Tuesday, June 30, 2009

U.K. Downturn Even Worse Than Previously Estimated

According to previous estimates, British GDP fell a "mere" 4.1% in the year to Q1 2009, and 1.9% (7.5% at an annual rate) compared to Q4 2008. That was bad, but still not as bad as the euro area average of 4.8% and 2.5% respectively.

Now revised estimates say that U.K. GDP fell 4.9% compared to 4 quarters ago, and 2.4% compared to the previous quarter, meaning that the U.K. slump is no longer considered to be less severe than the euro area slump. These revised numbers also says that the U.K. recession definitly started already Q2 2008, whereas the previous numbers suggested that GDP started to shrink in the third quarter of 2008.

Sunday, June 28, 2009

Interest Rate Quiz Solved

I recently challenged readers to figure out how it could be true at the same time that low interest rates created economic imbalances (excessive borrowing and consumption/malinvestments) in America and high interest rates created economic imbalances in Iceland. Some of the answers were on the right track, but didn't really solve the mystery.

The most common answer was that high interest rate created massive capital inflows into Iceland, which in turn meant that capital were more available and so created the economic imbalances. That is not entirely inaccurate, but it doesn't really explain how it encouraged borrowing. The implicit assumption seems to be that this is related to the terms of credit. But in order to encourage borrowing you would need to lower interest rates, and since the premise was that interest rates were high, it really can't explain it.

Another answer was that high nominal interest rates could simply reflect high inflation and not high real interest rates. But while that could explain while imbalances could arise despite high nominal interest rates, it doesn't explain why the high interest rates could be the causal factor. This would rather implicate high inflation as the causal factor.

Another answer was that high interest rates encouraged Icelanders to borrow in foreign currencies (such as U.S. dollars, euros, francs). But while that can explain why the relative proportion of foreign currency loans increases, it can't explain why total borrowing increases. High Icelandic interest rates doesn't make it more profitable to borrow is dollars or euros, it only makes it less profitable to borrow in Icelandic kronors. Or in other words, the amount of domestic currency debt should be reduced while the amount of foreign currency debt should be unaffected.

Also, to the limited extent the uncovered interest parity condition holds, not even that part about relative profitability holds.

And moreover, none of these explanations really explain why this didn't lead to reduced imbalances in America.

The solution lies instead in the hint I gave about the difference between the United States and Iceland. There are many differences between these two countries, of course, but one of the most important is the size of the population. America has slightly above 300 million people, while Iceland has slightly more than 300 thousand people. America is in other words almost exactly 1,000 times bigger.

What does that have to do with this issue? Well, remember what I wrote about how a currency appreciation caused by the capital inflows caused by high interest rates will makes imports cheaper and therefore induce people to demand more of it (And at the same time it will make exports more expensive to foreigners and therefore reduce exports). Currency appreciation will, other things (like interest rates) being equal, increase net borrowing from abroad.

As currency appreciation often results from higher interest rates, this effect will to some extent cancel out the borrowing reducing effect from higher interest rates.

But since foreign trade is a lot more important in tiny countries like Iceland than in giant countries like the United States, this imbalance enhancing effect from exchange rate movements will be a lot greater in small countries than in large countries.

At the same time, the interest rate effect on borrowing will be at least as large in large countries as in small countries. Indeed, it will probably be a lor larger in large countries as the use of foreign currency financing is more accepted in small countries with small and illiquid currencies like the Icelandic Krona than in countries with a widely accepted and higly liquid currency like the U.S. dollar.

And so, while low interest rates in America had a great impact on the capital market side of the economy while the indirect effect on goods markets (through currency depreciation) was limited , the opposite held true for Iceland. The capital inflows that some of the commentators focused on in the case of Iceland did cause this, but not through the effect on interest rates, but through the effect on exchange rates.

One obvious conclusion here is that the value of "independent monetary policy" to stabilize the economy is dependant on the size of the country/currency area. Even if done right, small central banks have little or no chance of stabilizing their economy. If other central banks pursue inflationary policies then any attempt to counteract that will cause excessive currency appreciation which will create the kind of imbalances that the independent policy was supposed to prevent. By contrast, larger central banks like the Fed and the ECB can choose whether or not they want to create bubbles.

Saturday, June 27, 2009

Personal Transfer Receipts Now Larger Than Tax Payments

The trends that I described before, with a falling market based income and rising net income from government (also known as the budget deficit) in America continued in May.

