Bond Markets Will Rule

 Thanks to Buck Klemkosky for being our guest blogger this week. Buck has been the dean of the SKK Graduate School of Business at Sungkyunkwan University, Seoul, since 2004. SKK GSB is the top MBA program in Korea and one of the top programs in Asia. Previously he was a finance professor and served as associate dean and chair of the finance department at the Indiana University Kelley School of Business. He follows the markets closely as a money manager as well. A version of this article in the Korea Times appeared on Dec. 11, 2011.

Recent elections in Europe show popular support for anti-austerity fiscal programs. But the results of elections may not be the final arbitrator of fiscal policies, especially in Europe. As contagion spreads from country to country, it appears as if the bond markets will be the primary force imposing discipline on European governments, central banks and commercial banks.

Two of the primary signals for sovereign debt problems are credit spreads and credit insurance. Investors compare sovereign bond yields to those of Germany or the U.S. to assess the probability of sovereign debt default or some sort of restructuring. As credit default spreads widen, the market places a higher probability on potential default. Investors also pay attention to how much it costs to insure against sovereign debt default in the credit default swap market.

Of course, politicians don’t like discipline, especially market-imposed discipline. Their first reaction is to blame higher bond yields on evil speculators. But politicians lose sight of what markets do. One of their primary functions is to process information and set prices for financial assets. For bonds with fixed coupon rates, the bond price determines the yield to maturity, if investors buy today and hold the bond to maturity. Once the coupon rate is set, if investors want a higher yield because of higher default risk, they can get it only by buying the bond at a discounted price. So there is an inverse relationship between bond yield and bond price. Bond investors also do not have to buy the bond and hold to maturity. They can anticipate or speculate on changed in yield and hold for time period less than maturity.

Burt the basic question is: Should you trust the markets? If you believe that the bond market for sovereign debt efficiently processes information, then bond prices do reflect public and private information. This is referred to as the Efficient Market Hypothesis in finance. Informational efficiency is a matter of degree, but research shows that bond markets are fairly efficient at processing information and setting prices and yields.

What does it take to have an efficient bond market, even with speculators? Foremost, you need a large number, not all, of investors who are rational and compete for information to value bonds. The incentive to search for and analyze information comes from trying to maximize returns for a given level of risk. Markets can also be efficient even with speculators present as long as they have diversity of opinion, independence of thought and use multiple sources of information. Speculators invest their own capital and assume risk, so they have a big incentive to get it right. So speculators do not necessarily separate the financial markets from the real economy or make prices more volatile than economic fundamentals warrant. Speculation also does not necessarily cause asset bubbles (irrational markets). So the collective wisdom of markets and the self-interests of investors can provide the most efficient prices.

Of course, hindsight shows that asset bubbles do occur:  technology stocks (1996-2000), housing in many parts of the world (1996-2006) and various commodities. But the bond markets have not been as subject to irrational exuberance and collective investor euphoria as other asset classes. If bond yields don’t reflect economic fundamentals in many countries today, it is because central banks have kept interest rates abnormally low as a monetary tool to help slow-growth economics.

Governments have proposed or imposed various rules and regulations to curb perceived speculation: place a tax on financial transactions, ban short selling, put position limits on derivatives contracts and eliminate or curtail the use of some products such as credit default swaps. Most of these are imposed with little empirical evidence as it is easier to blame speculators than to address real economic problems such as deficits, promises that can’t be met and sovereign debt.

What the bond markets are telling us is that the euro zone has massive problems that probably can’t be fixed in the short term. The PIGS (Portugal, Ireland, Greece and Spain) have been replaced by the PIIGS (add Italy). The source of the financial contagion has been the European Central Bank and the politicians doing too little too late.  While politicians in some countries worry about moral hazard by reducing incentives to reduce deficits and restructure economies, others believe that austerity programs will cause recessions and widen deficits and increase the sovereign debt problem.

The interconnectedness of European banks and sovereign debt has created a perfect storm in which investors are losing confidence in some euro zone countries and banks.  Investors realize that some of the countries are too big to fail, but also perhaps too big to save, given what has been proposed thus far. The probabilities of the collapse of the single euro zone currency have increased and will continue until bold actions are taken to stop the contagion. Confidence has to be restored decisively.

So European politicians and bankers have not liked what has been happening in the bond markets. More than one has denounced the markets and stated the need to establish or re-establish the primacy of government policy over the markets. But the bond vigilantes are a tough group. If they could speak with one voice, it would be: “The markets aren’t the problem. It’s the banks and the politicians who caused the mess. If you don’t like what we, the markets, do, don’t borrow money in the bond markets.”

