One Salient Oversight

I've been working

2012-01-28T22:12:00.001+11:00

That's why I haven't been blogging lately.

More on EV Batteries

2011-11-29T20:28:00.002+11:00

I've been doing some more thinking about Electric Vehicles and the battery technology that will drive it to eventually replace internal combustion cars.

In the previous article I pointed out that Electric Vehicle Battery Packs need to have an energy density of around 675 Watt-hours per kilogram (Wh/kg) if they are to have an equal range to today's petrol-powered cars. I also pointed out that the Nissan Leaf - the world's first truly mass-produced electric car - has a battery pack with an energy density of around 131.57 Wh/kg. This means that the Leaf only has an effective range of approximately 117km (72 miles). "Range Anxiety" is truly a problem for Leaf owners - even though the total cost of charging the Leaf is lower per kilometre than the cost of filling up regular cars with petrol (the equivalent fuel efficiency for the Nissan Leaf is 2.4 litres per 100 km - 99 miles per gallon).

As a result of this study, I've done some more number crunching - this time taking into consideration various different types of vehicle. The Nissan Leaf is essentially a "Compact Car" or "C-Segment" vehicle. The other electric car that is dominating the EV market is the Mitsubishi i-Miev. The i-Miev is different to the Leaf in that it is a "Subcompact" or "B Segment" vehicle (also known as a Kei Car). This means it has a smaller engine (47kw compared to 80kw in the Leaf) and is lighter (1080kg compared to 1521kg). Thus the cars can't really be compared.

So what I did was examine the various different types of cars and work out just how much battery density needs to increase before the range of that particular vehicle class can be effectively equaled by an EV.

The image from my spreadsheet is too large to post here, so click here to see it directly. I obviously need to explain it, so have it open in one tab while looking at this page and flick between them.

Each different column colour represents a vehicle class. We have Subcompact / B Segment all the way up to Full SUV / J Segment. In each of those columns I have also included a base vehicle to use by way of comparison. Since we recently bought a VW Caddy, I decided to stick pretty much with Volkswagens as far as possible, with the notable exception of the Australian Ford Falcon and Range Rover. Each of these vehicles is given a fuel economy figure in Litres per 100km (to convert to mpg, click here). I've also included the size of each fuel tank, in both litres and in weight, as well as in kilowatt hours of storage. The cars I used all had petrol, not diesel, engines.

Column B shows energy storage in Wh/kg. This assumes that, as technology improves, more and more power is able to be stored in an EV battery.

All those numbers from column 9 downwards, and from column D onwards, are the range (in kilometres) of each vehicle class according to the energy storage numbers in column B. The most important cell in this section, and the spreadsheet, is F19, showing 117km range at 131.57 Wh/kg for a compact car. This is the base figure for the Nissan Leaf that I mentioned above and in my previous post.

The important figures are shown there in bold. I'll dot point them here:

Subcompact (VW Polo): 600 Wh/kg for 600km range.
Compact (VW Golf): 675 Wh/kg.
Mid Size (VW Passat): 785 Wh/kg
Compact SUV (VW Tiguan): 950 Wh/kg
Full Size (Ford Falcon): 1100 Wh/kg
Mid SUV (VW Toureag): 1300 Wh/kg
Full SUV (Range Rover): 2800 Wh/kg

As you can see, it is obvious that 675 Wh/kg may be enough to completely control the Subcompact and Compact markets, but as soon as you take bigger vehicles into consideration, the energy density needs to be higher. And this shows how the market will react as time goes by: the smaller, lighter vehicles will become more dominated by EVs than the bigger, heavier vehicles.

I've also placed another figure to look at: the energy density needed for the vehicle to have a range of 1000km. This is an important figure (though arbitrary) that will affect EV design. If we assume, for example, that battery energy density reaches 1300 Wh/kg (and thus control the mid sized SUV market), what would happen to the subcompact market? Well according to the spreadsheet, such a vehicle would have a range of 1300km, more than twice what is probably needed. When this occurs, it is very likely that EVs will have less space dedicated to battery packs and more space dedicated to other aspects, such as greater boot space and leg room. Thus the cars will have an ever increasing usability.

This is not outside the realms of possibility. Think about the battery packs needed to power your mobile phone or laptop - they have been decreasing in size and increasing in energy intensity for some time. The same should be true for EV battery packs.

Now the second part of the graph needs some explanation. It is essentially the application of Moore's Law to battery technology in column B (column C is the multiplier for the spreadsheet, so ignore that unless you wish to check my figures - which you are welcome to). Moore's Law, in this case, assumes that battery energy density will double every two years. If we take this year (2011) to be the year when battery packs of 131.57 Wh/kg are currently available to the market (ie the battery packs for the Nissan Leaf), then you can see the sort of battery energy density that could be theoretically available as years go by.

If we take...

a range of 300km to be the sort the market will respond to positively (and thus begin to be competitive with petrol driven vehicles),
and if we see a range of 600km to be the sort that will completely control the market (and make petrol driven vehicles obsolete),
and a range of 1000km to be the point at which these vehicles begin to reduce the amount of space needed for battery packs (and thus increase usability by having more space),
and if we apply Moore's Law to battery technology...

...then we will see the following:

Subcompact EVs will begin to be used in number from 2014. They will begin to control the market in 2016. They will begin to increase usability from 2017 onwards.
Compact EVs will begin to be used in number from 2014. They will begin to control the market in 2016. They will begin to increase usability from 2018 onwards.
Mid-Size EVs will begin to be used in number from 2015. They will begin to control the market in 2016/2017. They will begin to increase usability from 2018 onwards.
Compact SUEVs will begin to be used in number from 2015. They will begin to control the market in 2017. They will begin to increase usability from 2019 onwards.
Full Size EVs will begin to be used in number from 2015. They will begin to control the market in 2017. They will begin to increase usability from 2019 onwards.
Mid-Size SUEVs will begin to be used in number from 2016. They will begin to control the market in 2018. They will begin to increase usability from 2020 onwards.
Full-Size SUEVs will begin to be used in number from 2018. They will begin to control the market in 2020. They will begin to increase usability from 2022 onwards.

Now I don't really know too much about how the car market reacts to new vehicles and how long it takes for them to be taken up by the market, but it is probably likely that 2014-2016 will be the years when the electric car begins to hit world markets in number.

Battery technology is the key to EV Growth

2011-11-17T22:48:00.002+11:00

In order for Electric Vehicles to enter the mainstream and compete equally with petroleum powered vehicles, battery technology must improve.

I consider the Nissan Leaf to be the one of the most important electric vehicles on the market today. Unlike the Prius or even the Volt, the Leaf is not a hybrid electric vehicle but a completely electric one. It is powered by an electric motor and energy is stored in the car's battery packs. The Leaf will not need to be "filled up" with petroleum, it needs to be plugged in to ensure that its rechargeable batteries have enough juice to keep the Leaf going.

The problem is that, while the cost of charging a car with electricity is very low compared to the cost of filling up a car with petroleum, the range of the Leaf is disconcertingly small. "Range anxiety" prevents many Leaf owners today from driving their vehicles beyond the normal commute. As a result it is more likely to be owned by people who already own petroleum powered cars that have greater range that they can use when needed. Nissan says that the Leaf's range is 160km but that is a very optimistic figure which does not take into account normal driving patterns: an "eco" mode ensures that acceleration is lower than it could be. In "normal" mode, and taking into account the need for air conditioning, heating, and music, the range of the Leaf is more likely to average out at 117km.

(Such normal driving patterns also lower the range of petroleum powered vehicles as well - it's just that we don't notice it too much because the car's range is still reasonably high).

After consulting the specs of my own comparable vehicle (A Mitsubishi Lancer) I have determined that modern cars need a range of around 600km. This would mean that, in order to properly compete, the Nissan Leaf's batteries would need to store 5.128205128 times more energy than it does currently.

And this is where the engineering challenges can be quantified.

The Automotive Energy Supply Corporation (AESC) is the company that builds the Battery Packs for the Nissan Leaf. Have a look at the specs on their product here.

From these specs we notice a number of things:

The Nissan Leaf does not have one battery pack, but 48 individual packs located under the car's floor.
According to the Leaf's specs, the total amount of energy stored in these 48 packs is 24 kilowatt hours (Kw/h).
Therefore, each battery pack contains, on average, 500 W/h.
Each individual battery pack weighs 3.8kg.
Therefore, the energy density of each battery pack is 131.57 W/h per kilogram.