As a result of the latter trend, personal transfer receipts (such as social security and unemployment benefits) for the first time exceeded personal tax payments. Personal transfer receipts were $2,235.5 billion in May 2009, up 18.1% from 6 months earlier. Meanwhile, "personal current taxes” fell 20.6% to $1175.5 billion while the separate tax category "contributions for social insurance" fell 0.8% to $987.8 billion. While total tax payments exceeded transfer receipts by $578 billion 6 months ago, they are now $72.2 billion lower.

That personal transfer receipts now exceed personal tax payments is quite extraordinary since transfer payments do not include direct government purchases (spending on the military, law enforcement, schools, roads etc., which total more than 20% of GDP) or interest payments on the national debt. While the government also receives some income from corporate income taxes, payroll taxes and sales taxes, these revenues are relatively small in America, much smaller than spending for government purchases and interest payments. This means that unless the deficit is really extraordinarily large, personal tax payments should exceed personal transfer receipts by a large margin. The fact that transfer receipts are now larger confirms that the deficit is extraordinarily large.

Friday, June 26, 2009

More On The Cost Of Environmentalism

As a follow-up post on the previous post, I can report that George Will has another great column, this time exposing the fraud of how "cap and trade" and similar policies from Obama will create "green jobs", using the dismal experience of such policies when implemented by Spain's socialist government:

"The Spanish professor is puzzled. Why, Gabriel Calzada wonders, is the U.S. president recommending that America emulate the Spanish model for creating "green jobs" in "alternative energy" even though Spain's unemployment rate is 18.1 percent -- more than double the European Union average -- partly because of spending on such jobs?...

...Calzada says Spain's torrential spending -- no other nation has so aggressively supported production of electricity from renewable sources -- on wind farms and other forms of alternative energy has indeed created jobs. But Calzada's report concludes that they often are temporary and have received $752,000 to $800,000 each in subsidies -- wind industry jobs cost even more, $1.4 million each. And each new job entails the loss of 2.2 other jobs that are either lost or not created in other industries because of the political allocation -- sub-optimum in terms of economic efficiency -- of capital. (European media regularly report "eco-corruption" leaving a "footprint of sleaze" -- gaming the subsidy systems, profiteering from land sales for wind farms, etc.) Calzada says the creation of jobs in alternative energy has subtracted about 110,000 jobs from elsewhere in Spain's economy."

Calzada's report can be read here. Another study with the same conclusions can be read here.

Thursday, June 25, 2009

The Economic Damage From Cap &Trade

Paul Krugman and other supporters of the so-called "cap and trade" (more accurately called "cap and tax") scheme have cited a study from the Congressional Budget Office that argues that the scheme would impose only small costs to the economy ("merely" $175 per household and year). But even assuming the CBO got all their numbers and methodology correct, the study is in fact associated with so many explicit caveats so as to make it useless, as is noted in this Wall Street Journal editorial. As the article demonstrates, there are good reasons to believe that "cap and trade" will cost the average household a lot more than $175 per year.

Quiz About Interest Rates & Economic Imbalances

This post will be somewhat unusual, as it will present you with a quiz to think about. Whether or not I will continue with more posts of that kind is not clear at this point and will depend on the responses to this post as well as if I can come up with appropriate questions in the future.

In his book about the financial crisis, A Perfect Storm (I reviewed it in Swedish here), Swedish libertarian writer Johan Norberg on the one hand argues that the Fed’s low interest rate policy was a contributing factor behind the U.S. housing bubble. Later in the book, he attributes Iceland’s imbalances on excessively high interest rates, as it caused the Icelandic krona to be overvalued, which in turn made imports too cheap and exports too expensive.

At first glance, that would appear to be a contradiction. After all, economic laws should be the same in all countries, and if there was something about low interest rates that created imbalances then surely high interest rates should have the opposite effect and prevented imbalances. And if high interest rates through the effect on exchange rates in Iceland created imbalances there, shouldn’t the depressing effect on exchange rates from low interest rates in America have prevented imbalances in America?

The apparent contradiction gets even worse if you adhere to a Keynesian analysis, according to which currency appreciation will reduce cyclical excesses, which would make the Icelandic bubble even more incomprehensible.

There are however good reasons to think that no contradiction exists here, and that it at the same time can be true that low interest rates created imbalances in America and that high interest rates could have created the imbalances in Iceland. This also further illustrates the fallacy of Keynesianism.

