Tuesday, December 28, 2010

Happy New Year

Many people around the globe celebrated Christmas on Saturday and whether or not you are a Christian Christmas it is a big day for most of us. Those who like to shop love the opportunities December affords. Those who cherish the spiritual part and the giving can feel and share their love of God and their fellow man with great intensity. Those who enjoy parties will get plenty of time to revel and gain weight which they can dutifully plan to shed in the New Year. The rest of you will hopefully enjoy the beauty of winter and the anticipation about what 2011 will bring. Those of you on the East Coast may have enjoyed enough winter!

I am pleased to give you all a really big gift by taking this week off from venting my spleen in my blog. But I do want to thank-you for giving me the chance to spout off in 2010. As you know I retired from Indiana University last January and I was not very sure how the first year would go. As it turned out I got chances to teach for a couple of months in South Korea and Vietnam. Last January I was lucky to share some ideas about macro on a nice little island off the coast of Florida. These teaching experiences kept me connected to macro and teaching. But the blog was my constant companion over this year and it gave me impetus each week to keep up with the latest news and issues. As you know it was a year in which macro could have won an Emmy Award.  There was never a time when I sat at my computer wondering if there was something juicy to write about.

Writing helps me to think in a more organized way. It also helps me get things off my chest. I always feel a lot better when I post a message. I admit that it is a very selfish affair for me. I can only hope that you benefit from my macro-thoughts. For all that I leave you with my thanks and a brief personal message.

My family and especially my parents and spouse always saw and see the world through an optimistic prism. To them, the world’s glass (of JD) is always half full. They never met an enemy and usually interpret difference of opinion and argument as a result of the complexity and changing nature of most phenomena. We might think of an adversary as misguided or misinformed but mostly we believe the interactions with them make us better informed about our own judgments. How boring and cruel a world would be if we all shared the same opinions about everything!

No matter what I might say about an issue or a person or a political party I hope it is taken in this positive spirit. I will do my best in 2011 to respect those who hold different opinions but I hope I never shy away from what I consider to be the right and the wrong of a particular issue or policy. We humans have much more that binds us than divides us and I hope we realize that as we move into an exciting but potentially divisive year.

You might be curious who reads my blog. It is mostly insane people I know pretty well. They include my former students, my recent students in Seoul, Hanoi, and Sanibel Island, and many colleagues. But I also badger various relatives, friends, and neighbors who might have some interest in macro.  I connect with all these people through Google’s Blogspot, Facebook, Linked-In, and Twitter. I also send a personal email to 100 and something people.

Blogspot has a statistics option which lets me know information about those who read my posts. Here are a few facts:
  • ·         Since June of 2010 I posted 64 articles on 21 different macro topics (you can see all the topics on the lower right corner of the home page if you scroll down)
  • ·         I posted 11 articles on Macro Policy, 8 on Exchange Rates and Policy, 6 on Employment and Unemployment, and so on.
  • ·         The most popular articles were Fairy Tales Can Come True (Aug 6), AT&T (July 4), the Myopic Squirrel (Sept 13), The G20 (Oct 28), and Lilliputians(Aug 23).
  • ·         There have been approximately 4,000 pageviews – posts that have been read or at least opened
  • ·         While 75%of these page views came from the USA, I seem to have readers in South Korea, the UK, Vietnam, Canada, India, China, Germany, Spain, France and Finland.
  • ·         Almost half of you used IE to connect but 24% used Firefox and another 25% used either Chrome or Safari.

I look forward to more spouting in 2011! Best to you all.

Monday, December 20, 2010

Nobel Nonsense and President Obama

I was going to take the week off and send you a nice holiday message and then one of my colleagues sent me the link to a Paul Krugman article. I guess I will send you my holiday message later in the week. 

I don’t like to read Paul Krugman articles because it is bad for my blood pressure. This guy has a Nobel Prize in economics which makes you think he might really care about his science but instead he uses his elite position to be the spokes person for one extreme view of economics. With his behavior he gives a bad name to the science and it riles me a bit. I would think that even liberals would be embarrassed by some of his antics.

In “When Zombies Win” http://www.nytimes.com/2010/12/20/opinion/20krugman.html , Krugman uses colorful language to say basically two things. First, Obamanomics didn’t fail – the President simply didn’t try enough economic stimuli. He had the right idea -- he simply didn't do enough of it. Second, he says President Obama, unlike Reagan who stuck with his ideas, has been cast into a spell by conservative zombies and they are going to eat his brain and our economy with it. Really – this Nobel Award winner said that!

To prove that Obama’s stimulus package was too small, he says “government spending on goods and services grew more slowly than during the Bush years, hardly constitutes a test of Keynesian economics.” Wow – talk about a real economic scientist! He uses government spending on goods and services as the only real data pertinent to stimulus in the last two years. Dear Paul – what about government transfer spending? What about government bailouts? What about tax cuts? Does anyone really think he provides a full coffin of evidence about stimulus by measuring only GPGS? I am glad for any college student taking freshmen economics who would not give such an answer on his or her final exam.

Then Krugman says that conservatives are totally discredited because inflation and interest rates have not risen in response to the stimuli. I am guessing that few economists really predicted a rise in inflation BEFORE the economy started to recover in earnest.  Most of us believe that something called the GDP Gap needs to closed before inflation starts rising. We also would not see interest rates rising until the paranoia about slow growth significantly reduced the demand for government bonds. Krugman turned a very legitimate worry or concern about stimulus causing higher inflation and interest rates into a forecast – and one that all his adversaries must have agreed with.  Talk about creating a straw man!  He also says that disinflation continues. Technically, that means that the inflation rate continues to fall.  Does he provide a shred of data or evidence? How much did the inflation rate fall in the last, say six months? Three months?

That Obama had the audacity to praise Ronald Reagan and admitted that some austerity is necessary for historically high levels of deficits and debt, make the President Zombie prey.  Those nasty Republicans made him say “Uncle” and now, according to Krugman, he can never oppose their incessant demands for ghoulish austere economics.

Krugman cites Ireland as an example of why austerity policy is bad. I guess that is the sum total of his knowledge about austerity and the experiences of no other countries matter. I would hope that no freshman university student would write such flimsy answers to important questions. Of course, if you happen to be Irish then you might want to reserve judgment about what did or didn’t help the Irish find their way out of their very tough present economic condition.  

Like Krugman, I don’t like the way Obama supported a tax plan that goes in the wrong direction. As I wrote last week, this won’t create enough stimuli to reduce the rate of unemployment. But Krugman wants more stimuli and that’s where he and I part ways. The US economy is gagging on past stimulus and will eventually swallow and digest it all. At that time the economy will grow – especially if we quickly introduce a fiscal restructuring that deals with future deficits and debt. Krugman might call that austerity but I call it common sense. 

Monday, December 13, 2010

Shakespeare 's Comedy Plays Out in the US Government

On Sunday I watched CNN until I thought I was going to choke from excessive theatre. If Shakespeare was alive he would have applauded loudly at the farce we call Washington. I am not sure which play the current cast of characters would best fit – A Comedy of Errors or All’s Well that Ends Well? I won’t say a lot more about these plays since I read the Clift Notes versions at best as a freshman at George Tech in 1911 and don’t want to give away my total lack of understanding of the arts.

But you have to admit without actually being a Buddhist monk that these politicians are missing the big picture. No matter how you look at this thing what was once billed as a renewal of the Bush tax cuts is now the world’s most laden Christmas Tree. The unfolding legislation is a really bad deal for all of us. Yet the stage production repeated with excruciating analysis by the press and Internet conveys how and why it is of the utmost urgency. I don’t agree.

As many of the Ds and Rs and journalists hold hands and sing one more kumbaya we are lulled into a warm sensation that this compromise bill is going to stave off a double dip recession and be just what Dr. House ordered to reduce the unemployment rate.  But are we really holding their feet to the fire? Will the bill do what we hope? Here are some things to think about.