So in order for the Leaf to have a 600km range, each battery pack should store 2.56 Kw/h of energy, which means that the energy density of these battery packs must increase to approximately 675 Wh/kg (while assuming no increase in volume).

Of course battery technology is progressing in leaps and bounds - anyone who owns a mobile phone or laptop knows that storage capacity has improved considerably over the last five years. Nevertheless while the technology is moving forward, we need to remember that there is usually a lag between the technology being discovered and its ability to be mass produced at a reasonably low price.

I am quite confident that these technological and industrial goals can be met some time in the next 10-12 years.

How I would solve the EU Sovereign Bond Crisis and stop it from happening again

2011-10-25T11:50:00.001+11:00

Pool all sovereign debt into a central fund. At the end of 2010, this amount totaled €7,822,443 million. Source.
This central fund will be run by a supranational entity under the control of the European Union, much like the ECB.
A Eurozone-wide financial services tax is introduced. This would be based upon either a Tobin Tax or a Market Capitalisation Tax. The purpose of this tax would be to pay off the sovereign debt that has been pooled into the central fund.
Because nation governments have shown that they cannot be trusted to maintain the fiscal agreements of the Maastricht Treaty, a Eurozone-wide supranational entity - let's call it the European Revenue Service, or ERS - is set up to a) determine a nation's tax rates, and b) take over the tax collection duties of member nations. This will necessitate the ceding of tax setting and tax collecting by all levels of Eurozone government.

Let me expand on these idea further.

The central fund and the financial services tax.
The pooling of debt into a single fund and then paying it off by a Tobin tax or Market Capitalisation tax takes care of the current mess. Individual Euro governments will no longer be responsible for the debt that they have accrued up until this point. It's a way of both "cleaning the slate and starting again" while still setting up structures to ensure that the debt gets paid off (and not defaulted upon). Moreover, the tax that is instituted is aimed squarely at the financial industry (who helped set up the current crisis) rather than upon ordinary wage earners. A central Eurozone-wide fund is better than a series of national funds simply because the central fund (preferably backed by the ECB) would be given clear parameters and not be subject to the whims of individual nations.

The short-term goal of the fund is to provide market confidence in the payback of sovereign debt.
The long-term goal of the central fund is to pool together and eventually retire all levels of Eurozone sovereign debt by way of a financial services tax.

The European Revenue Service.
The setting up of the ERS is certainly a controversial proposal - but it is a proposal that will ensure that this crisis never occur again. Ceding the sovereign authority to set and collect taxes may sound frightening to those who do not support an ever-closer union, or who think the EU should no longer exist. Yet it is essential for the future of the EU - since it will prevent the blowing out of sovereign debt again.

Under this system, each member country has the power to spend as much they usually do - the ERS will not be responsible for spending decisions. What each nation will no longer have is the ability to set tax rates or tax law or have the ability to collect taxes - these things will be left to the ERS. The ERS will then set tax rates and tax laws for each member nation of the Eurozone to match the amount of spending they indulge in. Scandinavian nations, like Finland or Sweden, will continue to have big spending governments, which means that the ERS will set up high tax rates in those nations. Nations who have smaller governments in proportion to the economy will have lower tax rates. If a country decides to expand government spending, then the ERS will naturally increase the taxes in that nation over the long term; similarly, if a nation decides to cut spending, then the ERS will lower taxes over time. If a nation wants to "run a surplus" in order to create a sovereign wealth fund, then they will simply file this investment under spending, and the ERS will set taxes accordingly.

The ERS will also be the supranational tax collection agency, ensuring that the same quality of operations exists across the entire Eurozone.

The ERS will also have the authority to change tax rates in individual nations, or across the entire Eurozone, in response to certain economic conditions such as recessions or expansions. This would be done in conjunction with the ECB. Keynesian stimuli enacted by member nations will also be conducted in conjunction with ERS policy.

Individual nations can "reduce taxes" on certain industries if they wish through subsidies, which would have a net effect upon the taxes on that industry.

The short-term goal of the ERS would be to set tax rates in member countries, collect them and distribute them to these member countries.
The long term goal of the fund is to ensure that all nations maintain zero net sovereign debt over the course of the business cycle.

Notes:

The fund and the ERS will only operate within the Eurozone. Members of the EU who are not members of the Eurozone will not be subject to these entities (eg UK, Denmark). However, once an EU country joins the Eurozone, these policies will affect them: their sovereign debt will be transferred to the central pool and their tax system will be run by the ERS. The idea that sovereign debt may be paid off on entry to the Eurozone gives potential member nations a huge incentive to join.

As for the importance of government bonds in the European Financial industry, the ECB would be able to issue enough bonds to cover this need. Just because debt is being/has been retired does not mean that government bonds need to disappear as well.

US Recession Indicators - October 2011

2011-10-20T12:28:00.000+11:00

According to data from negative Real Interest Rates, another US recession is likely to begin between now and 2012 Q4, with 2012 Q1 the most likely... See below.

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Net Monetary Base vs Inflation (spread)

The growth of the Net Monetary base (M0 minus excess reserves) over inflation has been above the historical average since September 2010 and has remained high at 659 in September 2011.

These results continue to be high and any future recession will either be delayed or else the results will begin to drop drastically.

Already there has been two months of straight decline in both M0 and Excess Reserves (2011-08 and 2011-09 results). Nevertheless Net M0 remains positive because reserves had declined faster than M0.

Inflation in September was 3.9%, the highest it has been since October 2008. This is the third straight month of price increases since a deflationary monthly result in June. The rate of monthly inflation has decreased however, with 6% in July, 4.5% in August and 3.6% in September.

Note: A negative result implies that inflation is growing faster than the money supply, an event which indicates that a recession will occur within 1 to 36 months (with an average of 12 months)

Note: All recessions are preceded by a negative result.

Data Series:
St Louis Fed

AMBNS
EXCRESNS
CPIAUCSL
GDPC1
POP

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Federal Funds Rate vs 10 Year Bond Rate (spread)

September ended with a reading of 190 after 10 year bond rates continued to decline. This is the lowest spread since May 2008. The recent decline is increasingly precipitous.

What I said in August needs to be remembered:

If this indicator stays true to its historical data, then there will be one of two events leading up to the beginning of the recession.

The first is if the Federal Reserve will keep the Federal Funds rate effectively at zero, which it will do barring any major inflationary outbreak. If this occurs then 10 year bond rates will drop to zero as well, or at least converge to within a few basis points. This appears to be the situation currently.

The second event will occur if the Federal Reserve increases rates in response to an outbreak of inflation. If this occurs then the Federal Funds rate will exceed the 10 year bond rate, thus placing the indicator into negative and presaging a recession. Inflation has been increasing markedly in the last six months, so this event may yet be the result.

Will Ten Year Bond rates drop to zero? Or will there be an outbreak of inflation first?

Note: A negative result implies a highly restrictive monetary environment, an event which indicates that a recession will occur within 4 to 39 months (with an average of 22 months).

Note: If both the first and second graphs are negative at the same time it indicates that a recession will occur within 1 to 21 months (with an average of 11 months).

Note: All recessions are preceded by a negative result.

Data Series:
St Louis Fed

FEDFUNDS
GS10
GDPC1
POP

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Real 10 Year Bond Rates Rates

Real Ten Year Bond rates came in at -1.32% in September. As I have pointed out before, all experiences of negative 10 year bond rates since the 1950s have resulted in an eventual recession.

If we take previous instances of negative real bond rates into account, a recession will begin between now and 2012 Q4, with 2012 Q1 the most likely. These previous experiences also indicate that unemployment will also likely peak between 12.1% and 18.7%, with a result around 16.9% the most likely.

Note: Real Interest Rates based upon 10 year Bonds can indicate how the value of money is determined in comparison with the market's safest investment. A negative result implies that inflation is eroding the savings of those who have invested in 10 Year Bonds. A negative result over a three month average indicates that a recession may occur between 4-18 months, with an average of 8½ months and a median of 6 months.

Note: Not all recessions are preceded by negative real 10 year bond rates. Nevertheless all instances of negative 10 year bond rates (since the 1950s) have been followed by a recession.

Data Series:
St Louis Fed

GS10
CPIAUCSL
GDPC1
POP

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Market Capitalisation adjusted by USDX

(The orange line is the recession line, the red line is the line of resistance)

Data Sources

US Dollar Index
Russell 2000

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Archive of Historical graphs.

Real Interest Rate historical graph archive.