So the quiz challenge for you is to try to figure out why this is not a contradiction, despite the fact that it might appear so at first glance. A hint is provided through the mechanisms described, but there is a lot more to it than that. Some further hints can be found in certain previous posts from me related to the subject, but I won't tell you which. I know the answer, but before I present it I will give you the chance of trying to figure it out for yourself. And for those of you who have Norberg’s book, the answer can’t be found in there, as the apparent contradiction isn’t noted there. The reason why it's not there is probably that he hasn't thought about the issue, but if he reads this he is of course very welcome to tell us what he thinks the solution is.

Note also that there might be alternative solutions to this riddle unrelated to the one I had in mind and have hinted here which you might suggest. Just remember that it must explain why what applied to America didn't apply to Iceland, and vice versa.

You can think about this until Saturday (27/6) evening (Swedish time), after that I’ll present the answer. No comments on this post will be posted until then however, so as to prevent you from copying each other.

Tuesday, June 23, 2009

Bernanke vs The WSJ editorial page

The Wall Street Journal editorial page has a "See we told you so" editorial and reprints comments from it and Bernanke from 2003.

But while the WSJ editorial page was right in its prediction that consumer price inflation would increase significantly from the low levels seen in 2003 (reavhing particularly high levels in 2005 and the summer of 2008), contrary to their assertion in today's editorial, they actually did not predict the housing bubble or warn that a housing bubble could result from the Fed's inflationary monetary policies. The word "housing" and bubble" weren't even mentioned in the editorial.

Thus while the WSJ editorial page was closer to the truth than Bernanke, they missed the most important argument against the Greenspan-Bernanke policies, namely that these policies would create the housing bubble.

W-Shaped Recovery?

Nouriel Roubini thinks that the recovery will be W-shaped, and that the autumn of 2009 therefore, like the autumns of 2007 and 2008 will be associated with negative surprises. I too think that is likely as we are now experiencing the negative after effects of the previously very high money supply growth in the form of higher inflationary expectations and commodity prices, while the current pace of money supply growth has decelerated sharply. Such a combination is usually associated with downturns.

It should however be noted that it is in one way misleading to talk of a "W"-cycle since there actually never were any actual recovery (at least not in America-or Europe or Japan for that matter), it was only a deceleration in the pace of contraction.

Sunday, June 21, 2009

Life Expectancy & Health Care Costs

Greg Mankiw recently correctly observed (as did Gary Becker) that it is highly misleading to use life expectancy as a gauge of health care quality. While higher health care quality should ceteris paribus increase life expectancy, life expectancy depends on other factors, such as life style choices. This has caused various leftists (like this one)to criticize Mankiw and Becker.

And America's life expectancy is clearly depressed by the life style choices of its citizens, most notably the fact that Americans on average are fatter than any other people.

There are, as I pointed out in a previous post where I discussed the subject at greater length, several specific examples of how these other factors affect life expectancy. For example, Sweden and Denmark have basically the same health care system, yet Sweden is number 10 in the life expectancy ranking while Denmark is 47th. The reason for this is differences in life styles, with for example alcohol and tobacco consumption being a lot higher in Denmark than in Sweden. Similarly, Singapore and Hong Kong have health care systems that are at least as market based as America's, yet they come in at 4th and 6th place. Incidentally, health care spending (at 4% and 5% of GDP) is far lower than not just in America but also Europe and Canada.

A more rational way of estimating health care quality would then be to see how healthy people are given a certain level of initial medical problems (whether caused by genetics, life style choices or other factors). That way you directly control for other factors affecting outcomes. And in this category, America is number one, with for example cancer survival rates being higher than in Europe or Canada and the World Health Organization ranking America number one in the category of responsiveness to health problems.

It should further be noted that these other factors do not simply lower life expectancy, they also increase health care costs. If a lot of people suffer from cancer or are obese, then some of them will die prematurely and so lower statistical life expectancy. At the same time, both these people and those that survive will often require medical attention and so increase health care costs. So, life style choices and the other factors lowering America's life expectancy are at the same time a partial explanation for the high cost level. For that reason, the attempt made by leftists to use life expectancy in relation to health care costs is even more misleading than Mankiw and Becker argued they were.

Saturday, June 20, 2009

Climate Change Reduces Crops

One can now see why Al Gore and his followers have stopped talking about "global warming" and instead started to use the term "climate change". As this Telegraph article points out, a changing climate is causing problems and reducing crops-only contrary to what we've been told it turns out temperatures are unusually low, not unusually high, as the believers in "climate change" in the sense of global warming predicts.

