Tuesday, April 24, 2012

Exchange rates, my bicycle pump, and a rubber crutch

My front bicycle tire went flat. So I took out my trusty bicycle pump and put more air into the tire. Each day my tire would go flat overnight. I kept putting more air into it. It was getting flatter sooner and sooner and so in desperation I decided to get a new pump. Guess what – that didn’t make any difference. The tire kept getting flat. Why? Because the tire had a hole it that kept getting bigger and bigger. The problem was not the pump. The problem was the tire.

Some of you are saying. Davidson – you don’t even have a bicycle. But the truth is that I do though it does not have a hole in its tire. Some of you are saying – where is the macro? So here it is. I believe that exchange rates are like my bicycle pump. The pump might be the remedy for some minor adjustments in tire pressure but it is no match for a fundamental problem like a hole in the tire. A bicycle pump is not a solution to a hole in a tire and the exchange rate has nothing to do with a country’s competitiveness. If you want to fix a country or fix the international trade of a country you should not try to do it with a bicycle pump or with a change in the exchange rate.

This point has some relevance to us all because many people prefer to believe the opposite. Some folks would love to see Greece leave the Eurozone so it could have its wonderful drachma back. Depreciating the drachma, the story goes, will restore Greece’s competitiveness and it again will be the world’s greatest exporter of gyros and historic buildings. Other people would love to see China appreciate its renminbi so that the US dollar would depreciate – and restore US company’s competitiveness in exporting Playboy Magazines and slot machines. Brazil wants the US to stop printing money and thereby making the dollar depreciate and hurting Brazil’s ability to export caiparinhas and topless beaches.

There is some rationale for using an exchange rate to help offset short-term and relatively minor changes in a country’s competitiveness. An exchange rate tells you how much your currency is worth in terms of other currencies. So when the dollar goes from obtaining 1300 Korean won one day to getting 1400 the next day, we say the dollar appreciated against the won (and the won depreciated against the dollar). In this case someone with dollars can now get with $1 the 1300 won creampuff they usually get on the way to the bus stop on Monday and Wednesday mornings at Anguk Station plus have another 100 won left over. With the new exchange rate (1400 instead of 1300) that $1 can buy even more Korean stuff. That is, you can now get the usual cream puff and a new Equus. Okay – a new Equus costs more than 100 won but hopefully you get the point here. Big rule –

o   If your currency depreciates, your goods and services can be obtained with fewer amounts of foreign currency. Thus your stuff looks cheaper to the rest of the world.
o   If your currency appreciates, your goods and services can be obtained only with more foreign currency. Thus your stuff looks more expensive to the rest of the world.
o   Many governments are driven by the fact that they want their goods and services to appear more competitive to foreigners – so they often favor depreciating the currency.

These three facts help us to explain why (1) the Greeks might want to have a drachma that they can depreciate, (2) why the US wants China to let its renminbi appreciate, and (3) why the Brazilians want the dollar to appreciate. Like the bicycle pump and the tire, these desires are founded by short-sighted and incomplete analysis. And therefore, they are probably not going to lead to the results they want.

For example, let’s explore why these ideas could be self-defeating. Let’s suppose Brazil gets its wish and the US manipulates foreign exchange markets in a way that the value of the dollar rises and the value of Brazil’s currency, the real, falls. The governments could accomplish this by selling reals and buying more dollars in foreign exchange markets – that is the US or Brazil buys enough dollars to significantly appreciate the dollar (depreciate the real). This tends to help Brazil’s exports. But the story doesn’t end there. In doing this action, dollars move out of the economic system and reals move in. That is – the US money supply decreases and the Brazilian money supply increases. Left in place, these monetary changes should tend to increase inflation in Brazil and reduce it in the USA. Thus while the exchange rate manipulation seems to favor Brazilian goods – the implied monetary changes tend to do just the opposite. And to make things worse – both countries may not enjoy the fact that an international action has caused them to change their monetary policy. It is like each country loses control over its own monetary policy whenever it tries to manipulate its exchange rate.