  •      The bill, even with all the new ornaments they are adding, will amount to a very small stimulus. It mostly keeps tax rates the same in 2011 as they were in 2010? How is that a stimulus? How is that going to significantly reduce the unemployment rate?
  •     The bill in any manifestation will definitely add to the government deficits in coming years. These additions to an already bloated government debt pile certainty leads to even more uncertainty about interest rates and the soundness of federal, state, and local governments. Of course, you can translate that business uncertainty into a virtual certainty that you, I, and Mr. Jones are going to pay higher taxes at some point in the future. 
  •      This bill does absolutely nothing to reduce the explicit and implicit debt obligations coming from Social Security, Medicare, and Medicaid. And it does nothing to reduce or control healthcare costs for those who actually pay for their healthcare.
  •      Have you heard of bond vigilantes? This terminology is a colorful description of the people and institutions that make their living trading bonds. Call them geeks or greedy they have the tools and rights to decide when bonds are no longer a good deal. Most of us buy bonds and hold them to maturity. But sometimes we decide to sell them before maturity and it is these bond dealers who form a market so we can do that. We like them when they buy the bonds we no longer want so that we can buy villas on the Croatian coast. Anyway, as the US debt gets a big as Roseanne Barr’s belly, we recognize that there are way too many bonds out there and this should lead to a fall in the price of bonds. Knowing that – a lot of us want to sell these bonds before they lose too much of their value and the bond vigilantes are leading the charge with their faithful dog, Rin Tin Tin. No offense to Lassie. As bonds become as cheap as kimche in Korea, the returns on the bonds soar. Another way of saying this – it takes a much higher interest rate return to get people to hold all this kimche. Viola (or to you unsophisticated people who cannot spell in European, Walah) – the higher interest rates then act as an impediment to people who want to buy new houses and firms who want to buy new equipment. It generally slows things down.
So let’s summarize the above. This new legislation will not be a big enough stimulus; it will make the US debt larger; it will create more uncertainty; it will raise interest rates; and it will reduce spending on housing and investment. Hmmm.

You might be fuming at this point and say, LARRY, IF WE DO NOT PASS THIS BILL WE WILL GO DIRECTLY INTO A DOUBLE DIP recession. The capital letters implies that you are yelling at me or that you hit the Caps Lock key by accident. It is taken for granted by EVERYONE that if we let tax rates rise in the coming year that we will go directly without collecting $200 dollars to the square titled “Recession”.  So I have two things to say about that. First, this is not 2007 and we are not in free fall. While the economy is not growing as fast as we would like right now, it is growing and we are not in the same kind of panic situation as we were a couple of years ago. We do not need desperate policies. There are plenty of green shoots showing that the US economy is improving and as I have said in many past posts – we need to heal the housing markets and financial problems before the economy really picks up. This recent legislation does nothing directly to heal housing or finance. As I said above, passage of this bill does very little while creating very large risks.

Second, I am not advocating doing nothing. In fact, I would go along with some well-placed stimulus as long as it was coupled with Angelina Jolie.  That’s not right. I mean so long as some stimulus was coupled with a plan for long-run fiscal balance. I don’t need the long-run plan to start impacting us today. Too much austerity right this minute might not be good. But I do need the Plan to be legislated tomorrow with its first real impacts starting a few years from now. By legislating a plan today with impacts starting tomorrow – means we all can start planning today. That longer-term plan could have some elements of very short-term stimulus within it. But the longer term plan must show how we are going to pay for it in the future.

A good friend of mine had knee replacement surgery last week. He needed some pain medicine to get through the first week of recovery but soon he can get by without it. He knows that he has ahead of him several weeks of lingering pain and tough rehabilitation. By any definition, that plan for rehabilitation is tough and nothing to look forward to. But he knows that it is the only way to a recovery that allows him full use of his knee and leg. We in the USA can pretend that we don’t need a rehab plan yet, but the truth is that our government is giving us pain pills and are afraid to have us think about the future. We are better and tougher than that. We need better leadership and we need to make sure they know that. It is easy for them to legislate another round of morphine. Let’s not let them do that without also being very clear about what we need to grow again. 

Tuesday, December 7, 2010

The Fiscal Circus Has Two Rings

Now that Congress is making a little traction with a framework for fiscal policy, let’s not get carried away with dangerous partial solutions. It is one thing to keep the patient out of pain with an injection – it is quite another thing to apply the remedy to his problem. So let’s not get so excited about the easy part until we see the rest of it.

Any good circus has more than one ring.  In Ring 1 we have Congress working on an extension of the Bush tax cuts beyond 2010. That’s akin to a shot for the pain. In Ring 2 we have the serious stuff – a solution to fix our debt problems and therein address unemployment and economic growth.  It seems strange that the public has been so divided about Ring 1 since it is the easy one. Both democrats and republicans have joined hands in a holiday chorus and are singing a Hail Mary designed to focus on a possible deficiency of aggregate demand in the short-run. They had their little spats. The Ds don’t like it when stimulus includes the behaviors of high income earners – while the Rs don’t like the stimulus coming largely from the lower ends of the income scale. But let’s face it – they both get to go play on the monkey bars and jungle gyms at recess if they pass something before January 1. The public is going to shower them with love and kisses for saving our nation from a tax increase in a slow growth period with high and stubborn unemployment.  So it is unsurprising that they will find a consensus on the Bush Tax Cuts.

I am not against Ring 1 and am not against the general notion of keeping tax rates low right now. But I do see this as akin to a good dose of Demerol with no surgeon in sight. Ring 1 is okay so long as there is real action in Ring 2. This conclusion is based on one simple point – the Ring 1 solution will do little to reduce the unemployment rate without a satisfactory solution from Ring 2. Ring 2 contained the National Commission on Fiscal Responsibility and Reform. It went home with a few trout in the boat but not enough to start a real fish fry in Congress. It is true that 60% of the members of the commission voted yes to the spirit of a feasible but imperfect compromise law to attack our escalating government fiscal woes, but that wasn’t a strong and clear enough message.  Ring 2 is in limbo right now. The surgeon is not to be found.  Even if the Commission failed to get the required number of votes, it is still possible that the President and Congress can continue the work in Ring 2. So all is not lost.

While all is not lost, nothing yet is gained from a compromise in Ring 1. After all – in reality an agreement to leave the tax cuts in place for next year or beyond is simply a vote for NO CHANGE. The agreement keeps taxes from rising by keeping them the same as where they were in 2010. If we want 2011 to be better than 2010 then it takes some change. So the big question is – what needs to be changed?

Bernanke, Geithner, and many others still believe that the earth is flat. Oops, I mean they still believe that the problem with the US economy is deficient spending. So the kinds of change they are promoting in Ring 1 are fiscal and monetary policies that would stimulate more household spending.  They also believe that the economy has been very unfair to the average person so their preference is to help people with middle or lower incomes spend more. They don’t want to help Gazillionaires.

Another group sees it differently believing that aggregate demand is deficient because firms are hiring too few workers despite some signs of economic revival. Until firms start hiring more, no amount of stimulus is going to be effective. So all we need to do is figure out why firms are so reluctant to hire.  Or in other words, despite the fact that output has gone up in the last five quarters, employment has barely budged.  Why are firms not hiring? Without a significant resumption of hiring stimulus cannot work. First, the unemployed have few resources to spend. Second, even the employed people are reluctant to spend because until hiring picks up they are not sure that they won’t be the next to move to the unemployed pool.

Consider what happens when you hire a new permanent worker. First, the person must be trained. Second, the firm makes an implicit if not explicit contract to continue employment. If nothing else there is a goodwill gesture made on the part of both parties. Third, the firm will increase what it pays into the state unemployment pool. Fourth it will add to the payroll tax paid. Fifth the firm will probably incur expenditure for various benefits – including healthcare and pension. These are not entered into lightly.
Consider the alternative to hiring an additional new worker. Don’t hire anyone! When sales pick up it is possible to work the existing workforce harder. The firm can expect more output during the regular day or it can pay more for overtime. The company might also think harder about how to employ its workers. It might be possible to change its business practices in such a way that the same amount of labor can accomplish more in a given day. Clearly there are financial incentives for firms to not hire more workers. Buying a machine that makes existing workers more productive means not having to pay additional payroll taxes, healthcare benefits, pension benefits, etc.

So why would firms hire more? I love this question because it gets to the heart of economics since it is all about marginal benefits and marginal costs. According to marginal analysis, you hire another worker when the marginal benefit to the firm of one more worker exceeds the extra costs of one more worker. That is, the firm hires more if the increased employment increases its profits.

In a capitalistic system, firms are free to make hiring decisions and they generally hire more to capture higher profits. The government policy question, then, is as follows. If you want more spending, you need more employment. If you want more employment firms need to expect higher profits. Sales are expanding now so you would think that this would lead to higher profits. While profits are rising now the question is for how long? Firms would like some certainty that the recent short-term profits will not vanish as soon as they arrived.

And this is why Ring 2 is so important. To create the increased profit certainty that firms require will take increased attention to the things that might threaten future profits. Historically high government deficits and debt are real threats and all the current fuss over government instability in Europe points to how corrosive this can be. Government could go a long way to reducing profit uncertainty by crafting a solution for the government fiscal mess. This, of course, brings together the recent explosions of debt caused by stimulus legislation, health care, and by the ongoing and fully expected fiscal requirements of Social Security, Medicare, and Medicaid.  It is one thing to make a decision about the future of the Bush tax cuts – it is quite another thing to help firms better understand the tax and other regulatory impacts on them of dealing with the next 20 years of fiscal challenges.

