Wednesday, March 31, 2010

Obamacare Stops Romney?

As David Harsanyi points out, the battle over Obamacare could very well stop Mitt Romney's presidential ambitions. The rallying cry among Republican activists today is "Repeal!". But how could they then choose someone who as governor implemented a scheme almost identical to Obamacare?

Romney has basically sealed his fate by refusing to express regret over his plan and instead defend it. Yet when faced with the question of why he defends his plan and claims to oppose Obama's, he can come up with no answer except that his plan was on a state level, and Obama's on a federal level. But this "states rights" defense is hardly going impress very many people, and would make him a sitting duck in debates with Obama who no doubt will invoke the standard anti-"states right" argument of how this principle was used by Southern segregationists. So, the heated confrontation over Obamacare is likely to ensure that Romney won't become the 2012 Republican nominee. Harsanyi does point to what Romney could have said to save his presidential ambitions:

"Everyone makes mistakes. Heck, I made a huge one. My plan, first hijacked by state liberals and now copied by Barack Obama, has created a fiscal nightmare in my state -- one that, according to the former Democratic treasurer, has forced us to cut back on other basic services.

Though we promised an individual mandate would mean everyone would chip in, nearly 70 percent of the newly insured are subsidized by taxpayers -- with many paying nothing. Meanwhile, health care spending in our state is 27 percent higher than the national average, and we have a shortage of doctors, to boot. And that's just for starters.

Let me be clear. I am not here to defend Romneycare. I am here to extract my name from that botched experiment by repealing its ugly stepson, Obamacare, so Americans work together to pass genuine, common-sense, market-based reform."

Tuesday, March 30, 2010

Credit Rating Agencies Again Protecting Subprime Securities

So argues this article. Only this time it is not subprime mortgages, but subprime government debt from the U.K. and U.S, governments. Is it right? Both yes and no.

It would be irrational to expect any near term default from either the U.K. or U.S governments. In part this is because they receive good credit ratings.

Now many will say "wait a minute: are you in effect saying that they receive good credit ratings because they receive good credit ratings?". The answer to that question is "that's exactly what I am saying". Credit ratings are to some extent self-fullfilling prophecies. If they receive high credit rating then they will have no problem taking on new loans to cover deficits and maturing old debts, but if their ratings are lowered they will have much greater difficulty doing so, thus "confirming" the downgrade (This is just another reason why I don't think anyone should trust rating agencies). The fact that Greece's ability to refinance their debts at a reasonable cost declined dramatically after they were downgraded is just one example of this.

Another reason to believe their won't be any U.K. or U.S. default is that both governments have easy access to "printing presses", meaning that debt obligations in effect can be met by "printing money", as long as governments don't believe there will be any dangerous inflationary consequences from this. And neither the U.K. nor U.S. governments believe that this is a risk right now.

So, the risk of a U.K. or U.S. default is basically zero for the time being, and will remain so for several years. However, if several years from now the inflationary outlook changes in the U.K. and U.S., then this will limit the ability of them "printing their way out of trouble". And if rating agencies at that point turn against them, then the downgrades that would then follow would have a negative "self-fulfilling prophecy" effect on their ability to refinance their debts.

Moreover, to the extent that the U.K. and the U.S. "print their way" out of problems, this will reduce the real value of bonds, and thus in effect amount to a partial default.

Monday, March 29, 2010

U.S. Real Disposable Income Falls Again

After 3 monthly decreases between September and December 2009, real disposable income excluding transfer payments, dropped for the second month in a row in February.

The March number will likely turm positive, as the February number was depressed by the depressing weather conditions in north eastern United States during February. On the other hand, the recovery in energy prices will reduce real income.

In light of these special circumstances, it seems clear that the U.S. economy is still recovering-but that the recovery is weak and vulnerable.

Australia's Population Growth Driven Housing Boom

I have frequently discussed how growth in the Australian economy is driven by rising commodity prices. There is however another factor driving growth, namely high population growth.

Australia's population grew by 2.1% in the year ending September 2009, a lot higher than in most other advanced economies (typically population growth is less than 1%, and even negative in for example Germany and Japan). This has a particularly positive effect on the housing sector, which continues its long boom, despite high prices and interest rates that are higher than in most other countries.

As this article points out, the rapid population growth has contributed to a housing shortage, something which implies that both construction activity and house prices will continue to increase.

More rate hikes by the Reserve Bank of Australia will have a cooling effect, but as long as population growth remains high, the Australian housing sector will likely remain strong, or it will at the very least not see a significant crash, as a growing population implies growing demand for housing.

However, this doesn't mean that Australian housing will necessarily boom forever. Ireland and Spain both had high immigration driven population growth during the peaks of their housing booms, but when their economies started to cool, the flow of migrants turned, and they were left with a huge surplus of housing, a huge debt burden and many unemployed construction workers. If the Australian economy weakens because of renewed declines in commodity prices, this could happen to Australia too.

Saturday, March 27, 2010

Trade Isn't A Zero Sum Game

Jeremy Warner at The Telegraph notes that the economic forecast of Chancellor of the Exchequer (British finance minister) Alistair Darling assumes that net exports will increase (or in other words that the British trade deficit will decline).

As previous forecasts of increased British net exports have failed to materialize, there are good reasons to be skeptical of this forecast. Warner further notes the difference between now and the period following the 1992 drop in the value of the pound:

"The difference is that following the recession of the early 1990s, there was a lot more external demand than there is this time around, when there seems to be a real possibility of the eurozone, by far Britain’s biggest trading partner, stagnating entirely. Almost all countries are hoping to export their way out of trouble this time around, which is quite plainly a logical impossibility."

Warner is right to note that it is a logical impossibility for all countries to increase net exports/strengthen their trade balances. On a global scale, net exports or the balance of trade is a zero sum game. If one country sees an increase, another must by necessity see an equal decrease.

But at the same time, it should be noted that increased exports, or more accurately increased trade, is in fact a way out of trouble. While it can't alone solve all problems, increased trade will promote higher real income in all countries, as it allows for increased specialization something which in turn will allow us to reap the benefits of the principle of comparative advantage.

Removing trade barriers is thus a good way of promoting economic recovery in all countries, regardless of whether or not net exports would increase or decrease in certain countries.

While the balance of trade is a zero sum game, trade certainly isn't.

Friday, March 26, 2010

The Attractive Brazilian Carry Trade

I have previously discussed my own calculations which showed that "carry trade" (investing in countries with high interest rates, and perhaps to some extent with money borrowed in countries with low interest rates) was profitable in the long term. Securities in high interest countries Australia, New Zealand and Britain (Britain now has low interest rates, but until 2007 it was generally higher than in most other rich countries) gave a much higher return after taking both interest rates and exchange rate movements into account than securities in low interest countries Japan, Switzerland and the United States.

Of course, before embarking on carry trade, you must see whether the high nominal interest rates really reflect high real interest rates as opposed to high inflation. If they reflect high inflation, then carry trade will not be profitable (investing in Zimbabwe dollars during the recent hyperinflation there would have been a very bad idea, despite extremely high nominal interest rates).

After reading this Bloomberg news column by Alexandre Marinis about the high interest rate level in Brazil, I decided to look whether this would have worked in Brazil during the latest decade.

Brazil have indeed had higher inflation than most Western countries, with an average inflation rate of 6.8% versus 2.7% in the United States.

But nominal interest rates have been far higher in Brazil than in the U.S., with the differential being at double digit levels. Right now it is relatively low, "only" about 8.6 %, but it has often been much higher with a peak being reached in 2003 of no less than 25 %.

I haven't calculated the exact annual average differential, but it is clearly above 10%, meaning that real interest have on average been at least 6% more per year. Add to that the fact that the real exchange rate of the Brazilian currency, the real, has risen dramatically during the latest decade.