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Cost of US oil consumption as percentage of GDP

2011-10-19T13:01:00.001+11:00

The most recent figure is for 2011-Q2, which comes in at 1.17%.

With oil prices now $20 cheaper than 2011-Q2, 2011-Q3 will likely see a drop.

Methodology:

The average oil price for the quarter is multiplied by oil consumption for the quarter, which is then measured as a percentage of nominal GDP.

Sources:

West Texas Intermediate, price averaged out for quarterly figure. Link.
US Oil Consumption, quarterly. Link.
Nominal GDP, quarterly. Link.

Notes:

Orange lines represent recessions (annual decline of real GDP per capita)
Yellow line represents historical average of 0.82% of GDP.

US Defense Cost Overruns: F-35 vs F4

2011-10-10T17:48:00.001+11:00

The F-35 is a fighter-bomber aircraft that will be used by three of the four branches of the armed forces. The last time the Air Force, Navy and Marines had the same jet fighter was back in the 1960s when they all adopted the F-4 Phantom II fighter-bomber.

A good way to determine just how bad defense cost overruns are is to compare the relative cost of the F-35 with the F-4.

Of course there are a number of determining factors. One is the fact that inflation has distorted prices somewhat since the mid 1960s. Another is that real GDP has grown significantly in that time. The final thing to realise is that technology since then has improved markedly, thus granting "more bang for the buck" so to speak. So let's play with these adjustments:

F-4E Phantom II "flyaway cost" in 1965 was $2.4 million (wikipedia source)
Nominal GDP in 1965 Q4 was $747.5 Billion. (St Louis Fed source)
The cost of a single F-4E Phantom II thus represented approximately 0.00032% of GDP.
Adjusted for inflation, the cost of a single F-4E Phantom II in 2010 dollars is approximately $16.4 million (inflation calculator)
F-35A Lightning II "flyaway cost" in 2011 is $122 million (wikipedia source)
Nominal GDP in 2011 Q2 was $15,012.8 Billion (St Louis Fed source)
The cost of a single F-35A Lightning II thus represents approximately 0.00081% of GDP.
The cost of 0.00032% of GDP in 2011 Q2 was $48 million.
The F-35A is, in dollar figures, 644% more costly than a F-4E.
The F-35A is, in percentage of GDP, 154% more costly than a F-4E

So naturally the question arises: is one F-35A better than 2.5 aircraft that could've been built at lower cost but with far better technology that was ever available for the F-4? Or, better still, is one F-35A better than 7.4 of these aircraft?

The idea I'm trying to promote here is not a return to building F-4s, nor whether it would be better to build increasingly obsolete F-18s, F-16s or F-15s instead. Rather I'm trying to point out that a cheaper alternative could've been built than the F-35, and that this theoretical alternative would've replaced the F-18s, F-16s or F-15s.

This theoretical aircraft would not cost $122 million (like the F-35A), but be between $16.4m - $48m. While the chances are that this theoretical aircraft would be inferior in some ways to the F-35, it would still be superior to the aircraft it replaces and probably still be one of the best aircraft around.

Maybe the Pentagon should focus its attention upon cost, and let the developers and engineers work within that framework.

EDIT: Since the F/A-18E/F Super Hornet currently costs $55 million each, maybe it should replace all the obsolete fighter-bombers currently in service in the Air Force, Navy and Marines?

EDIT 2: Fixed up the last two dot points above to read "more costly than" rather than "the value of".

Market Failure

2011-10-05T11:02:00.001+11:00

When a market is dominated by a monopoly or a cartel, and they use their market powers to reduce supply in order to boost their own profitability, then the market has failed.

Were Cali Dairy Cows Slaughtered to Raise the Price of Dairy?

US Recession Indicators - September 2011 - Market turmoil edition

2011-09-23T09:57:00.001+10:00

According to data from negative Real Interest Rates, another US recession is likely to occur between 2011 Q4 and 2012 Q4, with 2012 Q1 the most likely... See below.

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Net Monetary Base vs Inflation (spread)

The growth of the Net Monetary base (M0 minus excess reserves) over inflation has been above the historical average since September 2010 and has remained high at 646 in August 2011.

The results for August were higher than expected but I think a peak is likely to have been reached. M0 declined between July and August from 2706.799 to 2679.481, while Excess Reserves declined during the same period from 1618.188 to 1583.525. The result was an increase in Net M0, since reserves declined faster than M0. Over the following months, this should lead to a converging of inflation with the growth of net M0.

Inflation in August was 3.8%, the highest it has been since October 2008.

Nevertheless since the introduction of QE2 in November 2010, the net monetary base has increased faster than inflation.

Note: A negative result implies that inflation is growing faster than the money supply, an event which indicates that a recession will occur within 1 to 36 months (with an average of 12 months)
Note: All recessions are preceded by a negative result.

Data Series:
St Louis Fed

AMBNS
EXCRESNS
CPIAUCSL
GDPC1
POP

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Federal Funds Rate vs 10 Year Bond Rate (spread)

Like last month, I have factored in recent market turmoil in this indicator. August ended with a reading of 220 after 10 year bond rates plummeted to 2.3% for that month. By the close of trading on 2011-09-22, rates have dropped further to a record low of 1.72%, which has led to a mid-monthly reading of 163. What I said last month still applies:

If this indicator stays true to its historical data, then there will be one of two events leading up to the beginning of the recession.

The first is if the Federal Reserve will keep the Federal Funds rate effectively at zero, which it will do barring any major inflationary outbreak. If this occurs then 10 year bond rates will drop to zero as well, or at least converge to within a few basis points. This appears to be the situation currently.

The second event will occur if the Federal Reserve increases rates in response to an outbreak of inflation. If this occurs then the Federal Funds rate will exceed the 10 year bond rate, thus placing the indicator into negative and presaging a recession. Inflation has been increasing markedly in the last six months, so this event may yet be the result.

Note: A negative result implies a highly restrictive monetary environment, an event which indicates that a recession will occur within 4 to 39 months (with an average of 22 months).
Note: If both the first and second graphs are negative at the same time it indicates that a recession will occur within 1 to 21 months (with an average of 11 months).
Note: All recessions are preceded by a negative result.

Data Series:
St Louis Fed

FEDFUNDS
GS10
GDPC1
POP

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Real 10 Year Bond Rates Rates

Real ten year bond rates came in at -0.83% in August. As I have pointed out before, all experiences of negative 10 year bond rates since the 1950s have resulted in an eventual recession.

If we take previous instances of negative real bond rates into account, a recession will start between 2011 Q4 and 2012 Q4, with 2012 Q1 the most likely. These previous experiences also indicate that unemployment will also likely peak between 12.1% and 18.7%, with a result around 16.9% the most likely.

Note: Real Interest Rates based upon 10 year Bonds can indicate how the value of money is determined in comparison with the market's safest investment. A negative result implies that inflation is eroding the savings of those who have invested in 10 Year Bonds. A negative result over a three month average indicates that a recession may occur between 4-18 months, with an average of 8½ months and a median of 6 months.
Note: Not all recessions are preceded by negative real 10 year bond rates. Nevertheless all instances of negative 10 year bond rates (since the 1950s) have been followed by a recession.

Data Series:
St Louis Fed

GS10
CPIAUCSL
GDPC1
POP

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Market Capitalisation adjusted by USDX

(The orange line is the recession line, the red line is the line of resistance)

Data Sources

US Dollar Index
Russell 2000

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Archive of Historical graphs.

Real Interest Rate historical graph archive.

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Writing Dreams

2011-09-09T12:45:00.001+10:00

Two recent events have rocked the world of a couple of internet denizens.

The first is David C. Simon, the creator of the webcomic Crimson Dark. Simon, a talented user of computer graphics and scriptwriting, has been nabbed by the Game company that is producing "Star Wars: The Old Republic". Simon's role will be mainly in writing, but there's no doubt that his skills in creating Crimson Dark were an important part of this process.

The second is that a Redditor named Prufrock451 with a good script idea is now in talks with a Hollywood company. While this is early days yet, it is the culmination of a very quick few weeks in which the Redditor began writing a sci fi/fantasy story in which a Marine battalion in Afghanistan is transported back in time to ancient Rome. The story, called Rome Sweet Rome, started off mere weeks ago as an experiment in writing that somehow gained a huge following amongst Redditors. Just the mere idea of Machineguns mowing down Praetorian Guards got people involved, not just in reading but also in editing. I suppose you could call it a Saw and Sandal epic (see here).

