus actually only rose 3% before adjusting for the calendar effect. So particularly for November, tax revenues adjusted for calendar effects and inflation are in fact falling.

Corporate tax revenues are falling particularly fast, indicating a significant decline in corporate profits.

Thursday, December 06, 2007

Singapore Lures Japanese Hedge Funds

Another interesting Bloomberg News article, this one about how Japanese hedge fund managers are lured to Singapore. While Singapore registered 78 new hedge funds last year, Japan only saw 3 new hedge funds. This is despite the fact that Japan has 28 times more people.

The reason? Japanese taxation of hedge funds is 4 times higher than Singapore's and Japan also has much more burdensome regulation.

Split in ECB Council?

Interesting Bloomberg News article about how the ECB council is likely split between hawks and doves who want to change interest rates in opposite ways. Spaniard Jose Manuel Gonzalez-Paramo has publicly hinted relatively imminent rate cuts, while German (of course) Axel Weber has argued for rate increases. Most likely, the board is split between members from countries that traditionally had inflationary monetary policies, such as France, Italy and Spain and countries that have had relative hard money policies such as Germany and Holland.

This likely means that the compromise of keeping interest rates on hold will be kept in place indefinitely until either the global financial distress disappears or inflation falls back significantly. Neither of which is likely in the coming 6 months, and probably even longer.

Wednesday, December 05, 2007

More on Ron Paul's Campaign For Gold

As I've written before, my favorite politician Ron Paul is unfortunately not likely to win, but his campaign will nevertheless help make the world a better place by spreading the message of Austrian economics and the case against the Federal Reserve.

The attention around this have now prompted even left-leaning the New Republic to publish an interesting article written by Alvaro Vargas Llosa laying out the case against the Fed. The article is illustrated by a big picture of Ron Paul.

Here is an interestering quote from Paul from an interview in Business Week:

"-Who are your economic advisers?

-I don't have any. I read Austrian economics, which I've been doing for 30 years. So my advisers have been [von] Mises and Hayek and Sennholz. "

Tuesday, December 04, 2007

The Rise And Fall of the Canadian Dollar

Bank of Canada, which controls the monetary policy of the world's sixth largest currency zone (After the U.S., the Euro area, Japan, China and Britain) cut interest rates by a quarter per cent today. The stated motive was "global financial difficulties" related to the U.S. subprime mortgage crisis as well as lower than forecasted inflation.

However, the reason for the downturn in inflation was the dramatic appreciation of the Canadian dollar against the U.S. dollar until just recently. That not only made energy prices rise a lot less than in the U.S., but also put strong pressure on Canadian retailers to lower prices as customers threaten to shop south of the border or at least expressed anger over the failure to cut prices. As a result, consumer price inflation have risen a lot less than in the U.S. and so-called core inflation actually fell in October.

However, these gains are now threatened by the fact that much of the Canadian dollar's gains have been reversed. While the euro, the yuan and the yen is near their 2007 highs versus the U.S. dollar, the Canadian dollar have lost 10% against the U.S. dollar in the latest 4 weeks (including today's decline). This threatens to again push up inflation nearer the U.S. levels. As this decline is partly related to today's cut (The oil price correction is another key factor behind the decline in the Canadian dollar), this ironically means that the Bank of Canada by pursuing this cut at the same time swept away one of the justifications of the move.

An unofficial reason for the move was complaints from exporters that the Canadian dollar had become too strong, a strength which can be removed by interest rate cuts.

The Canadian dollar's strength was driven in part by the factor which has caused the U.S. dollar to fall against nearly all other currencies and in part because of the rising price of oil, a key Canadian export. At the same time, currency markets overlooked the negative effect of the U.S. recession on Canada's non-oil exports. Now as there has been a small oil price correction and as Bank of Canada in a bid to save non-oil exporters have cut interest rates, it is only logical that most of the Canadian dollar's gain have been wiped out.

I am fairly bearish on the Canadian dollar in the future too, at least relative to other currencies than the U.S. dollar. While I believe oil will soon recover from the correction of the latest week and that this will provide support for the Canadian dollar, the weakness of the U.S. economy will create strong downward pressure on it. Some 80% of Canada's exports and 25% of its GDP is exported to the U.S., and most of that is non-petroleum. Canada's non-petroleum exports will probably be hit hard by the U.S. recession. And Bank of Canada will probably continue to cut rates so that Canada's exports aren't also hurt by an increase in the Canadian dollar's value versus the U.S. dollar. Therefore, the Canadian dollar will probably be as weak or at least nearly as weak as its U.S. counterpart.

Pär Nuder Agress With Me-Sort Of

Well, at least he agrees with me with regard to my forecast that inflation will rise in Sweden and that the Riksbank will have to raise interest rates even more. This in an article in Dagens Nyheter today.