Despite the higher inflation rate, the real has roughly the same nominal exchange rate against the U.S. dollar as a decade ago. This increase in the real exchange rate probably reflects to a large extent a Penn effect (or Balassa-Samuelsson effect from the high growth and improved terms of trade that Brazil has experienced primarily due to the global commodity price boom.

The result is then that the return on investments in Brazilian securities has been more than 10% higher per year, even more impressive than the returns from investments in securities from Australia and New Zealand. Even with the 2% tax on foreign capital inflows Brazil has sometimes (including right now) slapped on foreign investments for the purpose of limiting the strength of its currency, Brazilian securities have been, and probably will continue to be, a lot more profitable than for securities in the United States and most other countries.

With the 10-year yield currently being 12.7% versus 3.9% for the U.S., and with inflation being only about 2.5% higher than in the U.S. this means that even assuming that the 2% tax will be permanent and even assuming no further real appreciation, real return would be on average 4.3% higher.

Obama's Addict The People Strategy

Some have accused opponents of big government of favoring (In some cases this accusation have been true. In other cases it hasn’t been true) a "starve the beast"-strategy: first you pass popular tax cuts and temporarily "forget" about the unpopular offsetting spending cuts. Then a deficit will become a big problem, something which will enable people to say that spending cuts are necessary.

As Charles Krauthammer points out, Obama may have what one could call a "addict the people" strategy: first you pass big spending increases, and argues that the deficits are necessary for Keynesian reasons, and that the long term fiscal problems can be solved simply by "soaking the rich". In the long run, the deficits will prove to be unsustainable. As people have become dependent on the new spending programs, spending cuts might not be so easy to push through, while it becomes apparent that raising taxes for the rich won't be sufficient to reduce the deficit. At that point, it will be seen as necessary to raise taxes for the middle class and the poor as well, by for example introducing a Value Added Tax (VAT).

Krauthammer is probably right that this is Obama's strategy. Obama wants government to become a lot bigger, but he and his advisors realize that tax increases for the middle class is political suicide at this point (at least if it is honestly labeled as tax increases), which is why they are now only pushing through spending increases. Only later when a fiscal crisis will be obvious will they be able to push through a VAT or other middle class tax increases.

It remains to be seen whether the "addict the people strategy will work or not, though. The "starve the beast" strategy have generally not been so effective. As a VAT will be broadly unpopular (with conservatives hating it because it constitutes tax increases, and leftists opposing it because it is regressive), pushing through it will probably not be so much easier than reversing the Obama spending increases.

Thursday, March 25, 2010

Spanish & Irish Current Account Deficits Cut In Half

Both Ireland and Spain saw their current account deficit drop by nearly half during 2009. In Ireland, the deficit fell from €9.4 billion to €4.8 billion, or from 6.3% of GNP to 3.5%. In Spain, the deficit fell from €104.4 billion to €53.2 billion, or from 9.6% of GDP to 5.1%.

The difference between them is that while Spain has had a smaller economic contraction than most other European countries, Ireland has had the biggest drop in output in the euro area (and in all of Western Europe). Why one country with a previous housing bubble has managed the adjustment so much better than the other is not clear, though we can say with certainty that it is not about currency policy, since both Ireland and Spain have the euro as currency.

GDP Numbers Underestimate Depth Of U.S. Slump

"The Pragmatic Capitalist" points out that Gross Domestic Income has been consistently weaker than Gross Domestic Product ever since 2006 (Similarly, national income has been a lot weaker than net national product), even though they should be equal, something which both suggests that the recession was worse than the GDP numbers suggested and that the recovery has been weaker.

I have actually pointed this out repeatedly in the past, and in the latest post on the subject I also pointed out that this was also true for the fourth quarter of 2009, something which the "Pragmatic Capitalist" seems to think will be unavailable until tomorrow even though it was published here two weeks ago.

Wednesday, March 24, 2010

Obama The Candidate Argues Against Individual Mandate

See clip below where Obama as candidate ( HT Rush Limbaugh) attacks Hillary Clinton for advocating mandatatory health insurance-only to actively push for and sign a health care bill that includes individual mandate after he was elected.

"Change we can believe in" was Obama's slogan during both the Democratic primaries and the general Presidential elections. Well, people can certainly now believe that they got "change". Only it wasn't the kind of change many people thought they were going to get when they foolishly trusted Obama and voted for him.

If We Won't Recognize Problems They Will Go Away

Despite the relatively radical austerity measures Greece have undertaken, the yield spread remains stubbornly high against German bonds. The Greek government understandably doesn't want to pay such high interest rates, but as they need to refinance loans and borrow for the continuing deficit and as previous austerity measures haven't achieved much in terms of lowering interest rates, what is there to do?

Trying to exit the euro area, or defaulting on its debt payments aren't realistic options, for reasons that I've already explained (follow the links if you don't remember).

One option would be to borrow from fiscally stronger EU governments, such as Germany and Holland. But as that is perceived as a bailout, and as that is very unpopular in Germany and Holland, the chances of that seems slim. The one remaining option would be to borrow from the IMF, like several other EU countries (Including Latvia, Romania and Hungary) have in fact already done recently.

It seems increasingly likely that Greece will in fact like Latvia, Romania and Hungary borrow from the IMF, but some in the ECB and other institutions oppose this because, to quote ECB executive board member Lorenzo Bini Smaghi "The image of the euro would be that of a currency that is able to survive only with the external support of an international organization"

I find it this argument to be completely absurd, as such a move really would have no link to the survival of the euro (because first of all ditching it was never an option for aforementioned reasons and secondly even in the extremely unlikely scenario that Greece and a few other countries would ditch it, it would still remain in more than 10 countries), and would instead simply be a way to lower Greek borrowing costs.

While it could perhaps be argued that the existence of the IMF is bad for sounder nations and should therefore be abolished, there is no economic reason for any country that could lower its borrowing cost by using it to abstain from doing so. And that is true whether or not it has an independent currency. And to abstain from doing so just to deny the obvious reality that Greece has a high cost of borrowing is just silly and absurd.

Tuesday, March 23, 2010

France Temporarily (?) Rejecting Carbon Tax

More Tax Increases Following In America?

Now that the Democratic leaders have triumphed in the issue of health care with their government spending- and taxation increasing bill, they are now moving on to the issue of carbon taxation refered to with the euphenism "cap and trade".

While passing that won't be easy, as most Congressional Democrats from states with significant coal and/or oil production will likely oppose it, it is certainly a real risk that it will be passed, as Republicans aren't united on the issue, with for example infamous RINO Lindsey Graham collaborating with the Democrats on this issue.

U.K. Government Spending Rise Above 50% Of GDP

For the first time ever, at least during the absence of a major war, U.K. government spending rose above 50% of GDP in 2009. During the reign of so-called "New Labour" since 1997, government spending is up from 40% of GDP to 52% in 2009, and a projected 53% in 2010. This means that the ratio has on average risen by one percentage point per year during "New Labour". The increase has been fastest during the last two years, but it has risen ever since 2001.

The increase has in part been financed by tax increases, but mostly through a soaring budget deficit.

Though most other countries have seen their burden of government increase during the recent slump (Israel is one of very fex exceptions), the U.K. has seen a bigger increase than elsewhere, and unlike most others (the U.S. being and additional example) the burden of government spending was rising even during the boom.

As a result, government spending is now higher than in Germany and most other continental European countries, after previously having been much lower.

While I can't say I trust David Cameron, these numbers provides a very strong case for voting Gordon Brown out of office during the election that will come later this year.