Until you solve Ring 2 we will get no bang from Ring 1. Until you solve Ring 2 you get no decrease in profit uncertainty and no real commitment to hiring. Take no pride in a solution to the Bush tax cut extension until they get on with the real business of government. 

Thursday, December 2, 2010

A Keynesian Wolf misleads about the Euro

I thought I had finally settled the debate about the euro crisis with my last post (ha ha) and then along comes this piece by Martin Wolf in the Financial Times (December 1, 2010). http://www.ft.com/cms/s/0/259c645e-fcbb-11df-bfdd-00144feab49a.html#axzz16y45YdFO

My previous post argued that the euro might depreciate more but it would surely not implode. Wolf is a great writer and I usually like to disagree with him because he is a not-so-closeted Keynesian and I am neither closeted nor Keynesian. This article irks me more than his usual writing because it epitomizes really good analysis based on a really wrong premise. His article illustrates what is wrong with much of what is written these days and helps me try to live up to my goal for this blog – to spout off.

The title of Wolf’s article is “Why the Irish crisis is a huge test for the eurozone” and he concludes that by joining the eurozone, a country consigns itself to credit crises. His words of advice to countries that give up their own currencies to be part of something like a eurozone, “… be careful what you wish for: credit crises would replace currency crises – and these are likely to be even worse.” 

He has an elegant explanation for all that. He begins with the premise that it is inevitable that countries with “divergencies in relative costs” would have international trade imbalances. That is, without flexible exchange rates a country with a bump in relative costs would soon find itself less competitive and would soon have a structural trade deficit. A depreciated currency could have come to the rescue and offset the cost change and restore its competitiveness. Sans an exchange rate depreciation in countries like Greece and Ireland, each would be stuck with a trade deficit implying a need to borrow from abroad to finance their trade deficits. This means a larger foreign debt and should a country have trouble meeting the debt at some point – wham bam thank-you mam – a credit crisis would occur. Then –oh my goodness – national prices would fall worsening the credit crisis – and that makes it much worse than a currency crisis might have been (if the country had its own exchange rate).

Since you know I love to use analogies – Wolf’s point is like saying that you can solve the morning after problem for the drunk by taking aspirin instead of Ibuprofen. We can spend until hell freezes over debating which drug is more effective for a hangover (I prefer a nice strong Bloody Mary myself). We might even find that one of them is better for hangovers. But the only real solution for a hangover is to not drink so much and to not dance to 1970s disco music like John Travolta wrapped in colorful beads with a lampshade on your head. My point is that Wolf is writing about “effect and effect” rather than “cause and effect”. His defect is in his focus on effects without causes. He shifts our attention away from the real problems to a choice of medications.

When this very intelligent man analyzes the issue of the euro, why does he not once – not one single time – does he not go back to the idea he starts with – the cause of it all – the change in relative prices? Why – because he is a closet Keynesian. They usually ignore the original problem. They see any problem as an excuse or some clever ploy to get the government involved by spending more. After all – there are so many things the government could be doing if they just spent more!

If a rise in relative costs and prices causes a country to lose competitiveness – I ask – then why cannot this country work directly on reducing its relative costs and prices? Would it be impolite to even ask this question?  If a country is made more vulnerable because its households go on a spending spree and forget to save; if a country’s government goes on an economic development spending binge that reduces national saving available to corporations; if a country’s companies get lazy and don’t invest in the right technologies or products – in all these cases its competitiveness will be reduced. But notice that in all these examples of cost disadvantage there is a direct cause that could be directly addressed if politicians had the cough-cough sincere interest or kahunas to investigate. But that is too hard for them to do. All that discussion of details might not fit on the teleprompter. Rather than take a real educational and leadership role about a complicated problem – it is much easier to advocate a policy to increase government or household spending.

In this particular case Wolf is blaming the problem on a single currency. If the poor babies only had their currencies back then the boo boo would go away. NO IT WOULDN’T AND READING ANOTHER CHAPTER OF DR. SUESS WON’T HELP IT GO AWAY. If those weakened countries had their currencies back their exchange values would plummet towards zero and contribute to a generally hysterical situation. The rapidly declining currencies would lead to large and rapid outflows of portfolio and real capital. Declining currency values would make it more impossible to pay off their debts.  Maybe you have read about past currencies crises? They do happen – and it seems to me they happen a lot more often than credit crises.

But I don’t want to get sucked into Wolf’s trap. It isn’t about the currencies. It is all about the CAUSES of competitiveness changes. If countries lose competitiveness for fundamental reasons then their leaders ought to decide what those reasons are and address them. Debating whether European nations would be better off with or without the euro misses the target, misleads, and misdirects our energy. Policymakers should not be discussing a euro break-up. They should be discussing the regulatory, housing, financial, spending, and saving practices that led to their current predicaments. If leaders don’t get this right then they ought to be replaced. I hope our own policymakers in the USA get this message too or 2012 could be really interesting.  

Monday, November 29, 2010

The Euro -- Breaking Up is Hard to Do

Many of the international monetary experts are weighing in on the future of the euro.  While I might not be an international monetary expert I do need weighing, so here goes. There is little reason for the euro to implode, for Spain to leave the euro, or for there to be separate clubs for euro-weak and euro-strong countries. While the euro might weaken more in the near future I think it will remain the currency of at least 16 countries for the foreseeable future. I agree with Neil Sedaka's 1962 tune from the good old days -- Breaking Up Is Hard To Do. 

Notice that when a hurricane devastated much of Louisiana, that state was not kicked out of the dollar alliance of 50 states plus others. That was true even though it might have helped folks in New Orleans if they had their own currency and it depreciated a bunch. Just think of all the Japanese tourists with their Nikons who might have been able to afford a neat trip to Patty Obrien’s, including a swamp boat ride and all the ‘Gator-filled Po-Boys they could suck down. Of course, let’s not forget a midnight beignet at the Café Du Monde.  But I digress.

You might retort that Louisiana is part of country called the USA and Greece, Ireland, Spain, and Portugal are part of a monetary union called the Eurozone. To be part of this monetary union all 16 members of the Eurozone signed a treaty in Maastricht that is a very formal document with pretty lettering and no smiley faces. I agree that it doesn’t have the force of statehood but it clearly is not trivial – and was not entered into lightly. All members of the Treaty drank copious amounts of Belgian coffee with delicious French pastries over many years and I am guessing that on more than one occasion a German official pointed out after one-too-many Schnapps that all members were not created equal.  Clearly they spoke of contingencies and escape mechanisms.

But even if they didn’t and some of what has transpired in the way of country debts and economic contractions was not expected, there is still little reason to break up the Eurozone. At least until recently there was a line-up of countries that wanted into this elite club – and for good reason. The Eurozone did what it was expected to do – it removed a major irritant from international trade between a growing number of European countries whose economies were becoming much for economically integrated. I am among millions of travelers who remember how stupid and irritating it seemed, when traveling around Europe, to have separate little piles of lira, pesetas, deutsche marks, etc. To businesses, this inconvenience was multiplied into unnecessary transactions costs. Of course, when these European currencies were sometimes changing in uncertain ways this really hurt business planning and it made a lot of sense to eliminate that risk by adopting one common currency. Wow! How cool can you get! As there is still much integration to unfold in Europe, these benefits will continue to hold and grow.

There is much more to the benefits of the euro – and countries like Greece, Ireland, Spain and Portugal reaped some of them more than others. Clearly from the standpoint of currency credibility these four and some of the other members gained when they gave up currencies with bad reputations for one that seemed a much better bet for the future.

Still you might say, wouldn’t the weaker countries benefit if they could depreciate their own currencies? And the answer is probably not.  All countries have policies tools to help when things go wrong – monetary, fiscal, immigration, financial regulation, and many more. While it is true that exchange rate management can be a powerful tool for a country, there are many countries that never use it. Many prefer to peg to the dollar or some other currency or bundles of currencies. Many simply do not believe it is wise to try to fine-tune their economy with the exchange rate.  So it is not a universally accepted best-policy. Whatever could be accomplished by depreciating their currencies in the current crisis could be managed with other traditional policies.

And one could argue that such exchange rate management policies or dirty floats come with great risk. There are numerous recent historical examples where speculators or hedge funds have caused devastating impacts on countries that waited to use depreciation as a tool of macroeconomic or trade policy. Right now the euro is taking a little beating from the markets – but certainly nothing like non-Eurozone countries have experienced in the last couple of years. I doubt that Ireland, Spain or Portugal would be better off with their own currencies depreciating by the likes of 50% right now!