A proposed solution: Co-ordinated international fiscal and currency policy

2011-09-05T10:17:00.001+10:00

Synopsis: A new international agreement between China, Japan the US and the Eurozone should be made to boost economic growth: The US Dollar should be actively depreciated against the value of the Japanese Yen and the Chinese Yuan; Japan and China should enact substantial stimulus programs while the US dollar drops in value. This should boost internal demand in Japan and China which would result in a higher amount of goods and services exported from the US. The Eurozone should also enact a stimulus program while depreciating the Euro slightly. This would ensure both an increase in overall economic growth in all nations while solving the current account imbalances which helped create the economic crisis in the first place.

Due to the inter-relationships between various economies and the imbalances that occur between them, it strikes me that one of the better solutions to the world's current malaise would be to enact some sort of co-ordinated fiscal and monetary policy.

I am one who believes that our current situation has arisen mainly due to imbalances in world investment. Huge current account surpluses in some nations have led to a permanent culture of saving while huge current account surpluses in other nations have led to a permanent culture of borrowing. As a result, certain nations have become "geared" to either saving & production or borrowing & consumption. The response to the economic crisis so far has not resulted in a move away from this imbalance but has rather sought to entrench it further. For example, policy in the US is all about the importance to reviving consumption, either via various stimulus packages or quantitative easing - all of which are designed to boost consumption and reduce saving. Meanwhile, China and Japan and other nations geared towards saving and production continue to manipulate forex markets to keep their nations producing and their citizens saving, all the while waiting for the US to begin consumption and borrowing again.

Well let me suggest the opposite as a solution.

If we want to rebalance the world economy at the same time as boost it, then there needs to be a shift towards balanced current accounts. This would mean that the US would no longer be the world's borrower and consumer, and Japan and China no longer be the world's saver and producer. It would work something like this:

A new "Plaza accord" is agreed upon between the US, China and Japan and the Eurozone. This agreement would see a depreciation in the value of the US dollar against the Japanese Yen and the Chinese Yuan. A small depreciation in the Euro would also occur.
At the same time as this occurs, the governments of China, Japan and the Eurozone enact substantial fiscal stimulus programs to boost internal demand.
The increase in internal demand from Japan and China combined with a lower US Dollar will result in an increase in US production.
All three nations, along with the Eurozone, agree to have a currency board to ensure that a balanced current account exists between them. This currency board would not exist to peg the three currencies but to merely ensure that the current account remains balanced within the limits of a floating currency.

What this will do is ensure that future Chinese and Japanese economic growth is no longer linked to US consumption and borrowing. The stimulus program in China and Japan should increase the demand for US goods and services. This would increase aggregate demand in the US without relying upon US government spending. Now to some questions about this:

How does the Eurozone fit in?
The Eurozone already has a balanced current account. Unlike many commentators I support the notion of the Eurozone and believe that it is an optimal currency area, which means that any internal current account imbalances amongst Eurozone countries is not as important as the current account of the whole. At present, the Eurozone's current account is nicely balanced, which means that any new Plaza accord should aim to change the current account balances of China, Japan and the US, but not the Eurozone. Of course the stimulus program in the Eurozone would only be useful if the current account remains balanced, which is why only a small depreciation in the Euro is required.

But the US doesn't produce anything!
This is plainly wrong as any judicious person knows. The US has the world's largest manufacturing base. Any increase in external demand will result in an increase in US manufacturing. In order to boost manufacturing and create jobs (especially for those with lower skills) a balancing of the current account must be undertaken.

Can we trust the currency boards?
So long as there is an agreement between the nations involved, so long as the boards are kept free from political and market influence and so long as they are answerable for the decisions they make, then they should be trustworthy.

Can Japan afford it?
Japan's long period of economic malaise has been accompanied mainly by a lack of internal demand. Balancing the Japanese current account and enacting a stimulus would ensure that any boost in economic performance arising from the stimulus is felt mainly in internal demand. In short, Japanese consumption - which is problematic - will be boosted; simultaneously US production - which is problematic - will be boosted. Accompanying this new economic situation will be a decrease in Japanese savings levels - which are too high - and an increase in US savings levels - which are too low. The result of this should be an increase in Japanese economic growth and, with it, an increase in tax revenue. Japan's public funds are certainly problematic, and so I would suggest an increase in tax rates accompany the increase in government spending. The short term boost in spending - which would boost economic growth - would then give way to a longer term sustainable economic performance which, because taxes are higher, would result in increase government revenue and more government debt being paid off. It stands to reason that the Bank of Japan change its policy to, at the very least, prevent long-term deflation (a phenomenon that is felt more by the Japanese GDP deflator than in the CPI).

What about Wall Street?
Let the follow rather than lead. With an increase in US manufacturing and exports, Wall Street should begin investing in companies that actually produce goods and services. Then Wall Street will be doing its job properly.

What about the rest of the world?
With China, Japan, the US and the Eurozone combined, this agreement accounts for over 75% of world GDP. The other 25% will probably need further international agreements - but at the moment we can leave that for the future.

What about US Conservatives?
This agreement won't need much in the way of further government spending for the US. US Conservatives couldn't care less about Japanese, Chinese or European big government spending. Actually, they should be happy that US goods will be increasingly sold in China. They should also welcome the profits made by US industrialists.

Some interesting presimetrics

2011-08-26T10:55:00.001+10:00

I did some interesting "Presimetrics" yesterday - the study of the economy under various presidential administrations and the title of a book written by Mike Kimel. Since I prefer to use Real GDP per Capita as a measurement for economic success and failure (a decline in annual Real GDP per Capita being my definition of a recession) I decided to check up on how the post-war presidents have performed. I don't know if Mike Kimel did this in his book (which I have sitting in a box in my garage) so please excuse me if I have discovered something that Mike has already pointed out.

My study started with the desire to measure economic performance under Obama against GW Bush. Of course the problem with such comparisons is that Obama has not been in office for as long as Bush had been, so I had to measure according to how many quarters each president had served and divide economic performance by those quarters. The result was very interesting - Real GDP per capita under Obama has grown by 0.29% per quarter while under GW Bush it grew by a paltry 0.19%. Encouraged by this interesting result (Newsflash: Economy growing faster under Obama than Bush!) I decided to go back and compare everyone since Eisenhower. This is the result:

By way of methodology, I access the data on Real GDP, then divided that number by the population at the end of each quarter (with 2011 population data being mid-monthly) to get a Real GDP per capita figure. I then measured the change in Real GDP per Capita from the first quarter of the president's first term in office against the final quarter of his final term in office. For Johnson and Ford, I measured the first quarter in office as the quarter they became president, which means that Kennedy's and Nixon's last quarter in office was followed by the quarter in which they ceased to be president. Once I measured the change in Real GDP per Capita as a percentage, I then divided it by how many quarters the president spent in office. So what do we find?

Obama - 0.29%
Too early to tell but there has certainly been a growth in Real GDP per Capita faster than Bush II. I am predicting another recession, so I expect this number to drop over time. Moreover Obama's result has the statistical advantage of an economic trough being followed by a recovery.

Bush II - 0.19%
His presidency was bookmarked by recessions and there is no doubt that the 2008 credit crisis affected his result badly. A quick check of the spreadsheet tells me that up until 2007 Q4, Bush's performance was 0.38% per quarter.

Clinton - 0.71%
Do we miss the 90s yet? In hindsight economic growth during Clinton's time in office was based upon the unsustainable dot-com bubble. if we measure Clinton's performance to 1994 Q4 (the quarter before the bubble began to expand), growth was lower at 0.56% which is, however, a reasonably good result.

Bush I - 0.18%
GHW Bush's result suffers from a recession at the middle and end of his single term, but even if we factor that out his performance from 1989 Q1 to 1990 Q2 the result is 0.31%. I'm wondering if GHW's figures suffer from a bust from the Reagan years (though some conservatives would argue that his "read my lips, no new taxes" taxes killed it)

Reagan - 0.62%
From memory, studies into Real GDP show that Reagan's years weren't that good. Per Capita, though, the results are worth talking about. Yet while Clinton's higher growth came at the expense of a sharemarket bubble, Reagan's growth came at the expense of the public debt. In essence, Reagan borrowed against the future to boost the present. Now that the present is Reagan's future, I would argue that we are reaping now what Reagan and congress sowed back in the 1980s. Also, let's not forget Paul Volcker - killing inflation really did stabilise the economy in the 80s.