As James Carville, advisor to President Clinton, famously stated, “He wanted to be reincarnated as the bond market so he could intimidate everyone.” Market discipline will work when everything else fails, especially politicians and government.

Asian Kiss Part 2

I don’t usually follow one post with another one so quickly but it seems necessary in this case since I lumped two countries together in a way that just needs some correction. As some of you have pointed out, my last post was titled Asia but was really about Seoul, Korea and very little about Hanoi, Vietnam.

So since I was apparently too easy on my friends from Vietnam, let me try to playfully misrepresent their country and irritate them too.

While I did get an all-expenses-paid visit to Vietnam in 1972, I was asked to stay in the south. But most of my recent reflections stem from several visits to the north – Hanoi in particular.

I think I made the point that Koreans eat a lot of kimchi. The closest counterpart I can come up with for Vietnam is pho. Pho does not rhyme with Mo – it more rhymes with Duh. If you know the Vietnamese alphabet you know this because of the little thingy they put over the o in pho. Anyway, Vietnamese people eat pho at any and all meals. It seems to be a favorite for breakfast which is not easy for a westerner to take since we do not usually eat hot soup for breakfast. Pho is basically a broth that comes with noodles and you can add stuff to it. Most popular additions include basil, mint leaves, lime, bean sprouts, and hot peppers. Pho can also come with beef, chicken, meat balls, and various seafood.

A big difference between Korea and Vietnam is the stage of development or the average income level. These measured differentials seem misleading to me but Koreans earn about 10 times what Vietnamese earn.  Vietnam is a poor country with a single communist party. Korea is a high income capitalist nation. Vietnam’s long and skinny country has a population of more than 90 million. South Korea is a rocky and mountainous home to a little less than 50 million. So these are two very different countries!

I mentioned in my previous post that sidewalks can be dangerous places. This is true in both countries but there are major differences. In Seoul, you have to watch out for the motor scooters. In places in Vietnam you not only have to watch for motor bikes but there is the errant water buffalo, chicken, or draping power lines.

That brings me to driving. Traffic is very tricky in Seoul. In Seoul the problem is mostly the density of cars. Lots of cars. Modern cars. There are just too many cars in the streets. The second issue in Seoul is “fender-first”. While we Americans defer to a car ahead of us, most of the time we do not constantly compete for the front row position with the rest of the cars. In Seoul, two cars will do anything to get their fender one centimeter ahead of the other guy. Once that centimeter is establish, he/she has the right of way and will move his car, bus, 16-wheeler in the lane the other guy is occupying. The other guy will have to pull back and yield. This basically means that in Seoul any time you drive you feel like you are in the annual Indy 500 race.  

Fender first applies in Vietnam too but cars are not the main issue in Vietnam.  There the issue is motorbikes. Motorbikes are as thick as professors at a poetry reading. Seriously you have never seen so many motorbikes in your life. For many people the motorbike is like a family sedan. It is not uncommon to see the whole family on one motorbike and I don’t mean just the immediate family. Of course motorbikes also function as trucks. You have not seen anything until you have seen a Vietnamese motorbike loaded with 16 live pigs – or 16 tons of steel.  Barnum and Bailey have little to compete with Vietnamese motorbikes.

The second critical aspect of Vietnamese driving is the rules and/or following the rules. In Seoul taxi drivers and other people in a hurry will sometimes run red lights or pass in the oncoming lane. It is done more than here in Bloomington. So there is some lack of obedience to the rules in Korea. Often this behavior seems rational. For example sitting at a traffic light that is three light years away from anything in the middle of the desert seems crazy. But we Americans and Swiss follow rules. Koreans are a little more flexible. Well, if Koreans are flexible we might say that the Vietnamese are double-jointed.

Here’s the thing that gets you driving in Vietnam…cars coming out of a side street never stop – they don’t even brake. I am not sure if they have the legal right of way but it seems that way. Imagine you are tooling down some major road in the US and some yahoo comes out of a side street in front of you. What would you do?  If your seat belt was on and your insurance was paid up you would probably quit texting and slam right into him to show him how stupid he is. At the least you would tailgate him for 700 miles and then shoot him the finger when you finally passed him. That never happens in Hanoi. People are ALWAYS turning in front of you. And when I say people I mean cars, motorbikes, water buffalo, etc.  And you are always letting them do it. It is you who has the full field of view and it is you who is expected to cheerfully swerve, jam on the breaks or do whatever is necessary to let him/her into your lane.