The rest of his article is pretty much standard Social Democratic nonsense. He makes for example the false claim that productivity growth in Sweden is negative. Yet if you adjust GDP and so productivity numbers for the improvement in terms of trade then productivity growth is in fact positive. Moreover, the reduction of productivity growth is a statistical illusion in another sense as well. As employment has increased particularly much in low productivity sectors this have statistically lowered productivity without lowering productivity in any real sense for existing workers. Contrary to what he claims, that adds value to the Swedish economy.

He also falsely claim that the Swedish government's alleged tax cuts of SEK 65 billion is responsible for higher inflation. Not true, as first of all the net tax cuts are a lot smaller than that because other taxes have been raised and as government spending has been reduced and so there have not been any significant boost to demand through the budget. Moreover, as the tax cuts have boosted supply, the effect on price inflation from the government's policies is likely negative.

It is not the Swedish government, but the Riksbank who should be blamed for inflation. It held interest rates too low in the past -to a lesser extent it still do- and have so allowed money supply growth to reach double digit levels, a factor which have now started to reflect itself in rising consumer prices.

Sunday, December 02, 2007

Why the U.S. Recession is Already Here

This week, we were overwhelmed with statistics, including the Chicago PMI, the Beige book, durable goods orders, corporate profits, new and existing home sales, construction spending, consumer confidence, personal income and spending and jobless claims. And with the exception of the Chicago PMI who historically have often moved in a erratic way, all of these indicators indicated that the U.S. is already in a recession with negative growth. At least properly measured on a terms of trade adjusted basis, but probably also in the standard volume terms.

Just consider the various components of GDP:

-Residential investments: News on housing indicated that the downturn in the housing sector continues. Residential construction spending had another sharp downturn in October. The very low numbers of new and existing home sales indicate that this downturn is likely to continue in November and December. This means another big negative number in residential investments.

-Business investments: The input for equipment and software investments, shipments of non-defense non-aircraft durable goods orders fell in October. Although that followed two monthly advances, shipments should continue to fall in November and December given the much sharper declines in orders and the weaker gain in the previous two months.

Nonresidential construction spending also fell in October. While that too followed two monthly advances there are signs that the commercial real estate is heading down.

Meanwhile, the latest report on corporate profits indicates that corporate profits continue to fall even in nominal terms both in the nonfinancial and financial sectors. And these national accounts numbers do not even include writedowns. Nonfinancial corporate profits adjusted for capital consumption are down more than 8% in nominal terms in the latest year. Much more of course in real terms. Combine that with increased pessimism, it is difficult to see that business investments -both equipment and software and nonresidential construction or "structures"- could go anyway but down from here, something which will probably be reflected already in the November and December numbers.

-Personal Consumption Expenditures: Personal consumption expenditures fell marginally (0.035%) in October. That is still higher than 3 months earlier, but considering the likely much bigger decline in November it seems safe to say that once the August increase is removed from the base, the 3 month change will turn negative. And likely turn even more negative in December.

The sharp increase in energy and food prices likely means a relatively big decline in both real income and real spending. And with real income and house prices down, and with stock prices likely falling too and with the savings rate very low, consumption will likely continue to fall. The weakness in consumer confidence also makes falling consumption likely. This means that this quarter is likely to be the first since 1991 when real consumption falls.

But what about inventories, net exports and government demand? The outlook for inventory buildup seem uncertain and have historically often risen at the beginning of a recession, but the upside from this seem highly limited given the fact that inventories already went up so much in the third quarter. For inventories to give a positive contribution to GDP it is not enough for them to rise, they must rise faster than in the previous quarter.

The trade deficit declined in the third quarter, and given the weak dollar and the weak economy, the nonpetroleum deficit seems likely to continue to decline, which could give a boost to net exports in volume terms. However, the overall deficit is likely to be more stable as the higher oil price raises the deficit in petroleum. That means that in terms of trade adjusted terms, net exports will contribute only little or nothing at all to growth.

Government demand is very uncertain, but will probably rise to a new post-1993 high as a share of total GDP. However, as demand already rose so much in the third quarter and as state budgets are increasingly weak and as the price deflator for government demand usually rise faster than the GDP price deflator, this will mainly happen because of the weakness in the rest of the economy, rather than through it increasing particularly fast. The contribution to GDP should therefore be small.

Put it all together and it seems almost certain that GDP will fall in terms of trade adjusted terms as the large decline in residential investments and the declines in business investments and personal consumption will certainly outweigh the low and uncertain contributions from trade, inventories and government. In volume terms, the positive contribution from trade will be a lot bigger, so it is less certain that growth will be negative in volume terms. But it nevertheless seem more likely than not.