If you are still following me (yawn) you might say that if the country doesn’t like the loss of control over their money, they can always offset or neutralize the international impact described above with a domestic monetary policy operation. In the above case the US money supply is decreasing so the Fed can use its usual tools to increase the money supply. The Brazilian Central Bank can absorb some of the excess reals by a domestic operation that decreases its money supply. This has some merit but notice that this too is temporary. The tire has a hole in it. That is, whatever caused the trade imbalance between the US and Brazil will continue. What appears to be a one-time event becomes a more continuous one with the US constantly encountering disinflation and increasing its money supply and Brazil facing inflation and then tightening its money supply. If you are still awake you can see how crazy all this is.

This is because there is a hole in the tire with respect to trade. Brazil says that their trade problem is caused because of a highly accommodative US monetary policy that causes a global depreciation of the dollar. If this is correct, then the solution is for the US economy to return to normal monetary growth and interest rates. Of course, Brazil might consider that at least part of their loss in competitiveness comes from a world slowdown that has reduced the global demand for the commodities that Brazil exports. The hole in Brazil’s tire is, therefore pretty big. It may take some time for the US and the world to return to strong growth In the meantime, Brazil can work harder at internal factors that might promote its global competitiveness. But simply manipulating exchange rates is going to do very little and most likely will lead to reduced competitiveness as monetary effects increase Brazilian inflation and worsen their situation.

The same can be said of the issues with respect to Greece and the Eurozone and the issues between the US and China. Greece needs a currency depreciation like it needs a hole in the head. If Greece wants to be in the EU then it needs to try to be more like other EU countries. When Greece gets is labor and product markets as well as its government wages and pensions a little closer to the average EU country, then perhaps it has a chance of overcoming imbalances in its dual deficits in trade and government accounts. If Greece even pretends a tiny bit like it is going along with the prescription, both the EU and the IMF will likely continue to help them. That will buy them time to get fixed. The drachma and a depreciation might also give them time but notice that they still would need to fix their problems. And in the meantime all hell would break loose in Greece when they left the Eurozone.

The same can be said about the US and China. In this case there is a 16-wheeler full of tire holes. No one REALLY believes that a further depreciation of the dollar against the renminbi is going to succeed in restoring the trade balance. The US has had global trade deficits for decades despite a trade-weighted dollar that has done nothing but decline. Most economists believe the US saves too little and China saves too much. Neither of these tendencies is going to change anytime soon. Depreciating the dollar will likely do nothing but cause inflation in the US as we pump even more dollars all over the world. The US needs to pay attention to saving and to the other adjustments that could make us more productive, innovative, and competitive. China needs to rebalance its economy away from saving toward more consumption. Only when these savings imbalances are corrected in the US and China will headway be made with the trade balance with China and the world.

The exchange rate is a rubber crutch. Countries need to tend to their knitting or tire mending. 

Tuesday, April 17, 2012

Employment, US Profits, Jack Rabbits, and the Elephant

I recall the story about the blind-folded man who had never seen an elephant was asked to guess and describe an elephant by touching only one small part of it. One can only imagine which part of the elephant the blind-folded man touched as he tried to decide what an elephant looks like. If 1000 blind-folded people touched different parts of the elephant one can begin to see the chaos and humor in this project – and the various guesses made as to the shape, texture, and size of this elephant.

This is the way I think about the national economy. This is why one of my favorite “spouts” relates to the ways journalists, economists, politicians, and others react each day to the news that peppers them with information.  Let’s call the direction of the economy the “elephant”. The direction of any nation’s economy has so many pieces to it that no one person can digest it all. Thus, we all sample or taste little pieces of the economic growth day to day as a way to form an opinion about its direction. Once we sample enough and feel confident, then we can make decisions that are based on our view of the elephant. If the pieces of the puzzle are diverse, lack tangency or are otherwise unconnected, then we might go for some time without any strong feeling for the direction of the economy. Our decisions would reflect this indecision about the elephant.