The other cool thing about Hanoi is walking across the street. You might think that because the drivers have a red light and because the pedestrian signal gives you the green that you would be safe to walk with your ipod glaring in your bad ear as you day dream about your latest professional conquest. No No No. Just because you seem to have the right of way it does not mean that anyone is going to stop. Motor bikes and cars view the traffic signals as guidelines and not as pronouncements of the Supreme Court. But it is very safe to walk across even the busiest of streets in Hanoi if you know how to do it. Just like the cars coming out of side streets, you the pedestrian do not stop. If you want to get to the other side of the street, take a big breathe and start walking. The vehicles will not hit you. They will come close to you but they will swerve and miss you. The first few times it feels a little like walking the plank in accountant-infested waters. But I swear on John Maynard Keynes that so long as you walk at a measured pace and so long as you give the eye to oncoming traffic you will make it to the other side of the street without harm.

One final thing about driving is the honking in Vietnam. In the US honking is the equivalent of a four-letter word from one car to another. We honk to tell another driver he is a very bad person. We often honk out of frustration. In Vietnam the honking never stops. Honking is a warning system. Perhaps they honk so much because drivers do not use their rear-view mirrors enough? Perhaps they honk because they might be passing in the oncoming lane. I don’t know the origin but I do know that Vietnamese drivers are continuously telling the other drivers where they are and that they are in the process of passing you. It seems like a reasonable system especially if you can turn off your hearing aid. After a while you either get used to it or it drives you crazy.

Okay, now that I have written a little more about Vietnam I am expecting even more hate mail. J

As I said in the past post, I feel lucky to have met so many kind and generous people in Seoul and Hanoi. I look forward to seeing them again!

Asia Meets America and They Kiss

Some of you know that I have been spending more time in Asia – especially Korea and Vietnam. Some of you have asked me from time to time what it is like to live in Asia. My blog says that it is about macro and other stuff – so to make that a true statement I ought to write about other stuff sometimes. Other stuff could include lots of things including my attitude towards garden weeds, wild deer that eat our hostas, and why I am not fully appreciated by my friends and family. So maybe writing about Asian reflections is not a bad idea.

Before I get into all this I want to apologize to all my Asian and non-Asian friends if I fall into well-known traps of stereotyping or saying something wrong or something just plain stupid. But it makes no sense to even get into this question if we can’t stereotype a little bit. For example, if I wanted to write about differences between men and women you gotta admit – va va voom – that men and women are different. We might be alike in many ways but please EXCUSE ME for knowing that we are different. So it is the same thing with respect to Asians and Americans. Many Koreans have much in common with many Hoosiers. But come on – it is okay to say we are not exactly the same. Right?

So where do I start? I guess you have to start with an important difference so let me bring up kimchi. Koreans eat kimchi seventeen times a day and the really cool thing is that the constitution gives every Korean a kimchi refrigerator regardless of height, weight, religion, or economic status. When you go to a Korean restaurant you will usually get an unlimited amount of kimchi. Finish the tiny little bowl of kimchi in front of you and like magic, it is refilled. The kimchi angels keep it flowing. In fact, a typical Korean meal will have several bowls of different kinds of kimchi and other shared items that resemble roots, twigs, and tiny Michelin tires.  Of course you can also find kimchi in many delicious soups, stews, pancakes, fried rice, and nachos!

This gets us to another huge difference between our cultures – and that is the concept of double-dipping. There is no concept of double-dipping in Korea. In America if Larry plunges his fork into the group dish of nachos a second time, he will immediately be taken to the back of the restaurant and beaten by gangs of Manners Police. In America we believe that putting my fork back in the bowl once it has ventured near my bacteria-filled mouth area constitutes a crime against humanity. Koreans somehow know about the concept of bacteria yet you can sit with many of them at a meal and allow your metal chop sticks to plunge numerous times into the same shared bowls of delicious side dishes. This may have something to do with the strong sense of family and national pride shared by Koreans. In their culture if you think you might be sick or contagious, you would probably not attend a shared meal and you would probably wear a face mask around all day to protect your colleagues and relatives.