Carter - 0.47%
Malaise never had it so good. The further into the future we get the more we realise that Carter's presidency was better than what was believed. "History's greatest monster" he was not. 0.47% growth was certainly not as good as other periods in postwar history (and certainly not as good as Reagan) but is certainly better than both Bushes, Ford and Nixon.

Ford - 0.42%
Not a great sample size admittedly (10 quarters, or 2½ years) so we could probably add this onto Nixon. Certainly not a great number compared to previous years but better than recent times.

Nixon - 0.44%
What happened here? Nixon inherited some of the strongest growth on record and managed to halve it. Two recessions (1970 and 1974) damaged it severely. We also shouldn't forget the first oil crisis as well. Barring any further evidence of economic stupidity, I don't think Nixon is responsible for such low growth in this period.

Johnson - 1.00%
The postwar US economy grew fastest on a per capita basis under Johnson. This was aided by two wars - the war in Vietnam and the war on poverty. While military expenditure created a demand for labour, conscription created a shortage of it. At the same time wealth was redistributed via poverty reducing policies and the creation of Medicare. And this was done without a huge increase in public debt.

Kennedy - 0.97%
Obviously the Johnson growth had its basis in Kennedy's 11 terms in office, though Vietnam was not as prominent in calculations here. We also need to factor in the effects of substantially better transport infrastructure, thanks to Eisenhower.

Eisenhower - 0.14%
This has to be one of the most interesting results of all. It is generally believed that the 50s saw an economic boom but what we see here is something different. Under Eisenhower, real GDP grew from $2.3484 to $2.8002 trillion, a total growth of 19.24%. But per capita figures divide this by population. Under Eisenhower, population grew from 159 million to 182 million, a total growth of 14.24%. So while the economy undoubtedly grew, the sheer number of baby boomers born in that period reduced GDP per capita something severe and thus skews the figures.

An analysis of the past 30 years

2011-08-21T16:19:00.001+10:00

So I was playing around with my spreadsheet and some numbers recently and decided to work out just how much money has been invested in the sharemarket as a proportion of GDP. Of course we remember the time when the Dow hit 10,000 and unemployment was low - but it's currently over 10,000 and unemployment is high. This should indicate something strange going on, not to mention question the idea that the Dow represents the economy.

I couldn't use the Dow index, though. Instead I decided on the Wilshire 5000, which is an index that a) encompasses all shares in all publicly traded markets in the US, not just the top performing ones, and b) comes up with an index number that also closely approximates the dollar value of the entire sharemarket. For example, the W5000 index for 2011-08-18 (last Friday) closed at 11806.16, which approximates $11.8 Trillion. Historical numbers of this broad index can be found at St Louis, as always. So what happens when you look at this index and compare it to GDP? This:

By way of comparison, throughout the 1970s this index averaged around 56% of GDP, and swung between 38% and 83% of GDP. The 1980s and half the 1990s thus saw a W5000 performance not too different from previous experiences. Then from 1995 onwards we have the tech boom, which peaks in 2000 Q1 at over 140% of GDP. Yet there was no decline back to the sub 80s for the long term but a re-inflating of the bubble from 2003 Q1 onwards (which, by the way, occurs around the same time as the Federal Funds Rate drops from 1.75% to 1.25% and then 1.00% for the rest of 2003). A second, lower, peak is reached in 2007 Q2 (108%), which then plunges back down to 58% in 2009 Q1 as a natural result of the 2008 credit crisis. Since then it has re-inflated back up to 92% of GDP in 2011 Q2. Of course, there is a huge chance that this number is going to crash down again.

What appears to have happened is simple - there has been a sharemarket investment bubble that has inflated since 1995 and which has yet to be properly dealt with. My belief is that the higher the sharemarket value to GDP ratio is (as demonstrated by the graph above) the more chance there is of a bust and a damaging recession. Either the sharemarket needs to crash down or GDP has to increase to ensure a more sustainable level. Anything below 50% of GDP should be a policy goal. This can be achieved through a Tobin Tax or a Market Capitalisation Tax imposed upon the sharemarket - with taxation rates increasing the higher the ratio gets in order to prevent runaway over-investment.

This issue also reveals shortcomings in monetary policy. While monetary policy affects the entire market, it affects the financial market and its behaviour directly through its operations. If the market is in the process of over-investing, then all monetary policy ends up doing is re-inflating the bubble, rather than mitigating liquidity issues arising from a deflating bubble. Ideally monetary policy in this situation should create a "soft landing" for the deflating bubble - but in practice it has simply re-inflated the bubble and, as a result, postpones the bubble bursting to a later date.

This issue also reveals shortcomings in fiscal policy. Tax cuts for the rich have not resulted in a substantial increase in money velocity but rather a further investment into the share market.

Finally it also appears that our current economic state is the result of the tech boom's bust. We're paying now for decisions made by the financial market up to 16 years ago. While it is true that the 2008 credit crisis had a more damaging impact upon the economy and upon unemployment than the 2001 recession, we can trace back the credit crisis to the tech boom.

Now the second graph to look at concerns personal saving. I've based this upon the St Louis Fed PSAVE series which measure the dollar amount of personal saving. I've then compared it to GDP. What has happened since 1981? This:

By way of comparison, between 1951 and 1980, the ratio of personal savings to GDP averaged 6.04%, with the lowest being 3.86% in 1951 Q1 and the highest being 9.28% in 1975 Q2. The average between 1980 and today has been 4.27%.

So since 1980 personal savings as a percent of GDP has dropped. In fact it dropped below the 4% level on a more or less continual basis since... 1995 Q2. Now where have we heard of that quarter before? Oh yes... that was when the sharemarket tech bubble started. In recent years the savings ratio has tried desperately to rise above 5% but has gotten no further than 4.84%

My belief is that too much personal savings is bad, but that too little is bad as well. If we assume that the 1951-1980 period was a better period for personal saving then obviously it should increase in these times. But it hasn't. Why?

The first is that we need to look at personal saving at the same time as we look at sharemarket investing. As sharemarket investing has grown so has personal saving dropped. This indicates that people are investing more in the share market than they are in cash.

The second reason is that GDP has grown substantially in response to sharemarket investment. While it has created a "virtuous cycle" for part of that time, it means that ordinary people have had less money in proportion to GDP for them to save.

But here's another graph: Public debt.

One rule of thumb that people over the years have believed in is that when the government goes into debt, the private sector begins to save. Yet this doesn't appear to be true when it comes to personal saving. Since 1980 personal saving as proportion of GDP has decreased, while US government debt has increased. If the rule of thumb worked, then why wasn't there an increase in personal savings?

Well in one sense there was an increase in personal savings - investing in the share market. Share market investing, because it became so attractive, took money away from cash investment.

And the fourth graph is interesting too: The balance on the current account.

By way of comparison, the period between 1960 Q4 and 1979 Q4 saw an average current account surplus of 0.26% of GDP, with a high of 1.06% of GDP in 1975 Q4 and a low of -0.87% in 1978 Q3. Since 1980 the current account has averaged around -2.58% per year, with a high of 0.05% in 1991 Q4 and a low of -6.11% in 2006 Q3.

The first thing to note is that the first drop in the current account between 1984 and 1988 occurred during a time when the US Dollar increased in value. The Plaza accord was signed in 1985 Q3 to reduce the value of the US Dollar. This eventually saw the current account reach a trough in 1987 Q2 and begin to rise again.

The 1997 Asian financial crisis then saw a rush of investment into the US Dollar, which began rising again. By 1998 Q3 the current account had dropped past -2% of GDP. Since then the current account has been deeply negative.

We need to remember that the world cashed in on America's sharemarket boom as well. The current account deficit hid inflation and prevented any meaningful tightening of monetary policy to rein in the asset-price bubble that had formed.

In light of this, what would OSO do?

Institute a Tobin Tax or Market Capitalisation Tax to dissuade over-investment in the sharemarket. Rates would be increased the more the market over-invests. This money would, at the moment, be useful in paying off government debt.
Create a currency board to control US currency. This would not be an abandonment of a floating currency and nor would it be a return to Bretton Woods. Instead a currency board would act to ensure a balanced current account by entering the Forex market and either buying or selling US dollars in response to current account fluctuations. The US would also take the lead in creating a new world trade agreement to ensure that all major industrialised nations would institute currency boards to do the same thing for their own currency zones: ensure balanced current accounts (rather than current account deficits or surpluses). I go into more detail on this idea here.
Create more broad-based monetary policy to ensure a wider scope for its effect: Quantitative easing needs to do more than just buy back government bonds - it could also be used to directly fund treasury, to create banks or even be used in Keynesian stimulus programs.
Regulate the financial industry to dissuade the ponzi-like nature of modern financial investment. More details here.
Expand government services with a commensurate increase in taxation to create another "New Deal". A minor "Total War" economy needs to be examined again, though with money being spent on growth (and obviously the environment and global warming) rather than on military equipment and wars. More details here.