This indecision reflects a very conservative reaction to information gathering. This conservative approach envisions a person as being reluctant to make decisions until he or she feels that she has a dominant view of the economy. But that’s not the way all people behave. Less conservative behaviors magnify the importance of the latest piece of information. I just ate a huge piece of chocolate cake (with chocolate icing). From that I might deduce that I am on my way to being the new fat man at the circus. Tomorrow I have a bowl of kimchi jjigae laden with tofu. That would make me feel slim and healthy and I might enroll in the next Iron Man event. It sounds ridiculous that on two adjacent days I might want to check myself into the fat-reduction clinic and enroll in an Iron Man contest. But it seems to me that this is exactly the way people behave and think when it comes to the national economy.

Headlines this week and last week reflected what happened to US employment, business profits, and what will happen to inflation, retails sales and other economic barometers in the US and abroad. Each announcement brought a barrage of new conclusions about the progress of the economy. This barrage came despite the fact that one month’s worth of information is about as reliable as a fly perched on the end of the elephant’s nose. Does an elephant look like a fly? I don’t think so.  I thought the top was going to fly off the US economy last week when the employment number came in under expectations. Republicans peed in their pants as they faulted Obama’s policies and leadership. Republican point – this data point proves the economy is losing steam.  Democrats pointed out how despite the slowdown in March, they have rescued the economy from the evil policies of George Bush and Dr. No.  This one data point to Democrats reflected a general trend of rising strength in the economy.  This one data point relating to US employment in March 2012 became the focus of millions of words, electronic or otherwise. It’s like the blindfolded guy who happened to touch the weiner of the elephant explaining to us all what an elephant looks like.

The Financial Times wrote a very nice piece (Monday, April 9 “US job figures become a fickle political football) in which they pointed out many reasons why one’s month worth of employment figures tell us absolutely nothing about the health of the economy or the direction of employment. Yup I am not exaggerating. Nothing. Zip. Yet our experts spent days using that data point as if it meant everything. Why? Because some people think that if they react to every piece of news they can beat the rest of us to the jewels and gold. These folks are the pouncers. Data comes out. Pouncers draw quick conclusions and pounce. Tomorrow new data comes out and then they pounce again.

I am not trying to say that the pouncers are any better or worse than the non-pouncers. I am just saying they exist and they or their actions or their spokespeople make us non-pouncers sometimes think we are missing the boat – or the elephant. I am in Asia today and I am writing on a Monday morning August 9. I am wondering how the stock market will perform in the US when it opens in about 6 hours. The pouncers have declared the US a bad place to invest this week. The negative interpretations of the pouncers to the employment disaster and to the expected declines in business profits makes me worried that my precious retirement account will be worth less in a couple of hours.  So the pouncers are making me wonder if I should be buying or selling today. If they are right that these bits of news are part of a more long-term US decline, I might want to sell today. But if they are wrong and these news bits mean nothing – then maybe I should use the expected stock market decline as a buying opportunity. Since I am not a pouncer I will probably ignore the whole thing and ponder my next bottle of Soju.

One more example has to do with the profits or earning announcements of this week. The reports are saying that profits are falling and I can see why someone might be concerned about falling business profits. It does not bode well for employment or the economy in general. But if you read a little closer you find that the profits are regressing back to their means. That is, this means that profits are expected to fall to something normal and sustainable. To me the words normal and sustainable suggest a good outcome. Yet the fact that profits are falling seems to be dominating the idea that they are converging on sustainable and normal. Once again, the jack rabbits (I got tired of pouncers) are ready to hop at every piece of news. The word “decline” can be understood by anyone. The phrase “regressing to the mean” is somehow less easy to comprehend and less definitive. Thus even though the profit news is not necessarily bad, the rabbits are ready to sell and possibly in numbers. Perhaps they are wrong and this is another buy opportunity for the rest of us. After all, the rabbits have to have someone to sell to.