Koreans get close to each other. Women often walk arm and arm. Men will stand close to you when speaking with you. Americans usually prefer to stand back. In Korea standing back means you are not interested enough and might never get on that airplane, bus, taxi, or subway. To a Korean standing back means you do not have a great urge to get on the vehicle. If for example, you leave what you think is one foot between you and the gate, 1,000 Koreans will move ahead of you in that space. As an American you think they are rude and have unfairly crowded ahead of you to gain advantage. I don’t think so. They see you as not being in a hurry about getting on. They see the inefficiency of leaving a gap in the line. If you drive a motor bike in Hanoi you see the same thing. How many motor bikes can fit across a two lane intersection? My guess is about 100,000. Do not leave one inch of space between your car or bike and the one in front of you. An alert Vietnamese biker will go through a wall to fill a void if he sees it. This may have something to do with the fact that Seoul and Hanoi have little space for humans after you subtract the ubiquitous mountains. Space is at a premium when you compare it to the vast expanses of land in the USA. You can drive through North Dakota all day and see more Elk than actual human beings.

And then there is the art of walking down a perfectly calm sidewalk. Americans think that sidewalks are for people and for people on skateboards. That is a very limiting concept. In Asia a motor bike or a water buffalo go wherever they like. They are permitted to roam and run lights and they do that regularly. But they are also permitted to jump onto sidewalks at will. So don’t think because you are taking Fido for a walk on his leash that you somehow own the sidewalk in Hanoi or Seoul. 

The other challenging difference about peacefully walking down sidewalks is the preferred side. Americans ALWAYS stick to the right side. That is a very orderly and efficient concept. Always stick to the right. Even if you have to knock some fool over – get to the right. In fact we are so wed to walking on the right that if some evil communistic person is walking toward you on your side of the sidewalk you will quickly conclude that he/she needs a lesson in sidewalk directional etiquette – wherein you walk right over that elderly woman spilling all the items in her pushcart everywhere.  Asians seem to prefer walking on the left. But that is not a hard and fast rule. They are more fluid than we are.  Koreans seem to have a sixth sense about not running into each other. Since I don’t always know whether they will go left or right, I am conscious of them all the time. So I look a little like a high school running back on the sidewalk – dodging left then right then left again.  It’s pretty cool. I have to think about it. They seem to just bob and float in a great wave of humanity. They sting like a butterfly and float like a bee. Or something like that.

The next important thing to remember in Korea is who pours beer for whom.  The boss never pours his own beer. Unless you are the youngest and least ranked person at the table, it is a pretty cool concept. This reflects, I think, another aspect of a culture that shows respect and a strong sense of social togetherness. It is not enough that you spend an evening swapping stories or explaining the concept of diminishing marginal utility, In Asia there is a constant reminder of mutual dependence as each person at the table watches the other’s glass with the intent of making sure no glass goes empty.  Adding to this sense of camaraderie are the frequent toasts. Americans might have a special toast at the beginning or end of an event. Koreas keep toasting until everyone is pretty much toasted.

One Korean colleague was telling me something the other day about scientific tests that showed that Koreans look at a painting differently than a westerner. He said that westerners look immediately at the middle or point of focus – the place where the main action or story is. Koreans, in contrast, do not look there – they tend to look at the periphery and the area surrounding the central focus. One interpretation is that this is yet another piece of evidence of the strong social cohesion of Asians. The periphery defines or is integrated with the main actor or central focus. To westerners the art has a message or an individual focus. To the Asian this central focus is just one part of a greater consciousness.

As I said in the beginning above, stereotypes can be very misleading. If anything my time in Asia makes me that much more appreciative and aware of the best and worst of all cultures.  The individual focus and spirit of western countries has numerous and wonderful attributes but we all know that when taken to the extreme, selfishness can be an undeniable liability. The stronger social and interdependence of Asian cultures provides some very beautiful and efficient ways of interaction yet blind allegiance to unearned respect can blemish that approach. I feel very lucky to have been able to spend time in Asia and have the opportunity to learn and experience the truth that friendship means the same thing in every culture.  

Okay, I am sure I goofed up somewhere. Let me know what you think!

Flawed Keynesian Analysis Based on Confused Terminology

Larry Summers is a former US Secretary of the Treasury and is now a professor at Harvard. He is also an unabashed Keynesian who apparently will use any means to support ongoing stimulus. His latest nonsense was published by the Financial Times on Monday, April 30^th on page 11, “Growth not austerity is the best remedy for Europe.”

He might as well have added apple pie and mom into the headline. Notice that austerity means stern, severe in appearance, uncompromising, forbidding. Clearly austerity does not sound like anything you’d like to dance with on Saturday night at the Player’s Pub in Bloomington Indiana. Growth is just the opposite. We all want to grow – what could be better than growth in spirituality, wealth, height, etc. I tend to grow around the waist line but let’s not go there.