US Recession Indicators - August 2011 - Market turmoil edition

2011-08-19T15:59:00.001+10:00

According to data from negative Real Interest Rates, another US recession is likely to occur between 2011 Q4 and 2012 Q4, with 2012 Q1 the most likely... See below.

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Net Monetary Base vs Inflation (spread)

The growth of the Net Monetary base (M0 minus excess reserves) over inflation has been above the historical average since September 2010 and has remained high at 572 in July 2011.

As a result of recent market turmoil the numbers for August will be very interesting indeed. Since a recession will not occur until this spread turns negative, and since one indicator shows that a recession will occur within 18 months, we can assume that this indicator will begin to drop down over the next few months. Inflation has already picked up again and, at 3.6%, is the highest it has been since October 2008.

Nevertheless since the introduction of QE2 in November 2010, the net monetary base has increased faster than inflation.

Note: A negative result implies that inflation is growing faster than the money supply, an event which indicates that a recession will occur within 1 to 36 months (with an average of 12 months)
Note: All recessions are preceded by a negative result.

Data Series:
St Louis Fed

AMBNS
EXCRESNS
CPIAUCSL
GDPC1
POP

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Federal Funds Rate vs 10 Year Bond Rate (spread)

I have factored in recent market turmoil in this indicator. While July 2011 ended well with a reading of 293, the turmoil in recent weeks has seen 10 year bond rates drop nearly 100 basis points from 3.00% to 2.08% by the close of trading on 2011-08-18, which has led to a mid-monthly reading of 195. If this indicator stays true to its historical data, then there will be one of two events leading up to the beginning of the recession. The first is if the Federal Reserve will keep the Federal Funds rate effectively at zero, which it will do barring any major inflationary outbreak. If this occurs then 10 year bond rates will drop to zero as well, or at least converge to within a few basis points. This appears to be the situation currently. The second event will occur if the Federal Reserve increases rates in response to an outbreak of inflation. If this occurs then the Federal Funds rate will exceed the 10 year bond rate, thus placing the indicator into negative and presaging a recession. Inflation has been increasing markedly in the last six months, so this event may yet be the result. As far as I know, 6% inflation seems to be the new Fed goal so any change in the Federal Funds rate will have to see inflation increase beyond this amount.

Note: A negative result implies a highly restrictive monetary environment, an event which indicates that a recession will occur within 4 to 39 months (with an average of 22 months).
Note: If both the first and second graphs are negative at the same time it indicates that a recession will occur within 1 to 21 months (with an average of 11 months).
Note: All recessions are preceded by a negative result.

Data Series:
St Louis Fed

FEDFUNDS
GS10
GDPC1
POP

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Real 10 Year Bond Rates Rates

Real ten year bond rates came in at -0.43% in July. As I have pointed out before, all experiences of negative 10 year bond rates since the 1950s have resulted in an eventual recession.

If we take previous instances of negative real bond rates into account, a recession will start between 2011 Q4 and 2012 Q4, with 2012 Q1 the most likely. These previous experiences also indicate that unemployment will also likely peak between 12.1% and 18.7%, with a result around 16.9% the most likely.

Note: Real Interest Rates based upon 10 year Bonds can indicate how the value of money is determined in comparison with the market's safest investment. A negative result implies that inflation is eroding the savings of those who have invested in 10 Year Bonds. A negative result over a three month average indicates that a recession may occur between 4-18 months, with an average of 8½ months and a median of 6 months.
Note: Not all recessions are preceded by negative real 10 year bond rates. Nevertheless all instances of negative 10 year bond rates (since the 1950s) have been followed by a recession.

Data Series:
St Louis Fed

GS10
CPIAUCSL
GDPC1
POP

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Market Capitalisation adjusted by USDX

This is a new index based on some playing around with a spreadsheet. The idea is to adjust the Russell 2000 - the indice that measure market capitalisation (amount of shares multiplied by share price) for the whole market - by the US Dollar Index. This would, in turn, measure the value of US market capitalisation throughout the world, rather than just the US.

As you can see there appears to be a "line of resistance" that has formed since 2000. The high of 532.12 was reached in August 2000. The second high of 417.43 was reached in May 2007 while the third high of 351.4 was reached in February 2011. The 2000 and 2007 highs were followed by a recession and it looks as though the 2011 high might be followed by a recession too.

I'm still trying to work out if this is just a coincidence so take this indicator under advisement. Before 2000 such "lines of resistance" didn't seem to apply when looking at recession indicators. Note also that the most recent index number (286.01) is a mid August figure based upon figures from close of trading 2011-08-18.

(The orange line is the recession line, the red line is the line of resistance)

Data Sources

US Dollar Index
Russell 2000

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Archive of Historical graphs.

Real Interest Rate historical graph archive.

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The Man in Me

2011-08-12T09:15:00.000+10:00

Bob Dylan - The Man in Me - Lebowski from 43hk0804c26qsi8w on Vimeo.

Why not create new banks from QE3?

2011-08-10T10:35:00.001+10:00

Banks are unique to an economy. They are the creators of money, via the fractional banking system. How banks use their money greatly affects the way the economy runs.

Currently banks are sitting on $1.6 trillion in excess reserves. Excess reserves have always been a part of the banking system but not in the amounts seen since 2008 Q4. The sheer size of these reserves has hobbled monetary policy - every dollar sat on by banks in excess reserves is a dollar that has effectively been removed from the economy.

Why are the banks sitting on so much money? The answer is that they are suffering from an increasing amount of insolvency. They are Zombie banks, whose net worth is negative but who continue to operate. As Paul Krugman and others have pointed out, monetary policy is only effective in a liquidity crisis, not a solvency crisis.

Obviously these banks need to stop sitting on their reserves and begin lending again. If they lent their money out, the fractional system would gear up, increase money velocity and create enough money for the banks to operate their way out of insolvency. Ironically, the banks' response to the crisis is, in effect, perpetuating the crisis.

But there is a solution - new banks must be formed.

New banks, created without any solvency issues, have no real reason to sit on excess reserves. But new banks are usually created by the market itself. Since the market isn't creating any new banks, then new ones must be created by government: Congress, Obama and the Federal Reserve acting together.

Now it's not as though the government would own these banks long term. The idea would be to create them and privatise them as quickly as is practicable: onto the share market within 12 months of their creation.

But where would this money come from? Are we going to increase government spending and thus taxes? Well if the Fed is going to indulge in QE3, it might as well use the money it creates out of thin air to create something solvent and profitable, rather than prop up institutions that are insolvent and unprofitable.

The Fed's Quantitative easing program involved the Fed creating money out of thin air (by fiat) and then using that money to buy back government securities. Yet this process was hobbled by the Zombie banks because much of the money created in this process ended up in excess reserves. QE2, for example, resulted in excess reserves increasing from $971 billion in November 2010 to nearly $1.6 trillion today: that's around $600 billion in fiat money - the entire QE2 amount - that went nowhere.

But what if that $600 billion was spent capitalising a series of new banks? With no solvency issues to encourage excess reserves, these banks would've used their capital more freely. With QE3 a distinct possibility, why not direct the money at creating new banks?

There is a historical precedent here: The First Bank of the United States, formed in 1791 by congress (see pic above). Although this bank was essentially an 18th century version of a central bank, it did have direct market operations in lending money to the market, borrowing money from the market, and taking deposits. It was also created to be purchased by the market in the form of shares. Moreover, the precedent of creating a bank, coming almost immediately out of the formation of the first congress by the founding fathers, should prevent any complaints by political conservatives that such an action would be unconstitutional.

If we assume that these new banks do get created through the QE process, what of the Zombie banks still out there in the marketplace? My suggestion is that they should be allowed to permanently die - to be declared insolvent and shut down, with deposits (backed by the government) being shifted to newer and/or more solvent banking institutions. While killing off a Zombie bank would have a negative effect upon the market if it was done in isolation, killing them off while new banks are growing and blooming would be more sustainable.