Monday, March 22, 2010

The Growth Depressing Health Care Bill

While all 178 Republicans in the House as well as 34 Democrats voted against it, Obamacare still passed as the remaining 219 Democrats voted for it (see roll call vote here). It was close to getting voted down, until Obama convinced Bart Stupak and other anti-abortion Democrats to vote for it in exchange for an executive order prohibiting the use of federal subsidies for abortion.

One aspect which is rarely mentioned is the fact that this bill will be partly financed by yet further tax increases, as Larry Kudlow points to here. Specifically, high income earners will see taxes on work related income rise by about 1 percentage point and by about 4 percentage points on capital income. Combined with other planned tax increases, this will imply a significant increase in marginal tax rates, something which will depress growth.

Note that unlike some of the other tax increases (most notably the expiration of the Bush tax cuts) these tax increases won't take effect until 2013, meaning that there won't be any significant effects during the coming year or so.

Saturday, March 20, 2010

Health Care Observations

News are now dominated (at least in America) by the upcoming House vote on Obamacare. With Republicans united against it, passage depends on how many moderate or anti-abortion (a key controversy is whether Obamacare will mean federal subsidies for abortion) Democrats will vote for it, and how many will vote against it. I don't know which side will win, but it seems somewhat more likely that Obamacare will pass than that it won't. But regardless of whether it passes or not, it will likely be a close call.

I commented on the issue of the U.S. health care system back in 2007, a post that became one of the most popular ever on this blog. Some of you may not have read it though, and if so (or if you forgot what I wrote) do it here, My conclusion, in short, was that while it certainly can and should be improved,it is a lot better than what Michael Moore and others claim.

Here are a few additional observations

1) There are lots of free market ways to improve the health care system that the Democrats and usually even Republicans ignore. Alex Epstein lists several ideas here.

2) Republicans are hypocrites on this issue, which makes it more difficult for them to stop Obamacare.

The fact is that there is very little difference between the current version of Obamacare (the difference was greater when it contained a "public option")and the health care scheme imposed in Massachusetts by leading Republican presidential contender Mitt Romney (then governor of Massachusetts). The most essential elements of Obamacare in the form of individual mandate, ban on discrimination based on pre-existing conditions and subsidies to low income households were also part of Romney's scheme.

It is true that not all Republicans were in favor of Romney's scheme. But Romney sure was, and so was Scott Brown, who campaigned against Obama's scheme while favoring the nearly identical Romney scheme. Furthermore, most Republicans (with only a few exceptions such as Jeff Flake and Ron Paul) have a history of favoring expanded government role in health care when it is a fellow Republican that proposes it, most notoriously in the case of Bush's expansion of Medicare to include prescription drugs.

3) It's time to remind ourselves what a well known leftist pundit said about what would happen if you had individual mandates without a "public option" (which is to say, what will happen if the current bill passes):

"to make reform work we have to have an individual mandate. And everything I see says that there will be a major backlash against the idea of forcing people to buy insurance from the existing companies. That backlash was part of what got Obama the nomination! Having the public option offers a defense against that backlash.

What worries me is not so much that the backlash would stop reform from passing, as that it would store up trouble for the not-too-distant future. Imagine that reform passes, but that premiums shoot up (or even keep rising at the rates of the past decade.) Then you could all too easily have many people blaming Obama et al for forcing them into this increasingly unaffordable system. A trigger might fix this — but the funny thing about such triggers is that they almost never get pulled."

And here is a statement from another well known pundit and politician:

"Without a public, Medicare-like option, health care reform is a bandaid for a system in critical condition. There's no way to push private insurers to become more efficient and provide better value to Americans without being forced to compete with a public option. And there's no way to get overall health-care costs down without a public option that has the authority and scale to negotiate lower costs with pharmaceutical companies, doctors, hospitals, and other providers -- thereby opening the way for private insurers to do the same....

...I urge you to make it absolutely clear to everyone you know, everyone who cares about universal health care and what it will mean to our country, that the bill must contain a real public option. Tell that to your representatives in Congress. Tell that to the White House. If you are receiving piles of emails from the Obama email system asking you to click in favor of health care, do not do so unless or until you know it has a clear public option. Do not send money unless or until the White House makes clear its support for a public option."


"Our private, for-profit health insurance system, designed to fatten the profits of private health insurers and Big Pharma, is about to be turned over to ... our private, for-profit health care system. Except that now private health insurers and Big Pharma will be getting some 30 million additional customers, paid for by the rest of us."

Yet, both of these pundits, Paul Krugman and Robert Reich, are now urging the House to pass the bill, even though it doesn't contain a "public option". Perhaps it could be argued that they are now simply choosing a possible improvement as the perfect solution is impossible.

But as these quotes illustrates, they are deliberately pushing for a bill which they know would prop up profits for oligopolitic/monopolitic insurers at the expense of tax payers and the people forced to buy insurance.

By the way, to increase competition, a much simpler way would be to simply abolish the current restrictions on interstate competition.

Friday, March 19, 2010

Microeconomic Evidence On Unemployment Benefits

As a follow up on yesterday's macroeconomic illustration in the form of a comparison between the Swedish and Danish labor markets, I now link to this article by Casey Mulligan who presents microeconomic evidence on the issue, noting that the number of employed people getting jobs spike dramatically in the week following the exhaustion of their unemployment benefits.

Thursday, March 18, 2010

Swedish vs. Danish Labor Market Developments

To illustrate the effects of changed incentives through income tax and unemployment benefits changes one can look at two labor market statistics releases released today-one from Sweden and one from Denmark.

In Sweden, the number of formally employed persons was roughly unchanged compared to a year earlier, and the number of hours worked actually rose compared to a year earlier (though it is still somewhat below the peak levels of 2008).

In Denmark, employment dropped by more than 5% compared to a year earlier, both in terms of the number of formally employed persons and hours worked. The drop is even more dramatic in the private sector.

This discrepancy is not caused by a deeper cyclical slump in Denmark, as the drop in GDP has been roughly similar. And since the increased employment has all other things being equal increased GDP, it follows that the Swedish slump would have otherwise been bigger than in Denmark. Since it is mainly workers with relatively low productivity that have seen incentives improve, the positive effect om GDP is however smaller than the positive effect on employment.

While there may be other reasons for this discrepancy, the most important reason is the difference in terms of changing incentives for the unemployed. In Sweden, the centre-right government elected in 2006 has implemented significant income tax reductions (and payroll tax reductions), particularly for low earners while at the same time, unemployment and sick leave benefits have been cut and it has become much more difficult to be able to receive such benefits.

In Denmark, by contrast, even though it too has a formally "centre-right government" it has largely refrained from reducing taxes or government hand-outs, and it has more specifically lacked the focus of their Swedish counterparts in strengthening incentives to work by reducing unemployment benefits and taxation of low income earners.

Wednesday, March 17, 2010

Exchange Rates & Trade Balance Issue Revisited

China and Germany are drawing the ire of Keynesians everywhere, but particularly from British and American Keynesian pundits. How dare they advocate stable exchange rates and sound fiscal policies?.

While phrased in different ways by different pundits, the argument essentially boils down to the supposed unrealism of reducing unsound external deficits of certain countries through reduced fiscal deficits or by relative deflation. Instead, the only realistic way is for surplus nations like China and Germany to increase the value of their currencies (which in the case of Germany of course would have to involve some form of euro area break up).

But as Scott Sumner pointed out in the post I linked to yesterday, the United States has been calling on Japan to increase the value of the yen for the purpose of reducing its surplus ever since the 1970s, when a dollar stood at 350 yen. The value of the yen has since in accordance with American demands increased dramatically, so that a dollar now stands at just 90 yen, yet Japan still has a surplus (Though it is not bashed as much as before as China has taken over Japan's previous role of scapegoat in America).