So saying you are for growth and not austerity doesn’t take a background like Summers’. So what is he really saying? Basically he is saying that he wants even more stimulus in Europe. How can I conclude that?

Let’s get back to the term, growth. Growth has two definitions or meanings. First, growth has a very general meaning in macroeconomics. We say the economy grew by 2.2% last quarter because the value of real GDP in the first quarter of 2012 was higher than the value produced in the fourth quarter of 2011. It was higher by about 0.55% but when we annualize the figure it becomes 2.2%. Economic growth according to the general definition simply means a rising real GDP. To say that growth is the best remedy makes no sense. It makes no sense because one has to explain what will cause the growth. Will the strong European growth be induced by Adam Smith’s invisible hand? By another round of monetary expansion? By more government spending or tax cuts?  By imposing supply-side economics or restructuring?

His article is pretty clear that the solution is more spending during a time of large government debt. He clearly discounts any value from supply-side programs, “there will ultimately be a need to raise retirement ages, reform sclerosis-inducing regulations and restructure benefit programs.” But he is very clear that he is NOT recommending any supply-side programs now.  Those are not seen as generating growth but as something to do later. He explains that income is driven by demand. Austerity is bad because it drives down spending, income, and the ability to pay off creditors. He boldly says austerity makes it impossible for a country to pay its debts. More spending, in contrast, makes it possible. Is this convoluted or what?

Really this is what the former Secretary of the US Treasury is telling us. Let me repeat it.

• Spending less makes the debt problem worse

     ·      Spending more is the best way for a debtor country to pay off its debts.

·          

I hope he explains this to the investing public. They will be fascinated. When Spain decides to have much bigger deficits, Summers predicts investors will all join in a chorus of gumbya as they buy as many Spanish bonds as they can find. Seriously, nowhere in his article does he even raise the possibility that spending more in Europe could elicit a very negative response from world investors that would shake even the Sagrada Familia.

There is more to this that bond vigilantes. Growth has a second meaning in macroeconomics. Economic Growth Models are used by economists to explain what causes a country’s GDP to grow in the long-run. These models do NOT focus on short-term fluctuations. You might wonder how fast the US economy is going to growth in the next 10 years.  The US CBO thinks the US will grow by about 2.3% per year between 2011 and 2021. See this at page 2 of  http://www.cbo.gov/sites/default/files/cbofiles/ftpdocs/120xx/doc12039/economictables[1].pdf

Many of us would have a little more interest if Summers’ title was referring to this definition of growth. Why? Because if he is referring to longer-term trends, then this brings us a little closer to a meaningful policy interpretation. That is because most long-term growth models explain and predict a country’s economic growth with concepts like labor growth, capital growth, and productivity (see page 2 of the above link for this kind of detail). These long-term growth models usually are devoid of any demand-side variables like government deficits or money growth. Thus, to achieve a higher sustained rate of growth policy needs to focus on ways to improve labor supply, capital supply, innovation and anything that might make labor and/or capital more productive.

We do not usually associate monetary or fiscal policy with the sustained growth of labor, capital, and productivity.  Monetary and fiscal policy are Keynesian inventions used to fine-tune aggregate demand temporarily. What I refer to in past blogs as restructuring or supply-side policies – and the things Summer’s mentioned as policies that we can try later – these are the things that are usually associated with creating higher sustained levels of economic activity.

So if we want to get out of our current slow growth trap the answer is not more spending. The answer is more supply-side policies designed to improve outcomes in labor markets, capital markets, efficiency, and innovation. But there is one more point. Clearly austerity is an important part of a supply-side approach. If we want more growth then we need more austerity, not less. Why do I say this? After all, I quoted definitions above that describe austerity as something pretty ugly. The answer is that it sometimes takes something ugly to get to the other side of your problems.

Yes, spending less will probably create predictable downside short-run changes in spending and incomes and employment. But many countries have already ventured into this phase and will soon be emerging. Spanish unemployment is deplorable but Spain has encountered these kinds of unemployment levels before and lived to see a better day. It is like the reformed smoker who gets half-way through his prescribed regime only to smoke a couple of Camels to celebrate his month of abstinence. They should stick with the austerity so its benefits have time to work.

What is not consistent with Summers’ ideology and he never mentions is the well-known remedial affects of austerity. Why would a country ever be willing to go through austerity? You don’t do it for fun. You do it because it addresses what is wrong with your country. If financial excess caused the recession and knocked the government’s finances out of whack, then one has to reverse the financial excesses. Europe is trying to create financial regulations to address private financial excesses. But it makes no sense to address private finances while you are making government debt dramatically worse. Shifting financial excess to government excess can only work for a while. To heal, a country must convince the world and its own citizens that it will pay its debts.