And then there is the case of the strong countries, like Germany. Why not boot the scofflaws? Why should German citizens bear part of the brunt of weaknesses in neighboring countries? For one thing, Germany, France or the other stronger countries cannot really escape the fate of their weaker trading partners because of interdependencies. While the euro might be stronger today with a smaller club, contagion would still impact a wider group of countries whose economies are linked. Clearly the banks of the stronger countries hold the liabilities of the weaker ones. Business firms engage in cross-border trades in myriad ways. If Spain, for example, applies a fiscal remedy that slows economic growth in that country, clearly with or without the exchange rate impacts, this slower growth will spill over into its European trading partners. This is the price one pays for economic integration. If you want to receive the benefits of the relationships then you sometimes have to suffer through the costs – whether they come through exchange rate effects or not.  Furthermore, just because weaker countries might be asked to leave the Eurozone, they would still be members of the European Union. The EU might, in that case, be involved with policies to bailout or otherwise assist the weaker members.

In short, the benefits of the euro continue and neither the weaker nor the stronger countries will be better off by reducing the number of countries participating in the Eurozone. The best bet is that the Europeans will do what they often do – eat more croissants with that wonderful Spanish ham and debate until well into the night over cognac and brandy. The EU started a long time ago. The Eurozone is newer but has already endured much. In all, European countries show an ability and readiness to hash it all out and move forward. I bet they will continue to do the same now.  Don’t look for any pesetas anytime soon. 

Monday, November 22, 2010

Blinder makes Monetary Policy on the Moon

I eased off the topic of Quantitative Easing (QE) until now because there was so much being written about it. But then all this stuff about Prince William and Princess Kate hit the news and I realized two things. First, I am getting really old. Wasn’t Prince William playing in his crib last year? Second, you people need a little diversion from the Royal Family. And then to top things off Alan Blinder, a former Fed vice chairman, called QE2 a “garden variety monetary policy.”

Wow. Professor Blinder must be growing his artichokes on the moon if he calls QE2 garden variety. It is true that the Fed always does monetary policy by buying government bonds and by trying to influence interest rates. The buying of the government bonds washes the banks with new increased liquidity and reduces the pressure on the cost of bank borrowing. The general idea is that if the cost of bank funds decreases then banks will be willing to reduce interest rates on loans. The story continues – and then goldilocks lived happily ever after. Err, I mean the story goes that firms see lower interest rates and they jump in their Fords and drive down to the carry out window and borrow tons of money and spend it on new machines and workers. 

While I make a little fun with the story, the truth is that this sometimes works. The truth also contains the fact that most of the Fed's buying of government bonds is in bonds of short maturities. Therefore most of the direct impacts on interest rates occur at the short end of the term structure – on bonds that mature in two years or less. Of course, they hope that the reduction in short-term rates would bring about a decline in longer- term rates as well. To have the full or complete impact the story wants to have all rates decline. 

The above is garden variety monetary policy on planet Earth.

So what is different about QE2? First, it was invented in places like Japan and now the US where short-term interest rates are virtually zero so that the above story is no longer relevant. The Fed cannot reduce short-term interest rates and the cost of bank funds. So they decided that if they are going to make Mad Money (the TV show) on a regular basis they better come up with something cool and novel. If Nancy Pelosi cannot save the US economy, then maybe the Fed can.

Second, the Fed realized that even though they were able to drive short-term interest rates to zero (ta da!) rates on longer term assets were not coming down as much or as fast as they wanted. After all, to have the largest impact on spending it is important to impact loans with longer maturities. So QE is different – since it worries less about short-term rates and forcing even larger amounts of unused reserves on banks – and more on directly influencing long-term interest rates. While this has been tried by the Fed in the distant past, it is NOT DOING MONETARY POLICY AS USUAL.  And, of course, you wouldn’t have thousands of articles being written about QE if it were business as usual. 

Policy conservatives have plenty to chew on. QE and QE2 represent a broadening of the Fed’s tools or perhaps even its mandates. If policy conservatives want the Fed to focus its energies more narrowly (aiming only at inflation), then they are not going to sit around smelling incense as the Fed gets more active.  Moreover, policy conservatives might point out that QE1 already stuffed plenty of money into pillows and adding a second round is only asking for trouble. Professor Blinder can show you overhead slides of how easily it is to pull money back out of those pillows when necessary but what he can’t easily show you is how difficult that plan is to put in place in the real world right here on Earth.

Third, the difference in QE2 also relates to the business environment. Keynes convinced most of us that monetary policy is NOT the best tool to use when the recession is deep and when confidence is failing. Keynes and his legion of legally-obtained medical marijuana smokers have a preference for fiscal policy. Read recent articles by Krugman and Stiglitz to see why some activists prefer fiscal to monetary policy today. While you should not count QE2 out until the bell rings, it does not surprise me that most long-term interest rates rose – did not fall – once the Fed got serious about some of the details of QE2. As Keynes might say today, the Fed‘s flailing attempt to do something is doing nothing but creating a higher risk environment. Alan Blinder and some current Fed officials can say all they want – but markets are smarter than that. QE2 is not a good policy for the Earth at this time.

Tuesday, November 16, 2010

Voodoo Economics, Part 2

In my last post – Voodoo economics – I hit my page limit before I got to any real specifics. I laid out a rationale for why demand-side policy probably was largely spent and gave some background on supply-side policy. The main point is that supply-side policy has a checkered reputation that is mostly undeserved. It is pretty easy to dispense with the charges that it won’t work or that it is trickery. The more difficult aspect is that supply-side policy generally works BECAUSE IT STARTS by impacting rich folks and business firms.  But what matters most is where it ENDS – so let me get on with that point.

If you are imbued with equity and making sure that all people are always treated equally then you may find supply-side policy offensive. If you HATE capitalism and think that most capitalist policies are part of a great hoax that perpetuates current power and wealth, then you are probably not going to trust supply-side policy. If you are simply hoping to find a policy that will help us permanently exit this horrible recession and slow growth period, then you will want some assurance that any policy will do what it is supposed to do – create more economic prosperity and jobs. So where is the beef (or tofu for my vegetarian friends)?

Keep in mind that every policy is uncertain and risky. The Fed’s new quantitative easing policy is hotly debated. Another round of short-run government stimulus is no slam dunk and has its supporters and detractors. Supply-side policies are no different so let’s not read what I say here as blue-sky advocacy.  In my previous post I made the point that supply-side policy works because it directly impacts those who do the hiring and produce the output. The supply-side policy is directly aimed at business firms’ bottom lines. The basic intuition is that if policy can somehow make business executives more optimistic about their future revenues and costs, then they will be more willing to make capital investments and hire more workers.

Of course, like all policies, supply-side policy has its own moral hazards and unintended consequences. So we shouldn’t throw the baby out with the dirty bath water. Whatever advantages are given to companies and high income investors, attention must be paid to how they will translate into jobs and economic growth. I have said many times that I am neither a democrat nor a republican. Adam Smith was very clear that while he favored letting the invisible hand work, that firms are just as capable of corruption and waste as governments. While supply-side immediate impacts must be directed to firms and higher income investors – the true value of this approach is in its ultimate impacts in terms of higher output, more employment, and higher incomes.

What I didn’t do in the last post is to discuss the many ways this can be done. Notice that even among supply-siders there can be very different preferences for specific policies. Much depends on what you think is the biggest problem – what is making firms less willing to use their piles of cash today? What is making them less willing to make capital investments? Why don’t they hire more workers?

For starters, imagine one group of supply-siders who believe the economy is on the mend. They believe that we got hit by an economic firestorm that rocked our economic foundations but that the resilience of the economy provided the foundation for recovery and the policies of the last two years did not prevent some early healing. These supply-siders point to various green shoots or data that show promise of a continued recovery. Their supply-side recommendation might be – Don’t rock the boat! They might advise the government to create as little change as possible.  Just let the economy continue to heal. Firms will jump in as soon as they are surer that this recovery really has legs.

Of course, another group of supply-siders might believe that government policy was too aggressive and that we have created a very risky business environment typified by too much government debt. We all have seen some really worrisome estimates of future debt burdens. They bring up scenarios in which the US becomes the disdain of world investors causing a plummeting dollar, declining stock prices, and rapidly rising interest rates. It is not a pretty picture. These supply-siders believe that you can reduce the risky environment by paying attention to imbalances in the balance sheet of the Fed and the large liabilities of the government. Firms will not hire workers in sufficient numbers until they believe government debt and Fed policy are under control. Their supply-side policy means significant changes in the government budget and Fed policy.