Latest U.S. Monetary Trends

The Fed balance sheet has declined this year by nearly 9%, from $2,246 billion in the week to December 31, 2008 to $2,055 billion in the week to June 17, 2009. Almost as interesting though is the shift in composition.

"Securities held outright" has increased from $496 billion to $1,176 billion, as the Fed has increased its holdings of Treasury Notes and Bonds from $476 billion to $633 billion and increased its holding of Agency securities from $20 billion to $88 billion while also buying $455 billion of Mortgage backed securities.

But this has been more than offset by a decrease in other items from $1,750 billion to $879 billion. Particularly central bank liquidity swaps and commercial paper funding facility has declined dramatically.

It should be noted that some of these other items do not affect the monetary base, and so the monetary base has not declined and instead remained roughly unchanged at around $1,700 billion.

And money supply has continued to increase, though in the last three months only marginally for M2(up only 0.6% at an annual rate in the 12 weeks between March 16 and June 8). Since institutional money market funds (part of MZM, but not M2) have increased while small time deposits (part of M2, but not MZM) have dropped significantly, MZM is up by a more significant annualized 4.8%. That is however a lot lower than the annualized 20.5% rate in the preceding 23 weeks. That implies a slower increase in commodity prices, though that also depends on how the Chinese economy develops.

Friday, June 19, 2009

U.K. Budget Deficit At Record High

The U.K. budget deficit during the first two month of the financial year (April & May) doubled to £30 billion. It is now projected to reach £200 billion or 14% of GDP for the year as a whole, most of any EU country.

That is one of the reasons why, unlike in other countries with large external deficits in Europe, the U.K. hasn't seen its trade and current account deficits decline, despite the weak pound. Though since most other countries have seen their budget deficit rise too, it is clearly not the only reason.

Another reason is that the cause of the weak pound, the Bank of England's inflationist monetary policy, has meant that credit and money growth has stayed strong, which in turn has boosted demand for foreign goods.

A third reason is that the U.K. unlike the other deficit countries has very little (net) imports of oil due to its North Sea fields, so the great decline in oil prices from last year's peak has had a far smaller effect on the U.K.

Thursday, June 18, 2009

Why Financial Regulation Reform Is A Red Herring

Obama, and his sidekicks Tim Geithner and Larry Summers has now proposed certain changes in financial regulation, which includes giving the Fed more regulatory powers, raising reserve requirements for some large institutions and unspecified measures against "predatory lending".

Perhaps not all of these measures are useless or harmful, though most probably are. But even those that could do some good, like higher reserve requirements, are essentially red herrings with regard to the cause of this crisis and the prevention of the next. The all-important factor here is monetary policy and its deliberate policy to achieve credit and monetary expansion.

The point is that even if some regulation would have been in place during the last decade that would have held back credit expansion assuming a interest rate policy, credit expansion might still not have been lower. The reason for that is that Greenspan and the Fed wanted to achieve a certain level of credit expansion (the kind of credit expansion needed to increase inflation and growth).

If some regulation would have held back credit expansion, then given the Fed's desired credit expansion they would have pursued an even more aggressive interest rate policy, cutting interest rate even faster and more than they actually did. And if short term rates had fallen to zero then the Fed would have resorted to the kind of quantitative easing that we have seen now.

The end result would have been essentially the same kind of credit and monetary expansion that we saw, and therefore also essentially the same kind of bubble and therefore also the same kind of economic crisis.

In order to prevent all of this from happening again, we then need a monetary reform that takes away or at least limits the Fed's policy of expanding money supply. As long as there is a central bank the will and the power to significantly expand money supply, financial regulation has little or no relevance and is therefore essentially just a red herring.

Tuesday, June 16, 2009

Rewinding The Tape On Paul Krugman

In my last post, I should have perhaps included this revealing (given his current denial of the effects of budget deficits on interest rates) from one of his 2004 columns:

"For many years, advocates of tax cuts have insisted that the normal laws of supply and demand don't apply to the bond market, and that government borrowing — unlike borrowing by families or businesses — doesn't affect interest rates. But there's no argument among serious, nonideological economists. For example, a textbook by Gregory Mankiw, now the president's chief economist, declares — in italics — that "when the government reduces national saving by running a budget deficit, the interest rate rises."

Krugman was entirely right about that "there's no argument among serious, nonideological economists" part (Though it is incorrect to suggest that all advocates of tax cuts believe in that or that only advocates of tax cuts believe it(he himself is an example of that)). It's too bad that he has however revealed himself to be anything but [a]"serious, nonideological economist".