Okay so the elephant is hard to discern with the bits and pieces of information. But that does not mean that one cannot come to more realistic conclusions about the general direction of the national economy. For one thing, one can pounce or hop (or do a jig) after pulling together enough information over enough time. It is possible to ignore all the individual daily announcements and pull together what you learned over the span of a quarter or over six months. The last bit of information you received on April 17 might sway you more than the one you got on January 17, but surely you will get a better feel for the general momentum in the economy using three-six months of data than from one day’s. Second, it really helps to have a little understanding about cause and effect and global macroeconomics. The US profits figure for one month surely pales in importance to an understanding of the effects of shocks and policies that have impacts that last for months or years. What are the experts saying about the impacts of oil prices? What do they say about China’s economic growth? Is the EU making any progress with sovereign default? Will the US election cycle and the lack of any serious attention to deficit and debt cause economic problems?

It seems to me that we do not have to be pouncers or jack rabbits. Maybe some people prefer that approach. But it is possible to use more information in an intelligent way to make our important decisions. This approach might not sell daily newspapers but hopefully if followed it will create a larger perspective about  the chaos that follows news announcements.

Tuesday, April 10, 2012

New Age of Supply-Side Economics Part II.

Last week I spent some time trying to convince you that the Age of KE (Keynesian Economics) was being replaced by a new Age of SSE (Supply-Side Economics). I had so much fun bonking KE on the head that I ran out of juice and could not get to the best part – convincing you that SSE and SSE Policy are not evil monsters born of Bill O’Reilly and Ayn Rand but are legitimate policy options already being considered and tried in many nations. In fact, polite people these days are stressing policies of restructuring and/or rebalancing and these are really buzz words for SSE Policy. To bring all this out of the closet, let’s make a big point here:

            SSE Policy =  Restructuring
            SSE Policy =  Rebalancing

I feel a lot better now. I hope you do too.

But let’s start from the beginning. In a recent post I emphasized that economics is generally a discussion about demand and supply. It hardly makes any sense to talk only about demand. If you want to discuss procreation you talk about males and females. It makes no sense to focus on just one sex. As they say – it takes two to Tango. So the first thing to note here is that macro can and should focus on both of these main parts of markets – demand and supply. This is exciting stuff, eh? But it shouldn’t be. Why did macroeconomics survive for about 60 years ignoring SSE and SSE Policy?

This reminds me of the Internet joke that is going around now about the mother whose tiny daughter asks her what a virgin is. After stammering around for quite a while saying embarrassing things about sex to a five year old the mother takes a breath and the daughter asks her a second question. Mom, if that is what virgin means, what is extra virgin? Apparently her first question was about olive oil. It was not about sex.

That joke actually has nothing to do with this post but I have learned from experience that my readership improves proportionally to the number of times I write the words sex or oil prices.

The supply curve represents the actions of business firms as they decide how much to produce. Firms tend to supply more (and hire more workers) whenever their leaders envision a future with product prices and worker productivity rising relative to business costs. This is the kind of time period when firms see better returns on their investment. This kind of sanguine future supports the risks of investing in more capital, labor, and technology. It works in reverse too. If the macroeconomic environment is expected to be typified by wages and other business costs rising faster than product prices and productivity, firms are not going to buy more equipment, hire more labor, or otherwise invest in output expansion. They might, in that case, plan to reduce output.

Consider where we find the US and much of the world’s economy in early 2012. Huge government debt creates worry about riskiness of finance and is retarding company investments. Huge overhangs of money create a worry of future inflation and the eventual proportional increases in wages and business costs. So long as monetary and fiscal stimulus remain stretched it is hard to persuade business firms to produce more. Add to that a number of new government regulatory bodies producing literally thousands of pages of new business regulations. 

It is not surprising to find that the supply curve is hiding in the corner. It might sound backward to Keynesians – but one way to juice up the nation’s output is to convince these firms that wage inflation or interest rate escalation is not around the corner. Or convince these firms that the government is going to take firm control over the nation’s debts and will quickly clarify the details of regulatory compliance. Such a prudent macroeconomic policy would – therefore – lead to more certainty and optimism on the part of business firms and should cause them to hire more workers and produce more. 
So there’s your first SSE Policy—focus attention on reversing stimulus from the Fed and from the Government. Focus policy on reducing the uncertainty of future regulations.  