Other supply-siders worry about international competitiveness. They worry about a government that seems to give lip service to free trade and a strong currency but whose real actions seem to put off the real decisions about trade or they lead to a declining value of the dollar. Whether it was the recent Asian Summit or the G20 meetings, the US was able to accomplish little. We have stalled so long on bilateral free trade agreements that our potential partners now seem to be the ones dragging their feet. The US harps on about China’s currency when most people agree that the US is equally culpable. Geithner blames the recent spectacular declines in the dollar on a reversal of safe monies. But what does he think caused the “new” view that the US is an unsafe place to invest? Keep in mind that while dollar declines might help exporters – they do very little to improve the competitiveness of US importers and they accelerate the desire of foreign investors to move their money out of the US. If you were a foreign investor, would you really want to receive your future return in dollars that are worth 15% less?  Real free trade and a real strong dollar are not easy to buy today. But they are an indispensible part of a strong and viable supply sector. 

Most discussions of trade end up with a story about saving. We all know by now that the US saves too little – and therefore our imports end up rising faster than our exports. This implies a need to borrow from the rest of the world – and we do. It is pretty clear that we in the US need to save more and our trading partners could save a little less. But who does saving in the US? Short answer – rich people and companies! The only real way to increase saving in amounts that matter is to increase the reward to saving. A Fed policy aimed at zero interest rates does nothing to help! A threatened increase in income tax rates and capital gains tax rates does nothing but reduce the incentive to save. Opponents of lowering these rates always point to the disproportionate benefits that would go to rich people. But notice that their focus is on the immediate impacts. Instead they should trust that a country with normal or strong saving more easily channels resources for innovation and labor productivity without having to borrow from abroad. Saving is the key to economic growth and rising incomes.  The ultimate effect is the one we should be focusing on today.  Thus some supply-siders advocate lower tax rates for companies and households regardless of income.
I am getting too wordy again and I have only discussed four examples of supply-side policies. I don’t want to promise a Voodoo 3. There are so many other great topics to be talking about!

So let me just summarize the rest briefly. Another approach to supply-side policy focuses on the reward to produce and the reward to work. While the US used to have a reputation of a country with a small government and low taxes, this is no longer the case.  Whether it is taxes on energy or regulations that require firms to guarantee health care or be greener it is no secret that firms feel increasingly burdened by government. Given the inertia of the government, firms are also increasingly uncertain as to how these new regulations and taxes will impact their future net revenues.  Add to that a worry that current unflattering attitudes toward the rich and corporations raise expectations about higher taxes on the incomes of companies and high income individuals. A supply-side approach recognizes how counterproductive this environment is to economic growth and employment.

Several leaders of the Democratic Party have very recently pointed out that postponing increased tax rates for the rich is the fair thing to do. They also are holding social security out of any discussions of how to solve long-term government debt challenges. Again, the issue is fairness. But what does fairness mean? I really doubt that dragging our feet on needed policies for economic growth is going to have an impact on the rich or the poor. The rich will take care of themselves at the country’s peril. The problem of poverty has little to do with marginal tax rate changes and everything to do with very long-term factors involving sociology, education, and training.  All government policies should not be held hostage to fairness. The fair thing to do is to take a very comprehensive and realistic view of poverty in the US – and then do something about it. 

Supply-side policies deserve a good look. There are many ways to skin this cat. But we won’t get to the first step if we can’t get beyond the Voodoo. 

Wednesday, November 10, 2010

Voodoo Economics, A Trojan Horse, and Trickle Down: Is it time to give the supply-side a try?

In Econ 101 we learn that economics is all about supply and demand. I was recently in South Korea where flooding caused by a typhoon virtually destroyed the cabbage crop. While Bugs Bunny would be quite upset about such an event it was even more important and upsetting for Koreans whose main dish, kimchi, is largely composed of cabbage. Kimchi is eaten at least once a day by many Koreans. Most Koreans have two refrigerators – one for all their other food and the other just for kimchi. I do not hide the fact that I love kimchi as much or more than most Koreans and I have several shirt stains to prove my devotion to the wonderful dish.

It was no surprise to anyone when the price of kimchi rose by 600% this summer. Why? Because of supply and demand. While the demand for kimchi had remained largely unchanged by the typhoon the supply had been reduced by the bucket-full.  As such grocery stores and restaurants bid up the price of this very scarce commodity as they tried to fulfill the usual wants of their customers. The market result was a much higher price. As kimchi came into Korea from abroad and the supply began to recover, the price of kimchi peaked and then started downward.

As the US Congress reconvenes as lame ducks and then for real in 2011, we should remember that government has policy tools that can be aimed directly at demand, supply, or both. But as the title of this message suggests, any member of the US government who recommends a supply-side policy will have to get over huge political obstacles. When George Bush Sr. was competing with Ronald Reagan to get the Republican presidential nomination in 1980, he labeled Reagan’s policy Voodoo Economics. The implication was that Reagan was trying to foist magic on the American public. Supply-side economics was also referred to as a Trojan Horse implying this policy was a trick on the American people. Finally, supply-side economics is alleged to be a tool to help the rich at the expense of the poor – meaning that the real benefits go to rich people and companies and all we can do is hope for some benefits to trickle down to the poor and middle class.

In short – supply-side policies are thought to be magic, a cheap trick, and a tool to steal from the poor and give to the rich. That’s hardly a resounding vote of confidence. It is no wonder politicians do not want to stand up and be counted for a supply-side approach. But I will argue below that the supply-side reputation is better than the title suggests and supply-side policy is just about perfect for our challenges today.
Let’s begin by quickly defining the supply-side. Economics concludes that while society will want and express a demand for food, autos, appliances and multi-colored condoms, it takes business firms to produce them. When we study demand we focus on the factors that determine what households want to purchase. But when we analyze supply, we emphasize the ability and motivations of business firms to produce those products. Supply does not get created magically. Firms must put together resources – like raw materials, intermediate assemblies, labor, machines, factories, and energy – if they are to bring the right goods to market at a competitive price.

If President Obama wants to improve the climate for production and employment, then he has choices. A demand-side approach focuses on the consuming household.  He can recommend tax reductions and subsidies to induce households to spend. He can use government legislation to direct the government’s awesome machinery to spend more. When we talk about a “stimulus package” we are usually thinking about how the government can create more demand in the economy. Despite all the controversy right now, it is true to say that sometimes these demand-side remedies work. The government stimulates demand and firms respond like Pavlov’s famous dog – demand increases and firms produce more. To produce more they often hire more workers.

But right now at the end of 2010, it isn’t perfectly clear if the demand stimulus choice is the best one. We saw what happened when cash for clunkers expired. In a previous post I explained that households are repaying debt or are otherwise saving. Given the remaining uncertainty about the economic recovery it seems wiser for them to be saving and not spending. Of course, business firms are watching all this and are not about to risk their capital to produce more until they are more certain that any demand increases are going to have some staying power.  That leaves the government’s direct spending on the economy. But even here we learned how disingenuous Congress can be. So called shovel-ready projects were about as ready as a Medicare patient at a high-jump competition. Government largess was aimed at a multitude of Democratic pet peeves. We learned that the political process can be very slow and unreliable when it comes to quickly generating more demand for goods and services. Yet it was perfect at increasing government debt.

The second choice available to President Obama is a supply-side policy. Supply-side economics was boosted when Jean-Baptiste Say ( Say’s Law) declared that “supply creates its own demand”.  The general meaning of this statement is that factors which cause permanent changes in society’s capacity to produce often lead to conditions (e.g. falling prices) which raise the level of demand to the higher amount of supply. Most economists today use Say’s Law to guide their analyses and forecasts of long-run economic growth. These forecasts have no role for demand and totally explain long-run changes in economic growth with two factors: labor supply and productivity growth.  The upshot of economic growth theory is that strong growth will occur only if and when labor supply and labor productivity growth permits it. Persistent economic growth is the only way to have persistent and permanent increases in employment.

Today our demographics indicate there is very little potential to increase economic growth and employment through faster labor supply growth. Our baby boomers (hurrah) are retiring and there is only so much that can be done through immigration or inducements to remain in the labor force.  So that leaves labor productivity as the only real route to stronger economic growth and employment.  How does a government formulate policy to achieve stronger labor productivity growth? First, the government needs to recognize that innovation and higher productivity are the keys to business success – firms with higher productivity compete better. So the firms are willing partners in any policy that improves labor productivity.  Second, the government must realize that productivity enhancements are expensive and often require firms raising large amounts of capital. Third, firms will not take these large risks without believing that they will pay off – and create excellent returns to the owners and stockholders. Fourth, these payoffs relate very much to two key factors in the business environment – expected future revenues and costs.