Another example is Britain which in 2007 had an average monthly trade deficit of £3.75 billion. Since early 2007, the pound has dropped more than 20% against both the U.S. dollar and the euro, yet in January 2010 it ran a trade deficit (goods & services) of...£3.75 billion. That the number was almost exactly the same as in 2007 is of course just a funny coincidence, but the point is that despite a deeper recession than in the euro area and despite a drop in the value of the pound by more than 20%, the external deficit has barely budged.

This is not to suggest that exchange rates all other things being equal have no effect on trade balances. There are good theoretical reasons for believing that all other things being equal, a weaker currency will reduce a trade deficit (or turn a deficit into a surplus or increase a surplus, depending on the initial position) and vice versa for a stronger currency. But these cases illustrate that the effect is probably smaller than many people think, at least in the context of significant exchange rate uncertainty.

Why would great exchange rate uncertainty limit the export boosting effects of real depreciation? Because British manufacturers can't be sure that the current weak exchange rate will really be there in the future too, they won't invest to expand their operations or reduce prices even though it would have been profitable assuming that the pound would remain weak. Instead, they simply reap the windfall gains (something which of course comes at the expense of reducing purchasing power for others) but won't increase volumes.

There are good reasons for businesses not to act on fluctuations in exchange rates, because they are often temporary. One example is Sweden, which saw its krona depreciate by roughly 20% against the euro between March 2008 and March 2009. Now the krona has recovered almost all of those losses and if you take inflation differentials into account, the real exchange rate is in fact slightly higher than two years earlier. Swedish businesses that expanded a year ago to export more based on the weak krona would have now found themselves in a very awkward position as their new production facilities given the current exchange rate is unprofitable. And if they had reduced prices they would now be forced to raise prices, something which might upset customers.

Because businesses can't know whether the exchange rate weakness will only be temporary as in Sweden, or seemingly semi-permanent as in Britain, they won't respond to exchange rate movements anywhere near as much as they would if they knew that the change was permanent. And for this reason, exchange rate movements in a fluctuating exchange rate system will have a surprisingly (to many people) little effect on trade balances.

And furthermore, all other things usually aren't equal. Weaker currencies are associated with higher inflation which will not only make the real depreciation smaller than the nominal depreciation, it will also often reduce real interest rates, something which will prevent the adjustment in spending needed to reduce external deficit.

This is particularly evident in the case of Japan, where most of the increase in the value of the yen reflects consistently lower inflation rather than a real appreciation. Furthermore, during the latest year its surplus has recovered because deflation has persisted there, unlike in particularly Britain and America where inflation has returned to fairly high levels, meaning that Japan now has very high real interest rates while real interest rates are well below zero in Britain and America.

For Britain, its high inflation rate has similarly not only limited the real depreciation of the pound, but by pushing down real interest rates so far below zero it has encouraged people not to adjust spending. The large U.K. fiscal deficit has also helped prevent a reduction in the trade deficit.

Trying to push exchange rates up or down are thus much less effective than, and for that reason no substitute for, fiscal austerity and/or normalized interest rates to reduce unsound external deficits in certain countries.

Tuesday, March 16, 2010

Scott Sumner On Krugman's China Fallacies

I have often disagreed with Scott Sumner's writings, and while I can't say that I agree with everything he writes in this article about Paul Krugman's call for trade war with China over its currency policy (which I commented on here), I do agree with most of it. And he is quite good in those parts where he is right, so do read the article here.

One Unjust Discrimination Justifies Another?

Justin Wolfers is angry that the Texas Board of Education, as part of a general move to allow Texas students to hear not just the left-liberal perspective on various issues, but also hear "conservative" ideas, will start to present Milton Friedman and Friedrich Hayek alongside Adam Smith, Karl Marx and John Maynard Keynes when teaching economics.

He argues that this means that "Hayek is propped up by government intervention". First of all, any government mandated school curriculum constitutes government intervention. So, as long as government school curriculum exists it will be government intervention, regardless of whether or not Marxist and Keynesian views are challenged by Austrian ideas, or not.

His sole argument for why it is somehow worse to let students know about Hayek in addition to Marx and Keynes, instead of just Marx and Keynes, seems to be that Hayek is less quoted in academic journals.

But this just reflects the general leftist and anti-Austrian bias of modern universities. Austrian theory is the most logically coherent and empirically relevant around, and the fact that economics departments generally pretends it doesn't exist is no argument for why Texas schools should do the same. If anything, it makes this change all the more justified.

Monday, March 15, 2010

Krugman's Trade War Fiction

I used to think that while Krugman was terrible on macroeconomics he was good on trade. But since his awful macroeconomics is poisoning his judgment on trade, the latter part doesn't seem to hold true anymore.

This was again confirmed today when he wrote a column calling for punitive tariffs on China unless they revalue their currency. I have already discussed the most fundamental errors of Krugman's analysis of China's currency policy. Here I would like to discuss another assertion made by Krugman: that under current circumstances capital inflows don't boost domestic demand, and that trade deficits (the flip side of capital inflows) will therefore reduce output.

As you may remember, this is the old GDP accounting identity:


Where Y is GDP, C is consumer spending, I is investments, G is government spending and NX is net exports.

Protectionists/mercantilists often mistakenly believes that this implies that if the trade deficit increases (net exports decreases), then GDP will fall. After all, if one component on the right side of the equal sign is reduced, shouldn't there be an equal reduction of the left side?

Actually, no. The reason for this is that the equality of sums on both sides of the equal signs can just as well be achieved by increasing C and/or I and/or G as it can be achieved by reducing Y. In fact, under normal circumstances, equality will be achieved by increasing domestic demand (C+I+G).

The reason for this is that first of all, lower net exports means a greater domestic supply of goods and services, increasing domestic purchasing power. And secondly, the capital inflow that is the flip side of lower net exports will lower interest rates, increasing domestic demand in general and investments in particular.

Krugman argues that this second mechanism is closed because of the "lower zero bound barrier" for interest rates. But as he concedes later, this applies only to short-term Treasuries. It does not apply for medium to long-term Treasuries, or for that matter to other securities.

However, Krugman is unconcerned with this effect because he argues that the Fed can always compensate for this by buying more long-term Treasuries and perhaps other securities, and lower interest rates by a similar amount.

But why can't the Fed do that anyway? With long-term Treasuries and even more so other securities being far above the "lower zero bound barrier", there is no conflict between Chinese purchases of securities and Fed purchases of securities. If it would be desirable after a revaluation, it would be desirable now too. If one feels that a further monetary "stimulus" is needed, it could just as well be achieved by pushing down interest rates further rather than by reducing the trade deficit.

So, the second mechanism does still apply to the U.S. today. And not surprisingly, Krugman completely ignores how the purchasing power of U.S. consumers will be reduced by a dramatic increase in the value of the yuan.

Saturday, March 13, 2010

That's Not Soaring

Euro area industrial production for January was stronger than expected with industrial production increasing 1.7% compared to December (compared to the expected 0.6% gain), and with the December change being upwardly revised to +1.7% compared to the initial -0.6% estimate. As a result of the January increase and the dramatic upward revision of the December number, the 12 month change turned positive for the first time since early 2008. During the latest 6 months, industrial production is up a cumulative 5% (which is more than 10% at an annualized rate). This suggests that the fourth quarter GDP number might be upwardly revised and that the first quarter number might come in stronger than expected.

Still, with the 12 month gain being only 1.4%, it is perhaps a bit misleading to describe euro area industrial production as "soaring", as this news story did.

If you want to see statistics that describe "soaring" industrial production, look at Taiwan, where industrial production rose as much as 69.7% in January (with manufacturing alone increasing 77.0%). In the spirit of Crocodile Dundee (see clip below) I therefore say with regard to the aforementioned news story: "That's not soaring. That's soaring".