(I wrote about this before in November 2010)

The US Government needs more revenue

2011-08-08T11:37:00.001+10:00

Oh dear, Standard and Poors rating agency has maligned the US by dropping its Triple-A bond rating. Strangely enough this event has brought both progressives and conservatives together in maligning the rating agency itself, which is a fair call considering the cluelessness of ratings agencies generally in failing when 2008 hit.

Nevertheless there is a rather huge reason for the US being downgraded. I just played around with another spreadsheet comparing US and Eurozone debt, and I get the following:

Okay, first of all you need to understand that this is an index - everything is assumed at 100 at the beginning.

Secondly, these numbers are based upon total government spending and revenue, which includes Federal, State and Local government. This is to ensure that US oranges are being measured against European oranges. You can find US figures here (on pages 345 & 347 of 360) and European figures here.

Thirdly, also understand that while these figures have been indexed, the difference between Eurozone and US revenue and spending as a percentage of GDP is substantial. In the Eurozone the two figures are around 50% of GDP spending and 44% revenue, while in the US, the figures are around 25% spending and 15% revenue.

Fourthly, the figures for EA17 and EU27 are pretty much the same, which is why I didn't include EA27 (the entire European Union) in the graph.

So what can we learn?

The most important line in that graph is Eurozone revenue, the orange line in the middle. Despite the onset of the GFC, despite the tumult at the so called "periphery", Eurozone revenue has only dipped slightly. This means that the deficit, the space between revenue and spending, has been mainly caused by increased spending. Thus in a recovery, spending would drop off as the unemployed return to work while revenue from income tax would increase.

The second most important line in that graph is US revenue. The financial crisis since 2008 has decimated US tax revenue. Previous to 2008, US revenue and spending were around the same level (though obviously with less revenue than spending) but since then there has been a massive drop off in revenue. And while State and Local governments have certainly added to this, the main offender is the Federal Government. A recovery, therefore, would have to be more substantial for the US to ensure that the deficit is paid down.

This is not to say that Europe isn't in trouble. Nor does it ignore the fact that certain European nations have huge problems. Nevertheless in light of the recent debt wrangles in Congress you can understand the fragility of the US economy, the downgrading of debt and China's angry response to the problem.

However the biggest problem here continues to be the Tea Party Republicans and their decision to flatly refuse any revenue raising policies. When seen in light of the graph above, such an extremist position is seen for what it is: madness.

There's one more piece of bad news: since the chances are high that another recession for the US is on its way, we can expect the US budget deficit to widen even further before the end of 2012. While the debt ceiling has been raised enough to prevent any congressional wranglings before next year's presidential election, the question now is whether the new recession will blow government finances out so badly that another debt ceiling vote is needed before the election. God help us.

Another recession? I told you so.

2011-08-05T14:30:00.001+10:00

There have been some very severe financial fluctuations in the past 24 hours. I won't even bother linking to any news or financial sites because you know it already. Here in Australia a number of very respected people are saying that this is the beginning of another financial crisis that will inevitably lead to another recession.

At the risk of sounding unbearably smug I have been predicting such an event. To be honest, though, I didn't expect the sudden crunch happening now. Moreover I wasn't basing my prediction upon "gut feeling" but upon data.

It all started back on 2011-06-17 when I wrote a post entitled A Recession indicator has been triggered . This was not just an important predictive event but also an important step in my own understanding. The fact is that for some months now I have been publishing a series of posts called "Recession Indicators". What happened was that my own study of real interest rates seemed to prove conclusively that whenever real 10 year bond rates (10 year bond rates minus inflation) went negative, a recession was inevitable. This is what I said:

What I discovered from this analysis is that while recessions can occur without negative real interest rates, whenever negative real interest rates do occur, they are always followed by an eventual recession. This occurred in 1957, 1974, 1980 and 2008.

So what about the present? Last week US inflation for May 2011 came in at 3.4438% while Ten Year Bond Rates for that month were 3.17%, which meant that real interest rates dropped to -0.2738%... if the June result continues to be negative, and if this continues into July, then the chances are that a recession will be sooner rather than later.

Then on 2011-06-24 I published the June 2011 recession indicators where I said

According to data from negative Real Interest Rates, another US recession is likely to occur between 2012-Q1 to 2014-Q1, with 2012-Q4 being the most likely.

Then on 2011-06-29 I published another post entitled Real Interest Rates are predicting an upcoming recession. Between this post and the previous one I had refined my study of real 10 year bond rates - averaging them out over a 3 month period in order to iron out a statistical "bump" in the data (which turned out to be Hurricane Katrina). By comparing these results to GDP and unemployment data, I came up with the following assertions:

Once (real 10 year bond rates) turn negative, a recession occurs, on average, 8½ months later.
The median is 6 months.
Results vary between 4 months and 18 months.
The highest unemployment rate during the recession is, on average, 1.8 times the unemployment rate of the month when real interest rates turn negative.
The lowest increase is 1.32 times; the highest increase is 2.03 times.

Now the thing about this particular post is that the 3 month average had yet to turn negative, so I prefaced my pronouncement with the caveat that "if" rates went negative the following month, then:

A recession starting between 2011 Q4 and 2012 Q4, with 2012 Q1 (is) most likely.

Then on 2011-06-30 I wrote a lengthy piece about what was likely to occur between now and the recession entitled The events leading up to the coming downturn. The idea was that, because I had two other recession indicators that unerringly predicted past recessions in hindsight, then any potential recession coming up would also have to influence these indicators. I decided that there were going to be two possible situations occurring, an inflationary outcome or a deflationary outcome:

An inflationary outcome would result in inflation outstripping the new monetary base. This would mean that, in the time leading up to the recession, inflation would increase...

The deflationary outcome, like the inflationary one, won't have to be sudden or substantial to presage the recession. If inflation sits at 1% and the Net Monetary Base grows at 0.5% - both near zero but slightly inflationary - the result will still be a negative spread and an upcoming recession. A decrease in the price of oil and an increase in the value of the US Dollar (the USDX) is likely to accompany this deflationary outcome.

The deflationary outcome would mean that the Federal Funds Rate remain low while the 10 Year Bond Rate crashes down to similar levels. This, in turn, would mean that the Bond Rate would be 0.09% or below. This, of course, would indicate massive financial distress that would be accompanied by a sharemarket crash of epic proportions and a credit crunch that would make 2008 look like a picnic.

When I balanced the two out, I decided that the inflationary outcome was more likely. After yesterday's crashing market, there is a much higher likelihood of a deflationary one. To be honest, the thought of the 10 year bond rate dropping below 0.1% is quite frightening.

So they were my June predictions. What about July? On 2011-07-07, when 10 year bond data came out, I wrote an article titled The chance of avoiding another downturn is now almost impossible.

After having my views changed on austerity (namely that the economy was no longer able to produce jobs in a recovery), on 2011-07-09 I outlined "OSO's New Deal" in which I argued that the US Government needs to spend more and tax more in order to a) boost economic growth, and b) generate more revenue to pay off its already considerable debt. While this was not a predictor of events to come, it did outline what I thought (and still think) is the answer to our current economic woes.

On 2011-07-20 I published the next recession indicator series. I made the following points:

If we take previous instances of negative real bond rates into account, a recession will start between 2011 Q4 and 2012 Q4, with 2012 Q1 the most likely. These previous experiences also indicate that unemployment will also likely peak between 12.1% and 18.7%, with a result around 16.9% the most likely.

Since then my blogging was mainly concerned with the US debt ceiling crisis. Since the resolution of this crisis, the markets have teetered and fallen. While I would no doubt agree that the debt crisis spooked the markets, I would argue, based upon the data and conclusions that I have been publishing since June, that a recession / downturn was always going to happen at some point. It seems like the debt ceiling crisis was the trigger for it happening sooner rather than later.

Now of course I need to add the disclaimer. We're not in another recession just yet - it is still too early to tell whether we are, at present, suffering another downturn. Moreover there is nothing to suggest that the current crisis in financial markets is going to continue like it was 2008. Markets just might do that, but then again they might not. I'm not going to predict how the markets are going to respond over the coming days weeks and months. Nevertheless I do think that there is enough evidence to show that another market downturn and another recession are going to happen within the next 18 months, and I will stick by that.

A Magical Method in the Money Making Madness

2011-08-04T13:45:00.001+10:00

Inflation. No one likes too much of it, though there is some debate as to how much is good and how much is bad.

Inflation is often linked to money creation - though not always, since inflation can also result from supply shortages such as oil. Nevertheless history abounds with money printing experiments that ended up in hyperinflationary failure: Weimer Germany, Mugabe's Zimbabwe, Postwar Hungary and the Crisis of the Third Century being the best known ones.