Via Lew Rockwell, I also see another interesting quote from Krugman, from 2002.

"To fight this recession the Fed needs more than a snapback; it needs soaring household spending to offset moribund business investment. And to do that, as Paul McCulley of Pimco put it, Alan Greenspan needs to create a housing bubble to replace the Nasdaq bubble."

If you think the quote has been taken out of context, do read the entire article. It is clear there that the only misgiving he expresses about the strategy of creating a housing bubble is that he doubted (incorrectly, as everyone now presumably knows) that it would be possible to create the allegedly desirable housing bubble.

The now experienced effects of Krugman's 2002 policy recommendation should give you a hint of the effects of Krugman's current policy recomendations.

UPDATE: Now Krugman tries to spin his way out from the latter quote, writing:

"Guys, read it again. It wasn’t a piece of policy advocacy, it was just economic analysis. What I said was that the only way the Fed could get traction would be if it could inflate a housing bubble. And that’s just what happened."

That excuse is simply not plausible. Is Krugman saying that he, a man renowned for advocating Keynesian recession-fighting policies, saying that he opposed a policy he thought was needed to fight a recession? Give me a break.

While he may not have formally written "I advocate it", he didn't in any way suggest that it would be undesirable, and given his known preference of advocating policies that reduces the severity of recession in the short-term, he can't argue that he didn't advocate a policy that would do so by saying it would do so, unless he specifically argued against it.

Sunday, June 14, 2009

Krugman's Denial Of The Effects Of Deficits On Interest Rates

Though Treasury yields fell back somewhat during the last few days, they remain at a very elevated level. One of the factors (though not the only one) causing this is the increase in the budget deficit, as I explained a few days ago.

Now Paul Krugman tries to deny this by arguing that the decline in private borrowing more than offsets the increase in government borrowing. That is true in a purely empirical matter, at least if you look at the second derivative rather than the first derivative (or in simpler words, if you look at the change of the growth rate in debt, rather than the change in debt). It is however not true in the sense that total debt is falling, because it continues to increase.

And more importantly, it is not true in the sense that economists should be focusing on, namely the causal effect of a particular action, ceteris paribus. If the deficit had remained stable while private borrowing had collapsed, as opposed to what actually happened with a dramatic increase in the deficit, then this means that supply of Treasuries would have been a lot lower, which means that the price would have been a lot higher, which in turn means that yields would have been a lot lower.

There can in other words be no doubt that if the deficit had been lower, then so would Treasury yields. While Bush was president, Krugman recognized this casual relationship. But now that a Democrat is president, Krugman tries to make people believe it doesn't exist...

Saturday, June 13, 2009

External Imbalances &The Economic Crisis In Europe

For long, the aggregate euro area current account balance was roughly balanced, with only very small surpluses or deficits. But hidden behind that aggregate were large surpluses in a few countries, most notably Germany but also for example Holland and Finland, and large deficits in others, for example Ireland and Spain. The Germans, the Dutch and the Finns were in effect lending to the Irish and the Spanish to finance the housing bubbles in Ireland and Spain. A similar story was seen in the Baltic sea, where Sweden had a large surplus while Estonia and Latvia had large deficits, meaning that the Swedes lended to the Balts to finance the Baltic bubbles.

Now that the bubbles in Ireland, Spain, Estonia and Latvia have turned into busts, we now see the current account imbalances starting to unwind too. Ireland, whose deficit was roughly similar to America’s deficit relative to GDP (7%) at its peak, has seen its deficit vanish completely in Q4 2008. Considering how the trade surplus continued to vanish almost completely in Q4 2008. Considering how the trade surplus continued to increase in the first quarter,it is possible that there was a surplus in the first quarter of this year.

Spain's deficit hasn't decreased as much as Ireland's, but it is down from €32.3 billion in Q1 2008 to €23.3 billion in Q1 2009, or from roughly 12% of GDP to 8.5%.

In Estonia and Latvia, the improvement has been even more dramatic than in Ireland. Estonia had a deficit of 18% of GDP in 2007, but in the first quarter of this year they had a surplus. Similarly, Latvia who at the peak of its boom had a current account deficit of 24% of GDP has similarly seen a surplus in the first months of 2009.