Friday, March 12, 2010

Israel's Transformation

Back in 2002, anti-Israel libertarian writer Justin Raimondo wrote a column where he characterized Israel as a "socialist Sparta" (The reference to Sparta is meant to imply that Israeli society is militaristic, just like the society of ancient Greek city-state Sparta was). Most of his column was nonsense, including his predictions of Israel becoming more socialist and economically weaker (see more below on what actually happened ), but the accusation of being a "socialist Sparta" wasn't entirely misleading.

In the early 1980s, more than a third (34%) of Israel's GDP went to government consumption spending (most of it military spending). Meanwhile, tax rates were very high and inflation was even higher, while the collectivist kibbutz movement played a significant role in the economy.

While Israel was very strong militarily, having defeated in wars the much larger nations of Egypt and Syria (helped in varying degrees by other Arab governments and particularly in the 1973 war by the Soviet Union) repeatedly, in 1948, 1956 (only Egypt that time), 1967, 1973 and 1982 (only Syria that time), its economy wasn't strong. While per capita income was well above the level in Arab countries with little or no oil, it was well below the levels in the West (and more oil rich Arab states). With its strong military and weak economy, Milton Friedman (who was himself Jewish) remarked half-jokingly that "Israel disproved every Jewish stereotype. People used to think Jews were good cooks, good economic managers and bad soldiers; Israel proved them wrong."

However, the share of GDP going to government consumption fell steadily from the mid-1980s to 2000, to 26%. At the same time a lot of other free market reforms were made, including a reduction in the top marginal income tax being reduced from 66% to 48%, deregulation and last but not least a reduction of triple digit (200%) inflation rates to the normal single digit levels normal economies have.

As a result of these more market oriented policies, as well as the global tech boom and the large inflow of Jewish immigrants from the former Soviet Union, Israel enjoyed a very strong boom during the 1990s.

Between 2000 and 2003, Israel's economy suffered a serious setback, however. This was in part due to the end of the tech bubble, which hit the high tech oriented Israeli economy particularly hard. The collapse of the Camp David peace talks and the "second intifada" that followed made matters worse. The second intifada was much more damaging to Israel than the first. The first intifada involved mainly rock throwing Palestinians in Gaza and the West Bank. The second meant a wave of suicide bombings inside pre-1967 Israel. As the suicide bombers targeted places where they hoped to kill or maim as many Jews as possible, for example busses, night clubs and cafes, the service sector was damaged as people increasingly stayed at home out of fear of the suicide bombings.

The result of the bursted tech bubble and the second intifada was a significant (though not dramatic) drop in per capita income between 2000 and 2003, and because of the weak economy and the increased spending on counter-terrorist military operations, the share of the economy going to government consumption rose.

After 2003, however, the situation started to improve. The success of many of these operations in destroying Palestinian terror cells combined with the gradual construction of the security fence gradually reduced the number of suicide bombings, and during the last two years (As the fence has been completed) suicide bombings have disappeared completely. With the end of suicide bombings, the civilian service sector has been able to recover and boom.

Meanwhile, the global high tech sector have again started to boom, benefiting Israeli manufacturing. Also, because of the free market reforms and the radically reduced need for counter-terrorist military operations after the completion of the security fence, military spending has been reduced, enabling the government to reduce the budget deficit and also cut taxes.

As a result, Israel's economy has boomed since 2003. Between 2003 and 2009, GDP growth averaged 4% per year, far more than in just about all other Western economies. Even if you adjust for Israel's high population growth, per capita GDP growth was an impressive (Since it includes the crisis years of 2008 and 2009) 2.2%.

Because of the boom, the reduced need for military spending and a deliberate policy of reducing the role of government, government spending has dropped significantly as relative to the size of the economy. Between 2003 and 2009, government consumption fell from 27.8% of GDP to 24.2%. Military spending in particular fell, from 8.6% of GDP in 2003 to 6.5% in 2009, but non-military government consumption also fell, from 19.2% to 17.7%.

Government spending and tax rates are now lower than in most Western European countries, even including military spending, and even more so excluding it. And after the Bush tax cuts expire next year, the top income tax rate (at 45%, scheduled to be reduced to 44% in 2012 and 39% in 2016) will be lower than in many American states, including California and New York. And the corporate income tax rate will be lower than in all American states.

There are likely several reasons behind this transformation. With regard to the reduced role of the military, that is mainly a result of a reduced threat of an Arab invasion, something which in turn is the result of the peace treaties with Egypt and Jordan and the end of the former backer of Arab attacks on Israel ( By that I am of course referring to the Soviet Union). And with the completion of the security fence, the need for military operations in the West Bank has been dramatically reduced.

The causes of the general orientation towards free markets include that after the Israeli economy hit the wall in the 1980s, it became evident for most that the Israeli economy needed reform. Similarly, the dismal results of the Kibbutz communities more or less compelled them to become more market oriented. Another reason is Benjamin Netanyahu as a person. He has argued for free market reforms relentlessly since the early 1990s, and given the influence he has had (as Prime Minister, Finance Minister and pundit) since then this is a key reason for the transformation. Netanyahu has even expressed a vision that Israel should try to become "the Hong Kong of the Middle East" (referring to Hong Kong's reputation as the freest economy of the world).

Israel may still be far away from Netanyahu's long-term vision of becoming a "Hong Kong of the Middle East", but it has in fact gradually moved in that direction since the 1980s, and as a result it has enjoyed an economic boom most of the time (With the 2000 to 2003 period being the worst setback). And as a result of this, it has also moved further and further away from the "Socialist Sparta" status.

U.S. National Savings Rate Hits New Low

Most economists focused their analysis of yesterday's U.S. flow of fund report on the "balance sheet" part of it. While that is indeed an important part, it is not the only important part. And this particular quarter not much changed in that part, with household assets rising relatively moderately, and with debts being roughly unchanged.

More interesting was the news which is supposed to be first published during GDP reports, but that this quarter was first published in the "flows" part of the Flow of funds report. I am referring to corporate profits and national income and the national savings rate.

Corporate profits increased quite a lot, by $100 billion to $1458.9 billion (these numbers are annualized, as are the numbers below). However, most of that was for the companies eaten up by higher tax payments.

Most other components of national income also increased, but as the biggest component, compensation of employees fell even in nominal terms (and even more in real terms), total nominal national income increased only 5% at an annualized rate, less than the 6.3% increase in nominal GDP. Adjusted for the increase in the domestic price deflator, this implies an increase in real national income of 3% at an annual rate, versus 4.3% for GDP.

Since these two should increase roughly the same (exactly the same in fact after adjusting for net factor income from abroad and capital consumption), this means that the statistical discrepancy reached a new all time high, with GDP being $386.6 billion or roughly 2.7% higher than what you would conclude from income based sources. By contrast, in 2006, GDP was $220.6 billion or roughly 1.6% lower than what you would conclude from income based sources.

When two numbers that should be equal aren't, it is usually difficult to say which one is closer to the truth, but generally the truth lies somewhere in between. The implication of this is that the recession was likely deeper than what the GDP number suggested, while the recovery has been weaker than what the GDP numbers suggest.

Another interesting data point is that national savings reached a new post-Depression low. Gross national savings was only $1370.2 billion (or 11.0% of national income) while net national savings was -485.6 billion (-3.9% of national income). Usually the national savings rate is pro-cyclical (increases during booms, decreases during slumps), but during the current recovery it has continued to fall. This is in part the result of the large and increasing budget deficit, and in part the result of a decline in household savings due to low interest rates and rising asset prices.

Thursday, March 11, 2010

Again, Herbert Hoover Was No Deficit-Cutter

Again and again you (this is the latest example) hear the myth that we shouldn't reduce the deficit because that's what Herbert Hoover did and we all know how that ended.