Convincing the world of this financial improvement means that creditors will accept more reasonable interest rates. It means that companies will be able to borrow and invest more profitably. It means foreign investors will be more willing to invest in the economy. It means a lot of good things that can only improve growth. But austerity might not be enough. Combining austerity with supply-side remedies would be a powerful double punch that will support both short-term and long-run economic growth. Summers could not have the prescription more wrong! We need more austerity, not less. We need supply-side policies now, not later.

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. 

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.

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.

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. 

Limbo, the Maytag Repairman, and Macro Markets

How low can you go? Sometimes when spending seems weak and prices are falling there seems to be no end to that cycle. It’s like we are staring down into a bottomless pit. It seems like there is no end to the fall in prices. But prices never fall without limit and the real world is a little more like the limbo than a bottomless hole in the ground. 

You remember the limbo, right? It is a calypso thing. Two people hold the ends of a long stick and some fool with especially rubbery legs goes under the bar as people sing limbo limbo limbo like me while they drink tall island drinks with colorful parasols. As the bar goes lower some of the contestants no longer can go under the bar and the game ends when there is only one contestant who can go under the bar. For his efforts he is usually awarded discount coupons for orthopedic surgery. Or the game ends when your mom comes home and confiscates the rum you stole from her liquor cabinet.

The point of this post is to raise the question of the relative efficacy of market solutions to government intervention.  After five years we might want to question knee-jerk Keynesianism. To do this we have to take a little venture down supply and demand lane. We will now all hold hands and sing gumbaya.

For those who do not want a refresher in supply and demand you may cheerfully proceed down to the place marked “The Fun Starts Here.”

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Economists torture their students with supply and demand to discuss everything from wart growth to interplanetary travel. We can slap a S&D diagram on a white board or cocktail napkin quicker than you can say diminishing marginal returns. My friend Jimmy can wield a small hammer at limestone and produce a beautiful wall or walkway. My hammer is my set of colored markers that I can use to explain price and quantity changes of anything anywhere at any time.

The invention of the stirrup revolutionized warfare and led to a rapid increase in the price of saddles and horses.  Centuries later technological advances in computer chips led to astronomical declines in the price per unit of power for computers. The stirrup increased the usefulness and therefore the demand for horses and saddles and this caused their prices to rise. Computer chip technology made it possible to increase the supply of power at lower costs which led to declines in the price of computer power.

Supply and demand analysis has found its way into common discussion. Most of us are comfortable with the idea that bad weather which ruins crop yields will reduce supply and causes the price of tomatoes to rise. Of course when worry reduces investor appetite for risk we talk about how the decline in the demand for stocks causes stock prices to fall. You don’t have to be an economist to be familiar with the use of supply and demand concepts and how they come together to help one discuss past, present, or future expected price change. I am not trying to say that supply and demand is as well-known as a Charlie Sheen rant, but we have adopted this economic analysis tool to our everyday lives.

Supply and demand analysis is a pretty remarkable thing that comes up with predictions by making assumptions. For example, one assumption says that prices will change in response to the condition of a market. If the main change in a market is an increase in demand, for example, then in the absence of price change or before a price change can take place – this creates an imbalance in the market. In this example, we would observe demand greater than supply. This imbalance or shortage creates the incentives for both demanders and suppliers to agree to a higher price.  In the opposite case which finds supply much larger than demand, this surplus leads market participants to agree to a lower price.  When the price changes in response to these market imbalances, we say that the price change “clears the market.” Clearing of the market means that the price change brings supply and demand back towards equality. A conclusion of the usual market model is that prices play an important role of restoring balance to markets.

Adam Smith’s “invisible hand” concept explained that if markets were allowed to work then we would not need policy or policymakers or baboons to solve market imbalances. If there is too little or too much demand for a given supply you don’t need a committee of experts to solve the problem. What you need is a market wherein there is strong competition, good information, no impediments preventing actors from expressing market wishes, and no obstacles to prices changing as the market dictates.

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The Fun Starts Here

Those last paragraphs sound like a textbook and even I am getting sleepy. But a big point is that whether it is stirrups, tomatoes or whatever – we tend to adopt supply and demand analysis and use it to explain and predict real world outcomes.