But reduced or eliminated deficits in some countries must mean that surpluses in other countries decline. Germany saw its surplus decline from €65 billion in the first four months of 2008 to €25.9 billion in the first four months of 2009 , or from roughly 8% of GDP to 3.5%. Finland saw its surplus vanish during Q1 2009. Holland has not yet released Q1 2009 numbers, and during Q4 2008 the surplus had only dipped slightly (From €13.1 billion in Q4 2007 to €12.4 billion in Q4 2008), but a big drop in the Q1 2009 trade surplus suggests that the current account surplus will likely fall more during that quarter.

The Swedish surplus dipped
from SEK 81.5 billion in Q1 2008 to SEK 53.2 billion in Q1 2008 (From roughly 10% of GDP to 7%), despite the weak SEK.

All of the aforementioned countries have in the recent year experienced economic contraction. The difference is however that while the previous deficit countries have seen their balances improve because of the end of the boom, the previous surplus countries have seen their economies contract mostly because their net exports to the deficit countries have fallen so much. The current account balance adjustment is in other words an effect of the slump for the deficit countries, while being a cause of the problems in the surplus countries. The surplus countries participated in the booms as lenders and suppliers, and now suffer because the booms have turned into busts.

Wednesday, June 10, 2009

Could There Be A Link Between These Two News?

News item 1: U.S. Federal government post record deficit, meaning that supply of Treasuries are record high.

News item 2: U.S. Treasury yields reach the highest level since October last year, with the 10-year yield reaching nearly 4%, meaning that the price of existing Treasuries are plummeting.

Now let's see, what is the usual effect on prices from a higher supply.....?

Given the increase in the spread between TIPS and regular Treasuries, some of that increase also reflects higher inflationary expectations. But that is not really unrelated to the increased deficit as it rightly increases the fear of bond investors that the Fed will try to debase the value of their investments through inflation.

Tuesday, June 09, 2009

China Now Biggest Car Market

America has been the world's biggest car market for as long as cars have existed, but because of a big decline in U.S. sales and a big increase in Chinese sales, it now appears that China will overtake America to become the world's biggest car market.

While the rate of decline in U.S. car sales has gone down somewhat recently, it is still very high (34%), and much of that deceleration reflects base effects, so car sales remain very low compared to before.

By contrast, Chinese car sales are booming, increasing as much as 47% compared to a year earlier. This reflects both the fact that the Chinese economy is stronger than the U.S. economy (and almost all other economies as well), but also that they have cut taxation of cars, and in certain rural areas even subsidized them. Total sales of vehicles was 1.13 million, 829,100 of which was passanger vehicles, more than in America.

Sunday, June 07, 2009

Latvian Devaluation Imminent?

Following the failure of a bond sale, speculations of a Latvian devaluation has increased. For more details on the subject, see Claus Vistesen's posts on the subject (see here, here and here). While I don't endorse all of his arguments and conclusions, the posts are nevertheless informative.

Latvian officials seem in short determined not to devalue or float. Whether or not they will succeed with this depends on whether or not they get loans from IMF or others to finance the budget.

It could be noted that the deep slump have already recreated external balance. After having a current account deficit of nearly 20% of GDP, Latvia has actually had a surplus in recent months. With Latvia having already eliminated its current account deficit, it doesn't seem like Latvia is really in need of a competitive devaluation. And as was noted before, a devaluation would slow the necessary adjustment process.

However, if the widespread expectation of it makes it impossible for the Latvian government to finance itself, it might become unavoidable as a self-fulfilling prophecy.

UPDATE: It now appears that IMF funding has been secured in return for further reductions in government spending.

Saturday, June 06, 2009

Opportunity Cost Discussion Continued

I recently defended the concept of opportunity cost, which most economists (both Austrians and non-Austrians) support, but which George Reisman rejects. That prompted well-argued and interesting, but nevertheless mistaken, replies from Reisman supporters Wladimir Kraus and Per-Olof Samuelsson. Instead of posting the very long reply in the comment section, I will present in a new post. Here are the edited (to reduce length of the post and focus on the relevant parts, the unedited comments can be seen here) comments by Wladimir and Per-Olof and my responses:

Wladimir-> "I think Stefan has missed Reisman's point. For one, Reisman explicitly says (pp. 450-460) that it is better to have a bigger financial gain than a smaller one. In that sense, Reisman would agree with Marge but still reject the concept of opportunity cost as a valid construction in economics."

Me-> Again, the point here is that even though opportunity cost is not accounting cost, it is cost in a praxeological sense. It is what you forego by making a certain choice as opposed to other possible choices. It is a necessary concept to assess whether or not a choice is beneficial or not. Because all choices have opportunity costs, it is not sufficient to simply show that a choice generates benefits in order to make it a good choice.