So let's again set the record straight. Hoover was not a deficit-cutter. In fact, he increased the deficit more than any other President in peace time (except for Bush, if you, the wars in Iraq and Afghanistan notwithstanding, count that as peace time). If you don't believe me, look at the official statistics on the subject.

Between Hoover's first budget, for fiscal year 1930, and his last, for fiscal year 1933, the budget balance went from a surplus of 0.8% of GDP to a deficit of 4.5%. This reflected in part a drop in revenues from 4.2% of GDP in FY 1930 to 3.5% in FY 1933, but mainly an unprecedented (at the time) increase in spending from 3.4% in FY 1930 to 8.0% in FY 1933.

Some might think that while he pursued "stimulus" policies during most of his term, he did tighten policy during the last year. But that is not true. While he did raise taxes (Which non-Keynesians can agree was bad for non-Keynesian reasons), he increased spending even more, resulting in an increase in the deficit from 4.0% of GDP in FY 1932 to 4.5% in FY 1933.

Nor was it the case that the increase in the share of GDP going to government spending reflected merely a drop in private output. Real direct federal purchases increased a cumulative 45% between 1929 and 1933.

Because the price index for federal government purchases fell a lot less than the price index for private sector purchases (the federal purchase deflator dropped by 8.7%, while the GDP deflator dropped by 25.3%) , even this number significantly underestimates how large the increase in government spending was.

Given that Keynesians keeps arguing that direct government purchases (such as spending on schools, roads etc.) provides a more effective "stimulus" than tax cuts, this is especially significant.

It is true that the fact that Herbert Hoover pursued a radical deficit spending policy doesn't prove that deficit spending is bad (Instead, this cam be shown with a theoretical analysis). But to try to not only falsely present him as a deficit-cutter, but to imply or explicitly argue that his failure proves that reductions in deficit spending is bad, is worse than misleading.

Wednesday, March 10, 2010

Russia On The Rebound

A decade ago, Russia was once considered to be in near terminal decline. In 1999, It had recently defaulted on its debt and GDP was only $196 billion, less than in Sweden or New York City. Meanwhile, the population was in steep decline with only 1.27 million births (1.25 million if you exclude infants that died before their first birthday) in 2000 a nation of 147 million, while the number of deaths was 2.23 million, meaning that the population declined by almost a million per year. Apart from the permanent seat in the U.N Security Council and the large nuclear weapons arsenal it inherited from the Soviet Union, there seemed to be no basis for considering Russia to be a great power, much less a super power like the Soviet Union.

The general feeling in Russia at the time was one of great humiliation as the former super power had seemingly been transformed into a dying and impoverished "has been" nation.

Since then, a lot of things have changed. The Russian government has run surpluses and paid back its foreign debts and despite a set back in 2009 due to the global crisis, growth has been generally very high during the 2000s, and GDP rose to 39 trillion rubles, or roughly $1.3 trillion at current exchange rates. That is still smaller than for example Spain or California, but it is a lot more than Sweden or New York City.

The main cause of the rebound in the Russian economy has been the strong increase in commodity prices, especially oil. By contrast, in the late 1990s commodity prices were unusually low, something that contributed to the crisis at that time. Another key reason for the boom is the low flat tax instituted in 2001.

Meanwhile, in part as a result of the improved economic conditions and in part because of efforts by the government to encourage births, the number of births has soared, from 1.27 million to 1.72 million in 2008, even as the overall population fell from 147 million to 142 million, meaning that the crude birth rate rose from 8.6 per 1000 inhabitants to 12.1. The number of deaths has by contrast declined from 2.23 million to 2.08 million, with infant deaths falling particularly much, from 19,300 to 14,500.

During the first 9 months of 2009, births increased an additional 3.7% while deaths dropped an additional 4.2%.

Because of the steady increase in births and decrease in the number of deaths, the drop in Russia's population might soon start to stop its contraction and start to increase, especially if you consider net immigration (while Russia has net emigration to Western countries, it has a larger net immigration from other parts of the former Soviet Union).

On the other hand, the increase in births and decrease in deaths will particularly in the short term increase Russia's dependency ratio. But with the number of people in the age of 15-64 being 71.6% of the total, compared to 63.9% in Japan, this problem will be manageable. Furthermore, with the number of children in the age group 0-14 being bigger than in Japan (14.7% versus 13.4%), while the number of people in the age group 50-64 is much smaller (17.8% versus 20.6%), the coming drop in the working age population will be much smaller than in Japan.

Russia still faces significant certain or potential problems, in the form of a corrupt justice system, limitations in free speech and potential renewal of separatist insurgencies in Chechnya and elsewhere and the dependence on the commodity sector makes the economy vulnerable for another drop in commodity prices. But clearly, the future looks a lot brighter for Russia than it did a decade ago.

Chinese Oil Imports Soar

Perhaps somewhat unexpectedly (Given the Lunar New Year Holiday), Chinese crude oil imports increased at an even faster rate in February than in January, up 57.8% to 18.5 million tons or 4.85 million barrels per day.

This is one example of how it is strong demand in China and other Asian countries that is causing the price of oil to continue to reach new highs, despite weak demand in the West.

U.K. Economy Clearly Contracted In January

While Britain, like most other countries don't publish monthly GDP data, it seems very clear that its economy contracted in January as retail sales, net exports and industrial production all contracted.

Some of this was clearly attributable to the temporary weather factor, but it also illustrates that the underlying economy is weak. Now that the weather factor is disappearing, it remains to be seen how just how weak it is.

Tuesday, March 09, 2010

Swedish Welfare State Issue Revisitied

Swedish libertarian Marcus Bergstrom has an article on discussing the Scandinavian welfare state which is generally interesting and good and also references two articles written by me.

Bull & Bear Debate

Stock market bear Robert Shiller debate stock market bull Jeremy Siegel here in an interesting exchange of arguments.

As long time readers know, I agree with Shiller. Beyond that, I could add that Siegel's argument that the 10-year P/E ratio shouldn't be trusted because it is affected by write-offs overlooks that over the long run, write-offs don't affect earnings.

What I mean by that is they reflect real world losses suffered by companies. While these losses often aren't created during the exact quarter when there is a write off, that only means that losses are overestimated that particular quarter, that only means that losses are underestimated by a similar quantity other quarters. As a result, it is simply not true that write offs distort 10-year earnings measures.

Another of Siegel's argument, where he looks at analyst expectations for future earnings is also invalid. "Analyst expectations" are in a quite systematic matter consistently extremely over-optimistic (when it comes to future earnings. "Estimates" are then conveniently and quietly revised down in time for the actual reports so that it will appear that earnings are "better than expected"), and are therefore useless for the purpose of stock valuations.

Monday, March 08, 2010

Is The Euro Doomed To Short- To Medium-Term Weakness?

A reader asked for my opinion of this article by Wolfgang Münchau. More specifically, he asked about Münchau's assessment that the euro will be weak in the short to medium term future. Münchau's case can be summarized to the following premises:

1) Fiscal tightening will occur through the euro zone, especially in Greece and the other countries with large deficits.

2) Fiscal tightening either means that the private sector financial savings balance must weaken or that the current account balance will become stronger.

3) If the private sector financial balance weakens, then there will be a depression which will weaken the euro.

4) A stronger current account balance requires a weaker euro.

Since we given premises 1) and 2) must see either a weaker private sector financial savings balance or a stronger current account balance, then if we accept the truths of premises 3) and 4), a weaker euro is a certainty.

Is he right? Well, assuming very briefly for the sake of the argument that the premises are all correct, then he would indeed be right to argue that a weaker euro is unavoidable.

But are the premises correct? Well, premise 1) is nearly a certainty. Clearly most euro area countries, but particularly those that now have large deficits, will reduce their budget deficits.