This is why I am so perplexed about our application of these tools to macroeconomic situations.  While it might seem a bit far-fetched to some of you, macroeconomists apply supply and demand to a nation’s economy. Macroeconomists since J.M. Keynes have adopted the idea of national demand for goods and services and policy is often directed to stabilizing undesirable changes in aggregate demand. Accordingly, some macroeconomists believe that part of the solution to our latest recession is downward price adjustments. Since much of what caused the recession was a decrease in the demand for houses and financial assets, an application of supply and demand would argue that falling prices of houses and financial assets should part of the solution to market balance or equilibrium. At the macro level it is interesting that our policymakers were not content to just let Adam Smith’s invisible hand solve the problem. Rather than believe there was some reasonable end to a game of Macro-Limbo, they worried that prices were headed into a dark pit filled with rattle snakes and Rush Limbaugh. To prevent prices of financial, housing, and other assets from declining to the earth’s core, the Fed and the Treasury bought stocks, bonds, and companies like geeks at the introduction of the latest gadget at the Apple Store. To prevent housing prices from falling toward the South Pole the government not only bought houses but put in a whole new team to regulate foreclosures and to oversee an orderly disposition of houses.

Distrusting prices to equilibrate these markets, policymakers essentially stopped the markets from working and it appears in the end that they have drastically slowed the movement towards a new balance. Why did policymakers behave this way?  Why did they not allow market capitalism to function? One can only guess the reasons. One is that while they trusted markets to work for most things on most days, they lost their trust when it came to bigger events. Imagine if doctors decided not to use modern medicine every time they had to treat a really serious ailment! Second, what fun is it being in charge of a country if you don’t do anything but stand around watching prices fall and don’t get any credit when the problem disappears? Let’s call that the Maytag Repairman explanation. Third, perhaps they worried that prices would not move in the right direction. But of course, housing, bond, and stock prices did move in predictable fashion. Fourth, perhaps they worried that prices would fall too much and create too much havoc as they fell. It seems to me that this explains a lot of the mistrust of markets. When policymakers faced the public with sad worried eyes they proclaimed that it was necessary for government programs to forestall a horrible process.

Some policy makers are bragging about recent stock prices but notice that with all the merriment, the stock indexes are now only regaining a peak reached during the recession and still have a long way to go before reaching highs attained before the crisis. It has been half a decade of no real stock price growth. But with housing prices still falling, one has to wonder if the real truth of the intervention is that it simply stretched out the eventual adjustment. Prices were going to fall to clear the market but the government made sure the price change took years and years and years.

Geithner and Bernanke would say that I am a nut job. Letting the economy free fall would surely have caused a larger crash. But while most of my friends will agree that I am surely a nut job, I will not agree to what we can’t know. How far would prices have fallen and what would have been the side effects?  I suspect that without government’s mucking up expectations, prices of houses would have overshot in a downward direction and would have made housing the bargain of the century. After all – a house has real worth. It is composed of brick and mortar and sweat. That has value. If we overbuilt houses for numerous years the glut would lead to prices at the low end of that fundamental value. But clearly demand plays a role – and with housing prices cheap enough relative to the cost of producing new houses – the demand could come back. But we never let the prices reach those levels and we will never know how the invisible hand might have worked.

Let’s suppose housing or stock prices fell to these low values I proclaim above, wouldn’t that have killed off a lot of mortgages and created a national recession? Probably. But what I am raising here is that we chose to pull the band aid off slowly. Are we sure that the accumulated pain of the last five years of heavily regulated markets is not greater than the quicker and perhaps more intense spike of pain associated with a quick pull of the bandage? The unemployment rate has been high for quite a while and threatens to remain there for some time. Might these unemployed have been better off if that rate had risen even higher in 2008 or 2009 but was back to 6% today? What I do know is that it is now March of 2012 and we still hear our leaders proclaim that they saved the day and that without further stimulus the economy will go back into recession. I am not so sure that a market solution could have been much worse. The recession started in the beginning of 2007 and ended in the middle of 2009. Five years after the recession started and after trillions of dollars of very active policy, US policymakers admit that the economy is still too weak to be trusted. I think it is the policymakers that can no longer be trusted.

Stimulus Doesn't Add up

Joseph Stiglitz is a Nobel Prize winner for economics (2001) and a very influential economist. We should expect more from him in the way of good analysis. But like his other Keynesian compatriots (e.g. Paul Krugman, Martin Wolf) he writes cogently but is so driven by ideological goals that his analysis falls short of anything that one might actually call macroeconomics. In his recent article in the Financial Times (The American labor market remains a shambles, page 9, Tuesday, March 13, 2012), Stiglitz continues baying at the moon about macroeconomic stimulus. I have written numerous times in this blog about the risks of continued stimulus several years after the end of the US recession. I won’t repeat all that here but suffice it to say it behooves me to explain and defend my obnoxious allegation that such great economists fail to come even close to connecting the dots.