Reversing stimulus and regulatory burdens, however, are just the tip of the iceberg when it comes to SSE Policy. SSE is a holistic attitude toward economic well-being. This attitude recognizes that economic well-being comes from companies that create more and better jobs. And those companies exist and thrive when they compete, manage, and innovate as they meet existing and new needs of the world’s citizens. We somehow delude ourselves into thinking that somehow government manufactures economic welfare. Blackberry and Nokia are two recent examples of many. Samsung and Hyundai also offer testimony to the importance of companies. I admit that at some point in the history of these firms a government might have had some influence over their development. But the reality today is that no government can save Blackberry and Nokia from the ferocious surge of competition unleashed by Apple products. And no global electronics or auto producers can safely laugh off the challenge from Samsung and Hyundai. Firms come and go. The best ones meet the demands of the public. The best ones create employment opportunities and income growth.  

This holistic attitude has no room for KE. Instead it provides the kind of national atmosphere that strengthens competitive response. This agenda has at least the following components:
  •        Increasing national saving so that firms will find ample funds with low cost of capital
  •        A more flexible labor market that builds and motivates a skilled labor force and allows firms to flexibly hire and fire workers
  •        Laws and regulations that promote and facilitate innovation and entrepreneurship
  •        Low tax rates on income and removal of barriers that impede investment and the process of translating scientific advancement into new products and services
  •        State of the art infrastructure that supports all of the above with respect to communication, transportation, scientific research, education, training, etc.

My KE friends worry that the above list ignores one important thing – income distribution. The above looks like another party for the rich. Most of the ideas above seem to fit a trickle down story that the rich benefit directly greatly from a SSE Policy and only a few crumbs get dispersed to everyone else. Some of my KE friends would say that we have tried some of these things in the past and the poor get farther and farther behind. To my KE friends I would say that you are wrong for a couple of reasons. First the lives of most poor people in America today are infinitely better than what they were 100 years ago. The benefits of income and general living standards (including health, safety, etc) came because business firms have grown and provided millions of jobs and increases in real incomes.

Second, if the rich have benefited disproportionately in the last 10-20 years – it is not because we did too much of the above SSE Programs – but because we did too little. The US economy is in a global competitive dogfight that shows no signs of abating. Instead of unleashing our resources our corporate-government elite sat in private meetings off-microphone and restrained our companies. Corporatism reins in America as witnessed by the penchant for bailing out huge corporations. Meanwhile we become less and less able to unleash furious competition as we piss and moan and fight among ourselves about bailing out this group or that one. America is a great country with great people. A strong and clear SSE Policy is all we have to stay in the race.

Tuesday, April 3, 2012

The New Age of Supply-side Economics and Policy

Blame it on James and Fuzzy. In commenting on my post last week they both agreed I was not a nut-job. I am now emboldened by their trust and have focused my attention on Come and Go. Some of you remember the 50s song by the Dell-Vikings, Come and Go With Me. While the song has nothing to do with economics the words Come & Go suggest that things like Keynesian Economic Policy will come and go. And in this blog please underline the word GO. It is time for Keynesianism to go and I try to explain why here in less than half a million words. I am selling PUTS on Keynesianism. Please send your money directly to the IU Credit Union in my name.

Everything comes and goes. My baby boomer friends personally remember the Age of the Dinosaur. The smart brontosauri who saw the end coming transformed themselves into elephants and business school deans and survive until today. Look around and notice – no dinos. The Age of Dinosaurs is over. Similarly, the Age of Peyton Manning is over. Forward-looking Indianapolis Colts players and coaches jumped to other professional football teams or became lawyers. But look. No more Manning at the Colts. The age is over. Kaput. Adios. On Yong he ka sayo.