Premise 2) is an accounting identity and thus a definite certainty. Private sector financial savings is defined as the government budget deficit plus the current account balance, so a lower government deficit will require either a reduction in the private sector financial savings balance or an increase in the current account surplus.

Premises 3) and 4) are however clearly incorrect. A weaker private sector financial savings deficit is not by necessity coupled with a depression. Indeed, empirically the private sector financial savings deficit is in fact bigger during booms than during busts. By reducing the budget deficit, consumers will feel less need to save in preparation for future fiscal tightening, and businesses can invest more because of lower interest rates. While a lower interest rate will in itself weaken the currency, this is something which probably has already been priced in during the recent period of euro depreciation.

And the idea that a stronger current account balance requires devaluation is pure nonsense. Latvia has seen its current account balance swing from a deficit of 26% of GDP in 2007 to a surplus of about 10% of GDP in 2009, without devaluation. Because fiscal tightening reduces demand for imports it is an effective way of reducing a current account deficit without lowering the value of the currency.

And despite a dramatic dollar rally in late 2008 and early 2009, the U.S. current account deficit dropped significantly in late 2008 and the first half of 2009. Later in 2009 the dollar did again start to drop, after which the U.S. current account deficit again increased....

As I explained here (commenting on the fact that the U.K. deficit hasn't fallen despite the weak pound, which also contradicts Münchau’s' premise), movements in real interest rates appears to be more influential than movements in real exchange rates on external balances.

As a side note I have no strong opinion on the euro's near term movements. There are both good arguments for and against it becoming weaker. A key valid argument for it is that the ECB is likely to abstain from interest rate hikes for as long as the panic about government debt in Greece and elsewhere in the euro zone persists. But this is something which given the last few months' depreciation might have already been priced in. Also, because fiscal tightening will reduce inflation, real interest rates might be going up even if nominal interest rates remain unchanged.

Krugman Says His Own Textbook Is Bizarre

James Taranto at the Wall Street Journal points to how Paul Krugman is in effect calling his own writings bizarre. Here is what Krugman wrote the other day:

"What Democrats believe is what textbook economics says...

...But that’s not how Republicans see it. Here’s what Senator Jon Kyl of Arizona, the second-ranking Republican in the Senate, had to say when defending Mr. Bunning’s position (although not joining his blockade): unemployment relief “doesn’t create new jobs. In fact, if anything, continuing to pay people unemployment compensation is a disincentive for them to seek new work.”

In Mr. Kyl’s view, then, what we really need to worry about right now — with more than five unemployed workers for every job opening, and long-term unemployment at its highest level since the Great Depression — is whether we’re reducing the incentive of the unemployed to find jobs. To me, that’s a bizarre point of view — but then, I don’t live in Mr. Kyl’s universe."

Here is what Krugman himself wrote together with Robin Wells (his wife) in his textbook "Macroeconomics":

"Public policy designed to help workers who lose their jobs can lead to structural unemployment as an unintended side effect. . . . In other countries, particularly in Europe, benefits are more generous and last longer. The drawback to this generosity is that it reduces a worker's incentive to quickly find a new job. Generous unemployment benefits in some European countries are widely believed to be one of the main causes of "Eurosclerosis," the persistent high unemployment that affects a number of European countries."

I guess this means that Krugman writes textbooks about other universes. Maybe he can one day tip us off about how to travel between universes. Until he does, we can ask Krugman why anyone should be interested in buying his textbooks, since most of us prefer to learn about the universe we live in, rather than bizarre ones that we can't reach.

UPDATE: I see now that Krugman here tries to explain away his contradiction by saying that NAIRU is determined differently from unemployment, and that the supply curve doesn't matter in a recession. Which is complete nonsense of course, as a shift in the supply curve from an increase in supply (which is what less generous unemployment benefits would achieve) will invariably result in a higher quantity (which in this case means a higher quantity of employment) to a lower price in all markets, including labor markets.

Saturday, March 06, 2010

Ex Ante & Ex Post Rationality

I have repeatedly written in the last few weeks that I think the current yield spread between Greek and German government bonds of about 300 basis points is too high, given that the probability of default is actually very low.

But wouldn't you agree that the yield spread was too low in the past when it was more like 30 rather than 300 basis points? Previously I might have simply said "yes" to that, and I would indeed agree that 30 basis points would be too low today (Just exactly how high it should be is difficult to say, but 100 basis points would be fairly reasonable), but the issue is somewhat more complicated than that. To understand why, one must understand the difference between ex ante (before the act) and ex post (after the act) rationality.

Everyone makes mistakes, and I've certainly made my fair share of them. However, with regard to most of my mistakes I would still maintain that the decisions behind the mistakes were rational given what I knew then. Had I known what I know now I obviously would have made a different decision, given what I knew then most of the decisions were rational.

To illustrate this, let's compare two lottery tickets. Lottery ticket number one costs $10, and gives you a 75% chance of winning a $1 million. Lottery ticket number two costs $10, and gives you a 10% chance of winning $12. Assume that you only had $10, which one would you buy.

I think that just about everyone would choose the first one. But suppose that it turned out later that the first one was actually a blank lottery ticket, while the second was actually a winning ticket. Would you still say that the right choice was the first lottery ticket?

Knowing what we know now, the second ticket was clearly the best choice. But knowing what we knew before the purchase decision, I would maintain that the first ticket was the rational choice. The first ticket was the most rational choice ex ante, while the second ticket was the most rational choice ex post.

Turning now to the issue of whether the German-Greek bond yield spread was too low in the past, I would say that the yield was too low in ex ante terms but far too high in ex post terms.

Given the dismal fiscal track record of Greece in the past, and given that we didn't know with certainty what would happen, a yield spread of 30 basis points was too low.

However, given that we now know that Greece hasn't defaulted during the latest decade, the correct yield spread for all securities that have matured was in fact zero. If there is no default (or other problems like higher transaction costs) than any yield spread above zero is too high, since given that we now know there was no default, the investor in German bonds would earn less for no reason.

Given the knowledge we have now ex post, a 30 basis point yield spread is 30 basis points too high. However, given that we ex ante couldn't know for sure that there would be no default, and given what we knew about Germany and Greece, then 30 basis points was arguably too low, just as 30 basis points would be too low today.

Friday, March 05, 2010

Oil At Post-Crisis Highs In Euro, Pound Terms

Since October last year, the U.S. dollar price of oil has been moving within a trading range of roughly $70 to $80, though it has briefly risen slightly above that range. After the markets interpreted the employment report in a bullish way, it is again trading at somewhat above $80, $81.90 to be more precise when this is written.

However, it should be noted that while the price of oil is only slightly above previous post-crisis highs in U.S. dollar terms, it is in fact significantly above previous highs in terms of weaker currencies such as the euro and the pound. Compared to the November high of $80.38, oil is up only about 2% in U.S. dollar terms. But at that time the euro was trading at roughly $1.50 and the pound at roughly $1.67, meaning that in terms of those currencies oil was trading at roughly €53 per barrel and £48 per barrel respectively. Now with the euro down to about $1.35 and the pound down to $1.50, this means that the oil price in those currencies are up to about €60 per barrel and £54 per barrel respectively, an increase of more than 10%.

This is important to remember as even many people in Britain and the euro area irrationally tends to think of the oil price in terms of the U.S. dollar price, deluding them to think that oil has become only slightly more expensive for them since November.

Employment Report Difficult To Interpret

The U.S. employment report was relatively weak in an absolute sense, with both payroll employment and aggregate hours worked down.

However, given the weather related disturbances, the numbers weren't that bad. Since the exact impact of the weather factor is unknown, we'll have to wait until at least the next report to get a clearer picture of the underlying employment trends.