In this article, Stiglitz admits there has been a recovery in the US and comments that we have had several recent occasions of green shoots. Clearly this amounts to a recognition that all is not as fragile in 2012 as things were in 2008. But then Stiglitz brings up the risk factors – explaining adroitly how this recovery and expansion phase pales in terms of past ones in the US.  Stiglitz raises the correct issue – there is a concern that we have adequate policies to deal with an economy that simply won’t create jobs or output as fast as it used to. In the body of his article – and this is the frustrating part – he mentions some very real risks yet his own policy recommendation seems to avoid treating  these monsters in favor of mumbling a worn out Keynesian mantra – drill baby drill. No – just trying to see if you were still awake. The Stiglitz-Keynesian mantra is for continued big deficits, bigger debt, and a central bank that accommodates all that with more and more money.

Here are some of the trends and risks he singles out in his article:

• ·         Extrapolating current employment trends it could take 13 years to reach full employment in the USA
• ·         It will take sustained output growth of more than 4% to pull the unemployment rate down.
• ·         Even after deleveraging we should not expect the consumer to go back to previous rates of spending.
• ·         Over-building in housing leaves that sector unable to pull demand up sufficiently.
• ·         States and local governments have financial problems that prevent them from leading an upsurge in spending
• ·         Redistribution of income towards higher income individuals (who spend a smaller portion of their incomes) retards consumer spending. Wages not keeping up with inflation have exacerbated the redistribution of income.
• ·         The Great Recession reflects a transition from manufacturing to services.
• ·         Risks faced by the American economy include the European downturn, complacency in the US which prevents adequate government support, and that we are content with an unemployment rate above 7%.

From this he concludes…”the economy will almost certainly need more stimulus if it to return to full employment any time soon”.

It is telling that nowhere in this list of trends or risks is a worry about the negative impacts derived from sovereign risk associated with rising government deficits and debt. Equally noteworthy is how he fails to provide any connection between this very worthy list of trends/risks and his policy prescription for more stimulus.

It makes me think of the patient who sees his doctor about a knee problem and explains that she has been recently running 15 miles a day to prepare for the next Ironman race. The doctor says, young lady, I recommend that you take 6 aspirins with a spoonful of JD each day. While it is true that this medicine might have some impact on the pain it totally ignores the question of what is actually causing the knee problem – too much running. If this doctor has an improper relationship with Bayer or the Jack Daniels Company, then we might understand why he would give such bad advice. Of course, if the doctor is running for office then maybe he concluded that the patient would feel happier until the next election without giving her the tough advice to forget the Ironman.

Stiglitz’s advice is no different.  Like drugs the stimulus could have a short-term remedial effect. And like the drugs the bad advice could lead to long-term negative consequences.  An economist might say the risk of the stimulus is tolerable if it leads to some improvement. But surely this reasoning misses the point. If one does not attack the real causes of the knee problem or of the labor market’s under-performance, then we are certainly destined to stimulus addiction. Make no mistake that Stiglitz is advocating more stimulus. Those are his words.  I do not favor a strong and fast movement toward austerity in the USA. But many times in this blog I have explained why continuing the same level of stimulus or expanding it is the wrong thing to be doing now. 

Whether it is changes in age distribution, shift to a services sector, productivity, globalization, leverage, housing excess capacity or whatever – we get nowhere today if we do not address those issues head on.  Addressing these issues has nothing to do with more stimulus. Addressing those issues is what it will take to create the growth that will improve employment opportunities in the US.  And addressing those issues is why things are not likely to improve quickly. What is so devastating about Stiglits’s weak analysis is that it raises expectations about something that cannot and will not happen. These trends and risks that he mentions have been building for decades and the solutions will take time to work. Yes, we want the patient to have a good outlook and be positive about the future. But false confidence is wrong and will be counter-productive.

Stiglitz has every right to his opinion. But it is frustrating when a senior and prize-winning economist’s analysis is so superficial. The Financial Times has sophisticated readers and deserve to read a more thoughtful analysis of cause and effect. As in the doctor example wherein his poor prescription arose from an unethical relationship with drug companies or a populist approach to medicine, one wonders what promotes this lack of good economic analysis on the part of such an important economist.