The above lucid examples and your local funeral parlor prove that nothing lasts forever (except for Nancy Pelosi and Jerry Lewis). And this truth applies to Keynesian Economics (KE). Just like horses were replaced by cars and my comb gave way to a nose and ear hair clipper, KE is giving way to something else. And even though you have sworn a pledge to never say these words – Supply-side economics (SSE) – I brazenly predict that SSE will soon replace KE. You readers who are still awake may have noticed I got tired of typing and have replaced the longer phrases for the abbreviations KE and SSE.

This is bad news for Larry Summers, Paul Krugman, Martin Wolf and a host of other sweet but misguided guys I have written about in this blog. I shouldn’t be so harsh. KE had its place in history. There were time periods when the harm done by KE Policy was possibly over ridden by the benefits. But give your kid a bath too many times in one day and he gets wrinkled and itchy. Baths are like lots of things – just the right amount at just the right time can be really good. But too many baths or a bath at the wrong time or a three day soak in the tub just causes problems down the road.

Sometimes it takes a while for people to discover the end of an Age. Think of all the diets you have been on. You don’t really know squat about nutrition. But you keep trying to lose weight. You probably keep trying similar diets only to discover that no matter how many pounds you lose you always gain back that many plus 10. The body is a very complicated and uncertain system. It takes a while before we finally figure out that some of us are born with a cookie monster inside of us. To rid yourself of this cookie monster you have to buy special cookie monster dust. That is the only thing that will work. But don’t tell anyone I told you.

The point is that the economy is pretty complicated and even after about 60 years of experience with KE we are just now seeing why it must come to an end. It had its time and it probably succeeded a few times. But it has hit its limit and the ball game is over.
How do I know the ball game is over? I can think of at least four good reasons why The Age of KE is over. First, the essence of KE Policy is managing spending. It involves finding ways to get people to spend more during a recession. Well, after a Whopper Super-Size government stimulus, people are still reluctant to take the bait and will not spend much more.

Second, KE Policy has backed itself into a corner. Whether the government does more demand stimulus or less, people are not going to spend more. With less stimulus (or what people are calling more austerity) the obvious result is not more spending. But doing even more stimulus won’t increase spending because most people will associate higher government stimulus with economic failure and increased uncertainty. They may also associate more stimulus with higher inflation and increased debt – equally worrisome and bad for confidence and spending.

Third, if one takes the time to read Keynes, he believed monetary policy could not revive spending in a severe recession because people have low confidence. If Keynes was alive today, he probably would abolish KE himself since he would apply his negativity abut monetary policy to fiscal policy too.

Finally, one reason KE is wrong today is that it has its eye on the wrong ball. The problem today is not a lack of spending. The problems today involve the adverse impacts of globalization, aging, sovereign debt, industrialization, excessive leverage, deer over-population, and male pattern baldness. These are problems that need myriad and targeted solutions. If you were experiencing fever and high temperature because of multiple breakdowns in your heart, liver, foot, brain and several other places – you might be a little skeptical of a doctor who advised you to take a larger dose of aspirin…or of any other single treatment.

So KE had its day and there is no hope for its continued influence. Betting on KE to solve today’s problems is a loser. The Put is in. It is time to buy SSE and SSE Policy. SSE Policy is the perfect way to directly attack US problems. But talking about SSE Policy is like talking about someone passing gas. It just isn’t done in polite company. SSE Policy has been called a lot of names: Trojan Horse, Voodoo Economics, and Trickle Down to name a few. Those are not nice things to call an economic policy. Each phrase, however, exhibits a real reservation people have about SSE and each term is worth addressing. But calling SSE Policy a bad name or referring to a president as a bad actor and or a cowboy does not automatically disqualify SSE Policy. So let me explain why. 

I see that I am coming close to using up my weekly allocation of JD. And I am at my word limit too. So let’s postpone the positive story about SSE and SSE Policy to next week.  So take a little time off – pet the wife and kiss the dog and otherwise enjoy the week.