In the Simpson’s-example, Homer could point to how he earned a dollar through his choice, so unless take the forty dollar opportunity cost into account, it must be considered a good choice.

Wladimir argued against it by saying that if you adopt a profit maximizing rule, then you would also come to the conclusion that Homer made a bad choice. This is true but misses the point. We are analyzing the actual choice of not going to work. Was that a good or bad decision? And since it meant foregoing possible income of 40 dollars, and since costs means something that you forego when undertaking a certain action, it was from a praxeological point of view clearly a cost associated with that decision.

Perhaps now some would object that the forty dollars would have been counted as an income if you had focused on the alternative action of going to work. Well, that is true, but then we're not evaluating the same action. Whether something is revenue or cost depends on what action you focus on. There's nothing really strange about that. It is similar to how a given transaction can be counted either as revenue or cost depending on whether you analyze the action of the seller or the action of the buyer.

And just as it is objectively right to characterize the money that a buyer foregoes (and could have used for other things) when he chooses to buy something as a cost, it is objectively right to characterize as a cost the money (or other benefits) that you forego by not making the alternative choice that would have given you the money as a cost.

Wladimir-> "Economists routinely use OCs to embrace not only foregone monetary benefits, such as a foregone profit from selling a good, but also purely "psychic" costs such as the foregone pleasure of not spending one's time with friends if one chooses to work, for example."

Me-> Well, yes, and rightly so. The point is not to embrace the fallacy that working 24/7, or at least every moment you're awake, is somehow optimal. The point is to highlight to acting man that when evaluating possible actions, you choose what gives you the highest utility. Or to put it another way, whenever the amount of money you would make from working is higher than the value you perceive from doing something else instead of working, then the opportunity cost of not working is higher than the benefits of that option. This means that in a cost-benefit analysis you arrive at the conclusion that it is not a good option.

Wladimir-> "Briefly, *only* the category of productive spending, which Reisman defines as the expenditure to buy capital goods and hire labor services for the purpose of making subsequent sales, can give rise to costs of production. To see this, imagine there is no productive expenditure in the economic system. The only category of spending present is spending on consumers' goods.

What would that situation mean economically? In terms of "mere" accounting, no costs of production of account of either capital goods or labor services would be present."

Me-> Not true at all, because production of consumer's goods is associated with costs (try producing a hot dog at a hot dog stand without any cost), just as production of investment goods is. And indeed, a key cost associated with producing only consumer goods is the opportunity cost of foregone investment goods, which of course in the long term will be disastrous.

Wladimir-> "But one won't be able to recognize all that if one reasons from the point of view of opportunity cost doctrine. One will fail to recognize the pattern between low costs of production and higher profits if one reasons from the point of view of opportunity cost doctrine. One will be at a loss to understand what determines the amount and the rate of profit, how they relate to productive vs. consumptive expenditures if one reasons from the point of view of opportunity cost doctrine."

Me-> No, again not true at all. In fact the opposite is true. You need the opportunity cost concept to determine whether an investment is profitable or not. A key principle of (business) finance is that you can't evaluate a certain object simply by looking at whether or not it makes a profit in the pure accounting sense. You must also ensure that the return on invested capital is higher than the cost of capital (or discount rate), which is (should be) based on alternative uses if that investment capital. Cost of capital/discount rate is really the business management version of the economics concept of opportunity cost.

Per-Olof-> "I have a question for Stefan: If you disagree with Reisman's criticism of "opportunity cost", then what is your view on the preceding section (p. 459f) on "imputed income"? I ask this, because the criticism of those two doctrines is basically the same - namely that they both introduce incomes and costs that are fictitious."

Me-> See what I wrote about the praxeological nature of revenue/income and cost. Whether something is an income or cost depends on whether a certain action generated it or destroyed it. That means that what in accounting terms is an income could perhaps not really be an income in a praxeological sense (The Simpson example), and also what in accounting terms is an absence of cost is an income in praxeological terms. The most common example of "imputed income" is (I think), the imputed income of home owners from not renting. And that does make sense. Suppose we have two people both earning say 30,000 dollars (or euros or kronor or whatever) from their jobs, yet one earns 6,000 dollars per years from invested capital while paying 12,000 dollars in rent and another makes zero from investments yet only has 6,000 dollars in housing related expenditures from the home he own. Assuming that the 6,000 dollar difference in housing expenditure is related to the fact that the second person has invested his money in his house rather than in some securities, it should be clear that this difference in fact represents an income from the investment in the house, just as the 6,000 dollars that the renter earned from his investment in securities is an income.