In a nutshell – supply-side policy needs to create optimism and clarity among business firms about future profits. This optimism is necessary for the capital investments that will lead to higher economic growth and employment. Any policies that promise restrained business costs and more certain long-run revenues and after-tax profits are what we need right now. These policies are what we call supply-side policies.
Is this magic? Ask China and the dozens of other countries that have implemented similar supply-side policies if they have worked.
Is this a trick? The above discussion explains why the supply-side approach should work.  While this approach might not work, it clearly has a strong rationale for why it should be effective. This is no Trojan Horse.
Is this trickle-down? It is no act of deception to recognize that supply-side policy generally aims its most immediate impacts on business firms and wealthier people.  How much of the benefits are absorbed by the poor or the middle class is definitely a legitimate question. My reading of economic history is that the only real way to permanently raise the standard of living in a country is through long-term economic growth.  Schemes to redistribute income or to equalize incomes can be effective only in an environment of growth. 

Demand-side policy is very risky right now. It might not work. Worse yet, it might create higher uncertainty about the long-run future of America as it raises US debt, worries our trading partners, and opens up concern about when and by how much the future stimulus will be withdrawn.  It is time to give supply-side policy another look.

There is a lot more to say about this issue. Hopefully this is a start to a good discussion. Let me know what you think.

Friday, November 5, 2010

Misunderstanding Changes in US Competitiveness -- Miss Piggy and US Imports

Recent government releases of trade data have Americans concerned. The monthly trade deficit increase in July and was approximately $10 billion higher than in July of 2009. It got even larger in August and September 2010. The National Income and Products Accounts definition of the goods and services trade deficit found the deficit had increased to an annualized  -$515 billion in the third quarter of 2010 -- $124 billion larger than it was in the third quarter of 2009. (Data are real, annualized) 

The data speaks for itself but the press and politicians have generated only misinterpretation and confusion.  As usual – they are more concerned about winning friends and votes than they are about faithful interpretation.  A worsened trade deficit is nothing to be happy about – but there is much more to this picture. The graph below has annualized quarterly real net exports of goods and services (annualized exports of goods and services minus annualized imports of goods and services) for all quarters between 1995 and the third quarter of 2010. The most noticeable aspects of the graph are the deterioration of net exports between 1995 and 2005 and the subsequence reversal in trend starting in late 2006. The eyeball easily sees that NET EXPORTS ARE IMPROVING.  

While it is true that there was a deterioration in a few quarters since late 2006, the overwhelming story is the improvement. But as I will explain below, the recent improvement in net exports has very little to do with US trade competitiveness and should not be interpreted as a return to normal. It has more to do with large and erratic quarterly swings in our appetite for foreign goods. Inasmuch, there is little that policymakers can or should react to from these recent quarterly changes. Clearly, the one-quarter data does not suggest a need to cajole China or anyone else.

While it is true that the one-quarter change of -$106 billion in 2010 QII looks large, it does not necessarily bode ill. We have to wait and see. In fact, a closer look at the quarterly net export changes reveals a very large increase in quarterly variability since 2006 – the standard deviation was approximately $50 billion per quarter. That means that the large one-quarter change of - $111 billion in 2010 QII was within 2 standard deviations of the mean change since 2006 of $17 billion.  This means that $111 billion falls within the 95% confidence interval and therefore is not an unlikely outcome.  With this kind of volatility it would not be surprising to see net exports improve by $111 billion in 2010 QIV.

A second issue is the erroneous interpretation. When we read that net exports are deteriorating we question the ability of US firms to compete globally. While net export changes are the result of changes in both exports AND imports – we often focus only on the export side. The misleading interpretation is the conclusion that if net exports are worsening, then it must be because US firms cannot compete anymore. Or perhaps it means that China is an unfair trader – slapping egregious import tariffs on our goods or manipulating its currency. Clearly there must be some unfair practices in China and abroad or our US companies would do better. If we are having trouble selling goods abroad, the story goes, then this is hurting our recovery from the recession and is having a negative impact on workers who produce exports. Let’s face it – it’s a chilling story and it gives our politicians a way to ride in on their silvery steeds and save the day against those unfair and mean enemies.

Of course, none of this is true insofar as recent events are concerned.  US exports increased by $225 billion in the last five quarters – an increase of more than 15% in real terms. Exports increased in every one of those five quarters and by amounts ranging from $20 to $84 billion per quarter.  If anything – it has been these increases in exports that have sustained the US economy and prevented job growth from being even worse!
It turns out, however, of you want to talk about US Net Exports for the entire time period and the key sub-periods – the trade story is about IMPORTS not exports. The below chart – if it is readable on the blog – shows the quarterly changes in exports (blue diamond) and imports (red squares) since 1995. 

Here’s is what we should notice –

First, in the vast majority of quarters from 1995 to 2005 – the imports are above the exports – meaning that no matter how much exports increased in a particular quarter – imports increased by more. We can really suck in foreign goods!

Second, in the time period directly afterward 2005 – the changes in imports declined and then went negative. As the recession approached and worsened and US incomes decreased – we quit spending. We stopped buying all goods – both domestically produced and imported.  Export changes also shriveled but by less than the imports. So net exports improved! So for a while we see net exports improving not so much because US firms were more competitive in global markets – but because the US was hurting and our populations was buying less.

Third, in the final five quarters – 2009 QIII to 2010 QIII – we see the US economy starting to recover and our appetite for goods returning. Despite the large and positive swing in exports – imports started rising even more and the trade deficit worsened in 2010.

Fourth – looking at the chart you see that these recent changes in imports are probably unsustainable – since they are well out of line with the past history of import changes. The export recovery seems much more sustainable.

In summary, recent changes in net exports tell us less about changing competitiveness of US firms and more about the appetites of US consumers and firms.  Increased volatility of net exports warns us not to make too much of one-quarter changes of the recent past and coming future. If we want to restore the US to balanced trade, the data suggests we should think more about how and why US households and firms increasingly look abroad for their purchases.  If foreigners are so willing to buy US goods – why aren’t we? Pointing the finger at China might not be so smart. Our world exports are doing well.

Thursday, October 28, 2010

The G20, gruel, and low-hanging fruit

The G20 is meeting in Seoul to deliberate and the buzz is that they are going to focus on exchange rates and trade, among other things. Expectations are high among some people that this body will help resolve current trade issues. There were similar high expectations when the members of the World Trade Organization started the Doha Round. And there was good reason for optimism.  Globalization has shrunk the world. We are all more highly related in terms of business and economic policy. The global recession called for a coordinated approach to the slowdown and the financial problems that caused the worst economic collapse since the Great Depression.  Yet little has come of the Doha Round, coordinated financial reform, solutions to trade imbalances or currency competition. While it is true that protectionism has not raised its ugly face as much as it could have, there seems to be more than the usual amount of finger-pointing and populist face saving.  Deficit countries complain about surplus countries and vice versa. Germany wags its boney finger at the US for its inability to let go of its warm blanket – stimulus. Others worry that Germany, Great Britain and Canada maybe over-doing austerity.

Wazzup? Nothing more than common sense. While most of us love the benefits we get from clubs and teams we are not ready to give up who we are just for the sake of camaraderie. You love golf and are willing to shell out the monthly dues for the country club, but you aren’t about to throw out your favorite golf shirt just because other members are offended by it. Or you love the friends you met in your new bicycle club but you draw the line at 50 mile rides at 7 am on Sunday morning. And what is this – say again – I have to drive across town to meet with my Chocolate Martini Club because some of the members don’t have cars and prefer a location closer to their apartments? In short, we like the benefits from integration but there are limits to how much we really want.

The same can be said for international integration. While 16 countries of Europe decided to tie their sails to the euro, that doesn’t mean that the French will give up their snails or the Germans will welcome you in the morning with a bon jour. Politicians in each country are elected by their citizens. If globalization brings benefits to Spaniards, then they will applaud further integration. But when they believe that a particular new attempt at further integration will bring negatives to Italy, then Italians will throw their pastas in the face of any Italian politician who dares to sign the new free trade agreement.

In a paper I wrote some years ago, I talked about low-hanging fruit. Starting in the 1980s it seemed that globalization brought easy benefits to most countries. As tariffs came down in leaps and bounds, countries found that freer trade was like a tide that raised most boats. But as we approach 2011 and countries seem to have more equal strength and say-so than ever, the new  agreements seem more like zero-sum games. So each side fights tooth and nail. Each politician would rather say NO and go home and be honored, than make an  agreement that has some potential to harm his or her citizens.