German Factory Orders Rebound Sharply

German factory orders rebounded as much as 4.3% in January, after a drop of 1.6% the previous month that was smaller than previously reported. Compared to a year earlier, they were up 16.1%. They are still however significantly below pre-crisis levels.

This suggests that the German economy is stronger than generally thought.

Thursday, March 04, 2010

Remember: Rumors Aren't Reliable

The extent to which markets are driven by baseless rumors is illustrated by the panic about Greece.

In addition to many other inaccuracies, rumors that some form of EU bailout for Greece is imminent have hit us at least three (I might have missed some additional cases) times:

From February 11

From February 23

From February 28

Yet ultimately, in all three cases the rumors turned out to be false.

While it remains a possibility (though it looks increasingly unlikely) that a bailout will eventually come, the point is that you shouldn't trust press reports citing "anonymous sources". As that could be anyone (including even the journalist in question making it up. Since he could always claim that he simply "protects his sources", how could pure fabrication be proved?), it is clearly not reliable.

Wednesday, March 03, 2010

Humiliated Greek Unions

The marxist Greek government sector employee unions must feel pretty humiliated today. Here they launch two full day strikes against the governments plans to reduce their bonuses and freeze their base salaries. And what do they have to show for it? Well, they'll clearly lose the pay they would have received if they had worked on those days. And now they are also told that the government after these two strikes will cut their pay even more.

They may strike one or two more days, but the government will likely again respond by ignoring them or even respond with yet further reductions in their pay (in addition to the pay cuts that the strikes directly inflict upon them). With the bond market and other EU leaders putting strong pressure on the government´and with a majority of Greeks supporting the austerity plan, the government have no reason to give in to their demands. All further strikes will do is ensure that the striking workers will lose yet more pay.

Sectors Benefited By Cold & Snow

I have previously discussed how the weather factor, in the form of cold and snow up here in the northern part of the northern hemisphere is negatively affecting the economies up here.

There are however sectors which will benefit from this weather. One is of course the snow removal businesses. They have been a lot more busy than usual something which will also of course increase their incomes.

Another sector is the utilities (power plants). This was illustrated in today's industrial production report from Estonia. For the first time since the beginning of the financial crisis, Estonia saw an increase (though only very marginal at 0.3%), reflecting primarily base effects as the big declines in late 2008 are removed from the 12 month comparison, but also an increase in output compared to previous months. However, manufacturing still posted a 2.8% annual decline and mining rose only 0.6%. By contrast, power production surged 24.5%. The reason why power production increased so much is that the unusually cold weather in Estonia increases the demand for heating.

Because of the boost to the snow removal and power production businesses, the negative net effect on GDP will be limited. However, since snow removal and heating really aren't good things in themselves (they merely mean that the greater evils of snow on the roads and cold are averted), this limiting effect from this is arguably an illusion, and official statistics will therefore underestimate the economic welfare loss from snow and cold.

Tuesday, March 02, 2010

Latvia, Ukraine & Devaluation Issue Revisited

I found the reactions of Paul Krugman and Edward Hugh to this story by The Economist on Latvia to be rather strange-and misleading on the subject.

Contrary to what Krugman and Hugh seems to think, no one is denying that Latvia has suffered very badly during the latest slump, and from what I can tell that also includes the story in The Economist, as it frankly notes the big slump in GDP and the high unemployment rate.

The point of the story is simply to note that the people who argued that a Latvian devaluation was inevitable have been proven wrong. The Latvian government and most Latvians remains firmly committed to the peg to the euro and later adoption of the euro as currency. And with a large current account surplus, and with radical fiscal austerity measures combined with loans from the IMF, they won't be forced to do so against their will because of liquidity problems. Meaning that a devaluation at this point looks extremely unlikely, something which proves the people who thought that devaluation was inevitable wrong.

What Krugman and Hugh in their answers seem to do is try to shift the discussion from whether devaluation is inevitable (and whether it was ever reasonable to believe that) to whether it would have been or is desirable, an issue that wasn't at all discussed in the article they fume about.

It is of course true that just because something isn't inevitable doesn't mean that it's not desirable. There are lots of desirable things which unfortunately aren't inevitable or even likely. However, it is also the case that just because the Latvian economy is weak doesn't mean that devaluation would improve this situation.

If the alternative is worse, even bad things are preferable. The Czar of Russia and the Shah of Iran were arguably bad rulers, but what replaced them in 1917 and 1979 respectively were far worse.

Simply writing that Latvia's "internal devaluation" has been limited so far begs the question since it assumes that large (negative) real exchange rate movements are the key to prosperity-which is hardly self-evident.

I have dealt with the issue from a theoretical point of view here, where I concluded that devalution was in fact a worse option.

But that's "liquidationist" Austrian theory, some will think. "Look at how Latvia is suffering in the real world"! But again, the issue isn't whether Latvia is suffering or not (it clearly is), but whether or not they would suffer less with devaluation. And while everyone focuses on the suffering of Latvia, the equally large suffering of another country which used to be part of the Soviet Union, Ukraine, is conveniently forgotten. This is rather remarkable given the fact that Ukraine is in terms of population roughly 20 times bigger than Latvia (The Ukrainian capital of Kiev alone has more people than all of Latvia). If anyone of these two countries would be forgotten, you would have thought that it would be the far smaller Latvia rather than the far bigger Ukraine.

The fact that Ukraine has suffered badly of course doesn't prove that they would have suffered less without devaluation. This issue should be dealt with on a theoretical level, which again, I've already done. But the point is that Ukraine proves that countries can suffer dramatic drops in output even with devaluation, and that it is clearly wrong to assume that it can prevent such pain. And so, arguments againt my theoretical analysis should consist of theoretical counter-arguments.

Look Who's Talking

After Philadelpia Fed President Charles Plosser apparently noted the same thing that I did, that "core" inflation excluding rents (including "equivalent rents") is actually up significantly the latest year, Mark Thoma responds:

"Would he be as dismissive if only "certain relative prices" were keeping inflation high? I think not."

But the "core inflation" index itself represents an exclusion of "certain relatice prices" that keeps all-item inflation high, namely food & energy. And the point is that if we can exclude food & energy, then surely we can exclude rents.

Monday, March 01, 2010

U.S. Savings Rate Lowest Since October 2008

Today's U.S. economic releases were basically consistent with the bearish pattern I reported about last week.

While the ISM manufacturing index showed continued expansion in February, it was at a slower pace than the previous month. Meanwhile, construction spending fell in January.

While consumer spending rose, real disposable income fell both including and excluding tax & transfer payment changes. As a result, the savings rate fell to 3.3%, the lowest since October 2008. The savings rate is down from 5.4% during the second quarter of 2009.

This drop in the savings rate is likely primarily the result of the wealth effect created by higher house- and stock prices, as well as negative real interest rates. The low and falling savings rate will limit the ability of households to increase spending further.

German Fourth Quarter Growth Stronger Than It Appeared At First Glance

When the German first quarter growth number was first published, it was viewed as a disappointment as it showed zero quarterly growth and a 2.4% contraction in yearly calendar adjusted terms.

But while growth wasn't exactly vigorous in the same way that Taiwan's growth was, it wasn't non-existent either. As was revealed in the more detailed numbers later published, Germany experienced significant terms of trade gains, with export prices rising 0.9% on the quarter, while import prices fell 0.5%. As a result, the domestic demand price deflator fell 0.6% even as the GDP deflator fell only 0.1%. If you then adjust the 0.1% nominal decline with the 0.6% drop in the domestic demand deflator, you get an increase in GDP of 0.5%, or 2% at an annualized rate.

Compared to a year earlier, the drop in export prices was 1.9% while import prices fell 4.7%. As a result, the domestic demand deflator rose only 0.2% while the GDP deflator rose 1.1%, trimming the yearly decline from 2.4% to 1.5%.