Per-Olof-> "There's an expression in Swedish when someone is looking very frustrated: "You look like you have sold the butter and lost the money".

Well, if someone has sold his butter for x kronor and then - by having a hole in his pocket, or having been robbed at his way home, or whatever - having lost the money, he has of course suffered a loss of x kronor.

But suppose this person hasn't bothered to sell his butter at all, but has instead used it to butter his own bread. Isn't it true that according to the OC doctrine, he should still feel as frustrated, since he has obviously failed to earn those x kronor?"

Me-> No, of course not. The person who used the butter on his breads enjoyed a higher standard of living as he enjoyed that consumption. He enjoyed the "revenue" of the pleasure of consumption, while the other guy received nothing in return and so simply got screwed.

Friday, June 05, 2009

Why The Fed Can't Make The Problems Go Away

The party line is that we shouldn't worry about inflation, because right now the immediate concern is the risk of a deflationary depression. We must use all available means to prevent that and err on the side of inflation because the Fed could always reverse course if inflation really resurfaces and becomes a problem.

Given how the rapid increase in money suply has now finally begun to manifest itself in rising commodity prices and increased inflationary expectations, as well as signs that the pace of contraction is receding, we are quickly approaching the point where this will be tested in practice.

The behavior of central bankers is difficult to predict, but given the popularity of another idea it is unlikely that they will really reverse course soon enough. And perhaps even more importantly, if they do, we will see a quick return into an economic slump.

Remember, this line of thinking was also popular during the brief 2002-03 deflation scare, where Alan Greenspan, Ben Bernanke and other Fed officials worried about deflation. This caused them to lower short term rates to 1%, to eliminate the risk of deflation. If, as they hoped, this was successful, they would normalize rates. But they also realized that a quick reversal would create disruptions, so when they finally started to tighten again they deliberately tightened in a "measured" pace. But while that did create less short-term disruptions, it also ensured that the imbalances of the boom would continue to grow and so get worse for an even longer time. Eventually, a great interest rate shock was needed to prevent inflation-something which triggered the crisis. The "don't worry about it, we'll deal with it later"-approach failed as the problem simply grew bigger because it was dealt with later rather than sooner. But for many prominent pundits , the problem was that the Fed raised rates too much and thus created problems for all of those home buyers who had based their decisions on the previous very low rates.

Another similar example was the 1937-38 downturn which Paul Krugman and other Keynesians blame on fiscal and monetary tightening. Even though it happened several years after growth resumed, that was apparently to soon. If four years into the boom is considered too hasty, that means that fiscal and monetary tightening according to them shouldn't be implemented until 2014 at earliest. That's a lot of time for inflation to develop.

Given the widespread view that the inflationery policies should continue several years into the boom, it seems likely that the Fed will in fact do so.

Suppose however that the the less likely but definitely possible scenario that the more hawkish elements within the Fed manages to implement measures to limit inflation really materializes, what then? Well, then we will see another slump.

Inflationary booms are created on the basis of an unsustainable source of fundings, money creation. Once that is removed however, the boom will turn into a bust. Meaning that if Bernanke manages to create another bubble, that will turn into another bust as soon as they feel compelled to remove that basis. If that happens, then Krugman and his sympathisers will no doubt present this as a repeat of the 1937 slump caused by "premature" policy tightening.

Either way though, the outlook is not good.

Tuesday, June 02, 2009

More Signs Of Rising Inflationary Expectations

-Gold above $980 per ounce. The price of gold has been supressed for some time over worries over IMF gold sales, but now worries about inflation seems to have taken the upper hand over worries about gold sales.

-Also, the spread between nominal Treasuries and TIPS reached 200 basis points for the first time since last fall after having been less than half of that earlier this year. The yield on TIPS is at 1.68%, almost unchanged since the last time I reported on the subject and still 22 basis points lower than before the Fed announced its expanded asset purchase program. However, the yield on regular bonds has continued to rise, with the 10-year security trading at 3.68% when this is written. That is 23 basis points higher than when I wrote about it the last time, and 66 basis points higher than before the Fed started uts asset purchase program.

So, if the Fed wanted to increase inflationary expectations, they appear to have been successful. Contrary to what they believe however, that will likely make things harder for them.