The low-hanging fruit is gone. The WTO and other formats require consensus. How do you get such consensus with 20 diverse countries much less 160 of them? What you should expect – in the real world – is discussion and more discussion.  Clearly as the value of the dollar continues to fall, export-oriented countries whose well-beings are tied to strong exports will want to push harder to stop the dollar’s trajectory. Already we read more and more about weaknesses showing up in Germany, Korea, and several other countries. And many countries are not happy with the US for flooding their economies with dollars. But it is not in the immediate interest of US policymakers to have a stronger dollar or a more responsible monetary policy. Wam bam – there is no warm hug there.  With respect to trade problems in general – we cannot expect much fun in the sun either. Even with a declining dollar the US trade deficit is not going to disappear until US savings increases or our foreign friends reduce their savings.  But national savings in any country do not easily change since they are tied to culture, institutions, and very long habits.

So what we can conclude about this G20 meeting in Korea is that there will be no home runs and no singing in the sauna. The leaders are smart enough to know that nothing will be gained by sharp rhetoric and mean disagreements. Instead we will receive flowery speeches and unintelligible communiqués.  Milk toast will be abundant.  We have two things going on. We have a very difficult world economy  with no easy solutions. But we also have leaders who want to appear like they are doing something for their people. Since they know the real solutions are just about impossible and may mean some real sacrifice, we will get gruel. No low hanging fruit means we eat gruel! Bon apetit

Thursday, October 21, 2010

Currency War – My Mom’s tougher than your mom

The current discussion about a Currency War gives me pause to think about how far we have come during my life. I am at the leading edge of the baby boom because my father had one thing on his mind when he jumped ship at the end of World War II. So while I didn’t really live during WWII I feel that I can claim a connection. That was a hot war and there was no question about the meaning of war and that we don’t want to do anything like that again. While I missed the Korean War by being too young, I was just perfect to join the US Air Force and was able to participate in Vietnam.  I swore to the medical officer during my draft physical that I had flat and very smelly feet, but that didn’t seem to deter them from inviting me to join. Those wars were nothing to replay again. I spent most of my enlistment in an air conditioned office but we all know the horrible outcomes that all sides suffered from in Korea and Vietnam.

Most of my life, however, was impacted by a cold war which pitted my home country against the Soviet Union. I recall being a teenage boy and looking south in the Miami sky on the day that Kennedy called Krushchev’s bluff – a little game of missile chicken near Cuba.  I was wishing that I was from a richer family that could afford to dig a fallout shelter in South Florida. That was no fun either and we were all relieved if not elated when the Soviet Union imploded. I remember a jubilant colleague telling me that we would now be in an era of peace. No more war! What a great feeling.

Of course, what neither he nor I really foresaw was how the cold war between two key giants froze the outward manifestations of hundreds of years of animosity in many places of the world. As the cold war disappeared from memory banks, we have seen increased levels of conflict in former Soviet Republics, the former Yugoslavia, the Middle East, and more. We couldn’t be farther from a world of peace! In some ways we are even worse off than we were during the Cold War.

In this present context we read about currency wars. My first reaction is that this currency stuff has no connection whatsoever with a war. I don’t know why the press describes it in those terms. Maybe it sells more soap? In fact, I am not even sure that I understand who the enemy is and how we would fight them. In international trade as in all forms of trade there is competition among the players and they each try to gain their shares of the pie. In a time of great economic uncertainty when the world economy is growing slowly it makes sense that every firm and every government will want to compete harder to keep from losing business.  While war does involve a form of competition, competition frequently exists without any hint of war – from Dictionary.com here is one definition of war –“a conflict carried on by force of arms, as between nations or between parties within a nation; warfare, as by land, sea, or air.”

It is self-defeating to call trade competition a war even if there are elements of unfair competition and protectionism. It confuses people and you know how easy it is to confuse the people in our government!
In my last post I documented a trend in financial trading that when combined with our goods trade deficits makes it pretty clear why the value of the dollar has been falling. Add the Fed’s alleged policy of a new vigorous round of quantitative easing and you have even more pressure on the dollar to fall. In today’s world of global competition where many countries are VERY reliant on their exports – no self-respecting populist official can sit around drinking expensive imported beer and let their currency appreciate against the dollar. 

Holy cow –imagine the leaders in Brazil or Singapore or Japan drinking their Budweisers in their new hot Chevrolet Cobalts telling the folks at home that it would be great for world order if the dollar depreciated another 20%. And it’s not just the dollar. Recall that our friends in China like to peg their currency to the dollar. So when the dollar depreciates against most world currencies, the yuan is also depreciating again the yen and the won and the real and the Singapore dollar. Hmm – not only is the US seemingly getting a trade advantage, so is China. Now that gets my jets in an uproar and it makes me want to depreciate and I don’t even have a currency.

Okay – so back to war. Who are we going to fight here? Answer – no one. Put your Rocky dolls back in their holders and cool your jets. What we have here is a bout of international trade instability. And it is a unique bout. In past currency crises it was possible for enough nations to come together and decide it was a good time to work together to either appreciate or depreciate the dollar. But as I described above – that would not really fit the current situation because just about EVERYONE wants to depreciate. You can pine away all you want for a return to the gold standard or gold exchange standard – a time when exchange rates were largely fixed – but that ain’t gonna happen here either!

So what is the solution? First, quit calling this a war. Second, use common sense. There are fundamentals that are causing exchange rate problems. Fundamentals often take time to manifest and therefore it takes time to solve the problem. So don’t be in too much of a hurry. Third the US has to save more at home and spend less abroad. That will help reduce the downward pressure on the dollar. Fourth, the Chinese need to save less and spend more at home and that will reduce their need to rely on exports. That will make it easier for them to tolerate a yuan appreciation. As the dollar rises this will take some pressure off the need to have the Yuan fall and the other countries will be able to let their currencies float without harm.

You can call it a war and you can scream that you want the government to fight for your country’s exports, but none of that is going to do a thing in the face of real and fundamental international trends and cycles. A string of competitive devaluations or other forms of export protection will do nothing but exacerbate the problems. “My mom is meaner than your mom” just gets flung back in your face squared. Once people begin to see China, the US, Germany, Korea, and other countries addressing the real causes of trade imbalances then you will see this exchange rate issue diminish. Until then, let’s hope Obama doesn’t jump in the ring with a sumo wrestler or a Chinese bear.

Friday, October 15, 2010

The dollar is down for the 10-count

Recently the dollar’s value has depreciated and there are quite a few stories being written. As in most interesting topics in economics, the answers are not simple. There are many things that impact the value of the dollar but in this post I want to focus on a three year trend of global financial flows. The main conclusion of this post is that recent changes in the value of the dollar have very little to do with all the fuss over China. Many of us have worried about what would happen when foreigners decided to sell their US assets. Well– the future is here now and the trends do not look like they are going to reverse. It will not be easy to restore foreign faith in US assets especially when the substitutes are looking increasing better.

But before we oooohhh and aaaahhhh over pictures of hot data in skimpy pink pants, let’s just discuss the basic or fundamental forces that impact exchange values. These have to do with the fact that many cross border trades require a domestic citizen of one country to first purchase the currency of the other country. If a US citizen wants to buy goods or services in South Korea or China – she often will sell dollars and buy Korean won or Chinese yuan. We already know well that the US buys more goods from other countries than they buy from us. The implication is that this deficit in goods trades means that we are selling more dollars than foreigners really want or need to buy our goods. Thus, there is a glut of dollars on world markets because of goods trade. This glut pushes the value of the dollar down. But this is old news – let’s move on to groovier stuff.

It is also true that when US citizens buy foreign bonds, stocks, and other financial assets they generally need foreign currency to make the purchases. In the chart from the link below you see the net of US purchases of foreign assets (BOPO) in each quarter since 2000. You can see that between 2000 and early 2007 the US was building up its foreign assets (it is conventional to assign a negative sign when US citizens take money out of the US to add to foreign asset postions). So the BOPO line is going downward as US citizens buy more assets abroad. But afterward, the building slowed and by the end of 2008 we were net sellers of foreign bonds, stocks, bank deposits, etc (line is rising). As a result we were first net sellers of dollars and then became net buyers. That speaks well for a rising dollar since 2007. But read on -- that's only part of the story.
BOPI shows foreign interest in US financial assets. It is conventional to use a positive sign when foriegners Notice a similar pattern with foreigners wanting more US assets until the end of 2006 followed by a diminished appetite for increasing their net purchases of US assets. While there has been some recovery of their interest in US assets through the first quarter of 2010, the overall result is at first an increased demand for dollars and then a reduced need for dollars.


The net effect on the demand for US dollars from cross border asset flows can be seen by subtracting the US Net Purchases of Foreign Assets from the Foreign Net Purchases of US assets. This net amount is shown in the table below. The peak value of the net amount in early 2006 of $780 billion shows that foreigners needs for dollars to buy US assets exceeded by $780 billion dollars the sales of dollars by US purchases of foreign assets. Until 2006, therefore, we clearly see an increasing demand for dollars that should have been pushing the value of the dollar upward. Since 2006, we see less and less upward pressure on the dollar. The net amount fell to $165 billion in 2009 and looks headed even lower than that in 2010. Recent news suggest this is tue.

Year     NET Dollar Demand in billions of dollars based on BOPI and BOPO
2000     478
2001     400
2002     501
2003     533
2004     532
2005     701
2006     780
2007     631
2008     611
2009     165
2010*     55
* based on two quarters

Whereas speculators and governments can influence the value of the dollar – it is pretty clear that if we combine the long-term impact of goods trade deficits with a movement towards a finance deficit – we can see why there is plenty of fundamental pressure pushing the dollar down. Recent press stories are focusing on the relative strengths of emerging markets and the flow of investments moving to China, South Korea, Brazil, and many other countries. If this is the wave of the future, then it is difficult to imagine the dollar rising unless there is a change in the desire of foreigners for US goods, service, or financial assets. A rising dollar cannot come until the US clearly signals a return to competitiveness and strength.

These international asset transactions have several components – so I wanted to look further into the causes of these changes. What was accounting for financial transactions and money changing directions? What asset categories accounted for US citizens holding fewer assets abroad and foreigners wanting fewer US assets? To answer these questions I compared two time periods of equal length (12 quarters) – 2004 Q1 to 2007 Q1 versus 2007 Q2 to 2010 Q2.

Consider the US citizens holdings first. US net holdings of foreign assets fell by a total $1.9 trillion when you compare the changes in the second period to those in the first. That amounted to a decline of 58%. Foreign bank account holdings fell by about $840 billion and US citizens held about $587 billion less in foreign securities. But the largest reduction in US asset holdings abroad came in the category called “U.S. claims on unaffiliated foreigners reported by U.S. nonbanking concerns.” US financial intermediaries reduced their holdings of assets of their foreign counterparts by approximately $1 trillion. It is worth pointing out that virtually none of these swings were attributable to official or government flows in gold, currency, or reserves.

Foreigners held $2.9 trillion less of US assets in the time period from mid-2007 to mid-2010 when compared to the time period from early 2004 to early 2007. This withdrawal of foreign holdings from US markets was almost fully explained by a reduction in bank accounts of $1.6 trillion and a reduction in securities (not bonds) by $1.4 trillion. Again, almost none of the changes across these time periods had anything to do with recorded changes in official government activities regarding gold, currencies, or reserves.

Taking both US and foreign asset swings into account shows a net increase of a trillion dollars ($2.9 trillion minus $1.9 trillion) in sales of internationally trade dollars. We don’t yet have figures for 2010 Q3 but the current business and economic news suggest that these trends have picked up. Low US interest rates coupled with movement of funds into higher yielding assets in emerging markets suggest this trend could go for some time. When it looked like the US was emerging from its recession funds hung around for a while and the dollar played its role as a safe haven. But now that there is increasing worry about the US expansion while other nations promise stronger growth, the effect of these international transaction flows are having a more profound impact on the value of the dollar – moving it in a southerly direction.

While southern fried chicken is delicious, a currency crisis is not what this country needs. Quantitative easing and more stimulus will not help since QE will simply move more dollars off shore exacerbating the trends mentioned above. More stimulus will create bigger worries about US financial credibility and further movements away from US assets. It is time to move away from populism to solid thinking about the US economy. The future is here and there is no easy way out.

Thursday, October 7, 2010

A Circular Flow of Ideas and Backward Thinking: Should we attack unemployment first?

This week the news is buzzing about the next jobs announcement. Once the jobs number comes out on Friday morning planets will fall from the sky and well-behaved dogs will bite. I am sure of it because I saw it on CNN. While the House of Representatives will want to enact new laws to protect us from falling planets and viscous dogs, I am more worried that they will do something about the economy. Since they have the story backwards one can only expect more bad ideas in the next sack of legislation.

As I am writing I don’t know what number they will announce for jobs this week – and I don’t pretend to know its value. I can hardly forecast how many times I will get up to pee at night – so how would I know the future value of the unemployment rate?

What I am spouting about has more to do with the idea that if the number comes in as expected (or worse) people will increasingly worry that the lack of strong job growth will further restrain consumer spending and we will be stuck in macro purgatory. So if I can use a little professorial pedantry – I would write on a white board (what was wrong with black or green?) the following to describe the theory behind all this:

Employment → Consumer spending

I apologize for this little fit of mathematical elegance but this is the macro-theory all the talking heads are brandishing. The arrow indicates the direction of causality. This might seem pretty cool but the simple truth is that it is wrong and its policy implications are wrong too. This theory suggests that if policymakers could just find a way to increase employment then more workers would have more income and they would go out and buy lots of diamond earrings, steering wheels, and full body massages. And that’s just the firecrackers. When the first round of fireworks ends – then all those manufacturers (of earrings, steering wheels, and massages) will hire more workers who will buy even more stuff (stuff is a very technical term used by sophisticated economists). Before you know it, the unemployment rate will equal 5.5% and government can declare a holiday and take private jets to exotic islands with their stenographers. Note the essence of the theory – we start with a policy aimed directly at employment and that will generate more spending – and even more employment.

What could be wrong with this theory? To answer that question we have to take another sip of JD and review one of the first simple models first taught in dank caves in prehistoric times called the circular flow of income. In its simplest format, it can be expressed without calculus or a neutron microscope as follows:

Employment → Consumer spending

Consumer spending→ Employment

Here is the crux of the issue – this is called circular flow because there is no beginning and there is no end. We just go around and around and around and around. That’s fun for a while but at some point you wonder if there is some way to stop the merry-go-round because you are late for dinner and your honey doesn’t know that you are at the Office Lounge drinking beers with your students. That’s a no-win situation.

So you look at the model and try to decide where to interrupt it. Here is where such things as common sense or cause & effect come into play. If the circular flow is moving too slow – then the first question you ask is WHY. What is CAUSING consumers to spend and firms to hire workers at a slow rate?

Maybe I am way off track, but it seems to me that the answer has something to do with the recent history of the US economy. Consumers and firms took on too much borrowing/debt/ leverage and got themselves into financial trouble. Of course it is much more complicated than that – but the issue here is which of these two alternatives do you think was the main CAUSE of the slowdown today? Did all this get started because firms decided to lay off workers? Or did we get into this mess because of a financial collapse that led to consumers and firms being unable to continue spending and borrowing as they had in the past. I think the latter is the true cause -- we had a Wall Street Problem that spilled over to Main Street and employment. It was NOT the reverse.

If that is true, then it makes no sense to direct our immediate attention to employment. It reminds me of the physician who comes upon a person who is bleeding profusely from a bullet wound. He is screaming at the blood – “get back into that hole”. Surely, the patient would be helped if he had his blood back. But the doctor would have been more helpful if he attended to addressing the cause of the blood flow – a bullet they opened a wound. It would be better to remove the bullet and close the hole.

If the CAUSAL variable was really the finances and spending, then we should start there. And this is the real challenge right now– how do you make consumers and firms want to spend more? First, notice that since too much spending was a CAUSE of this mess – it hardly seems rational that simply encouraging consumers to spend more could be a solution. So the first part of logic is to accept the fact that households are going to take some time paying off debt and restoring saving before they run out and buy three Lexi (plural of Lexus) and a vacation in French Lick. The data show that households are doing just that and while they are not spending a lot, there is some further recent evidence that there is solidification and gradual growth. In short, if you want households to be more optimistic and you want them to spend more – work on the remaining issues with respect to the housing and financial problems and have some patience.

The second way to improve household psychology is to stop confusing people. I realize we have an election coming up and there are important reasons for the two political parties to clarify their separate and highly superior ideologies but there is just too much uncertainty arising from all this political clatter for households to believe that all is really getting better. Isn’t that sad that things really are getting better but our government is making it almost impossible to believe. And this gets me back to all the talk about the coming employment release. If the number is considered to be a bad one – it will be a lightning rod for even more activism by the President, the Congress, and the Fed. Unfortunately, the popular and wrong thing for these policymakers to do is to try to intervene in labor markets and/or induce households to spend at a rapid rate. This will create even more uncertainty and push them farther away from what we really need.

The employment market did not break down and cause our ills. It makes no sense to begin there. Households are waiting for their own financial situations to improve and for some certainty that the economy is improving. Policies that patiently and realistically address the true causes of a slow circular flow of income are the only ones that have a chance of succeeding now. More fireworks may burn down the barn!