Injudicious money creation will always create hyperinflation. If the Federal Reserve creates $1 out of thin air the amount of inflation it causes will be negligible. If it creates $1 Trillion the amount of inflation it causes will destroy the economy.

Of course money is created all the time through the fractional lending system. Most of this money is created by the commercial banking system. While some see conspiracies and unsustainability in this process, it has actually worked for millennia. Nevertheless the real heart of the fractional banking system is the role of the Central Bank, which, in the United States, is the Federal Reserve Bank.

Now I'm not going to go into the intricate details of how the system works. If you're unsure of how it works, go to the Wikipedia page. Using this as a basis, however, let me do some funny little experiments as to what injudicious money creation can theoretically do.

So here's graph no.1 showing how the system works in the United States. If we assume that the US economy is worth $1000 in total money supply, it looks like this:

This is, of course, identical to the Wikipedia page's graph.

But now let's begin playing. Let's say Congress and the President and the heads of the Fed suddenly suffer from a collective insanity... even more severe than the one they already have... and decide that they'll fix the deficit by simply creating money out of thin air. Now according to the latest data, the budget deficit is $1.2059 Trillion and represents around 8.11% of GDP. So what would happen if the powers that be decide to just create the money out of thin air, again assuming in our model that the US economy is worth $1000?

I've added the baseline there by way of comparison (the blue line). The yellow line represents the collectively insane decision.

That doesn't look too good does it? You're looking at a huge increase in the money supply and, as a result, a hyperinflationary situation probably similar to anything occurring through history.

But then let's take this even further. Let's say the US has been taken over by an Idiocracy... worse than the current mob... who decide that they'll just forget about taxes altogether and just create as much money as the government needs. Since the US Government represents about 25% of GDP, it would mean that an even greater amount of money would be added to the money supply:

Ouch. And that, my friends, is why money printing on the scale used by the Romans, the Germans, the Hungarians and Mugabe ends in abject failure.

But hang on, what's that thing called "The Reserve Rate"? - Well that's how much money commercial banks are forced to keep in reserve when lending. Adjusting the reserve rate is used by some nations (India and China for example) as a way of implementing monetary policy. If the reserve rate is increased, the money supply drops. If it is decreased, then the money supply is increased.

And so now my friends let me show you some real magic.

Let's go back to the US Government who wants to create money out of thin air simply to pay off the deficit, shown two graphs above, except this time we increase the reserve rate to 18.11%. Why 18.11%? Well it's the 10% reserve rate plus the 8.11% size of the deficit (in relation to GDP). So let's see what the outcome is:

What? Wait. Hang on? Is that possible? You're creating money out of thin air but not affecting the total money supply? Yes. How? By increasing the reserve rate.

Let me say this again: It is possible for large amounts of money to be created by fiat by a central bank and NOT induce inflation only if the reserve ratio is increased accordingly.

So what would happen in real life? Let's say the US Treasury, facing a shortfall in funds, approaches the Federal Reserve Bank for funds. The Fed then creates money by fiat, out of thin air, and gives it (not lends it) to Treasury. Treasury then uses this money to pay the bills. The Fed, however, increases the Reserve Rate accordingly to prevent the inflationary impact of this money creation.

Magic? No. Just a simple change to the equation - a change to the equation that was never thought of by Mugabe, Weimar Germany and others.

Don't believe me? Then do the spreadsheet yourself. Here is a screenshot of what I did with mine.

Long term readers of this blog might notice where I'm going here: My Zero Tax Idea. How would the graph look in the "Idiocracy" situation I described, where taxes are removed and the government is funded purely by money printing, except this time we adjust the Reserve Rate?

Yep. No increase in the total money supply and thus no inflation.

Is this mad? Does this completely misunderstand how the fractional banking system works? Or does this have the potential to revolutionise how governments work? It isn't Quantitative Easing, it's Quantitative Control.

Imagine: No taxes at all, but a completely functional government.

Note: This was discussed back in 2007 at Angry Bear. Megan McArdle at The Atlantic also examined it here. Since the math backs me up (as proven by the spreadsheet graphs), maybe we should seriously consider it?

EDIT: For nations that do not have a reserve rate (such as Australia) the baseline money creation would appear as a straight line going up at a 45% angle. In order for this system to work in countries that have no reserve rate, one must be introduced. This is how it would look:

But then what about nations with large governments? Take Denmark, for example, whose government represents 56.6% of economic output. How would this system react to such a large amount of central bank money? Would the fractional system still work? Yes:

Thoughts on the debt deal

2011-08-03T10:38:00.002+10:00

This was definitely a compromise solution, but one in which each side calls the other the "winner".

I read quite a few lefty blogs, which is fine because, if you look at the graph showing my political and economic positions, I am a lefty. Now the lefty blogs are all saying that this is a victory for the Republicans. They're also critical of Obama. I've just watched John Stewart and that's pretty much what he said.

But I also check up on Redstate once in a while to look at how the other side feels and they are definitely unhappy too. "Cut, cap and balance" was their mantra and that was not achieved.

I guess the best place to check this is Wikipedia which, ironically (at least to many), has a more dispassionate and factual summary of what was achieved:
Cut spending more than it increases the debt limit. In the first installment ("tranche"), $917 billion would be cut over 10 years in exchange for increasing the debt limit by $900 billion.
The agreement establishes a joint committee of Congress that would produce debt reduction legislation by November 23, 2011 that would be immune from amendments or filibuster. The goal of the legislation is to cut at least $1.5 trillion over the coming 10 years and be passed by December 23, 2011. The committee would have 12 members, 6 from each party.
Projected revenue from the committee's legislation must not exceed the revenue baseline produced by current law.
The agreement specifies an incentive for Congress to act. If Congress fails to produce a deficit reduction bill with at least $1.2 trillion in cuts, then Congress can grant a $1.2 trillion increase in the debt ceiling but this would trigger across the board cuts ("sequestration") of spending equally split between defense and non defense programs. The across the board cuts would apply to mandatory and discretionary spending in the years 2013 to 2021 and be in an amount equal to the difference between $1.2 trillion and the amount of deficit reduction enacted from the joint committee. The sequestration mechanism is the same as the Balanced Budget Act of 1997. There are exemptions—across the board cuts would apply to Medicare, but not to Social Security, Medicaid, civil and military employee pay, or veterans.
Congress must vote on a Balanced Budget Amendment between October 1, 2011 and the end of the year
The debt ceiling may be increased an additional $1.5 trillion if either one of the following two conditions are met:
A balanced budget amendment is sent to the states
The joint committee cuts spending by a greater amount than the requested debt ceiling increase.

My understanding is that cuts were achieved and this was done without increasing tax revenue. This is therefore a broad conservative political victory. Conservatives, nevertheless, do not see this as a victory because it doesn't go far enough.

The reason for conservative unhappiness has more to do with their extreme ideological position. Since the onset on the Tea Party and their influence on Republican Party politics, the GOP has, amazingly, become even more ideologically conservative. Minarchism is now the default position of conservatives, which means that any form of government spending outside of military spending and law enforcement must be excised. This form of ideology, however, is backed up by a crazy form of patriotism that sees minarchism as the intended model explicitly advocated by the "founding fathers", which means that any different position (whether it be left wing or centrist) is automatically branded a threat worth "watering the tree of liberty for" (ie the blood of tyrants and patriots resulting from an armed struggle). Add to this the peculiarities of the US congressional system and the only real compromise position is the one which was passed.

As far as the effect on the broader economy, my understanding is that most of the cuts will come in after a two year period, which theoretically allows Obama some breathing space to run for a second term in 2012. The debt limit has been increased to allow for borrowing in the meantime and, all things being equal, should not require another increase until after the 2012 elections. "All things being equal" though is not a good phrase in these dark economic days. I have already predicted that the US will enter another downturn in 2012 and if this occurs the debt ceiling may need to be increased before the election, especially if unemployment ends up in the mid-teens, thus reducing government income tax revenue.

As for the Keynesian approach of pump priming the economy via deficits, this piece of legislation is of no help. My own call for a "Total War / New Deal" type economy (whereby large increases in government spending in health, education and alternative energy are accompanied by large tax increases) is even less likely to occur. Since the US economy's many structural flaws have not been addressed since the credit crunch of 2008, I thus have little faith that the free market will be able to generate jobs and economic growth in the short-medium term.

My Favourite Song

2011-08-03T00:25:00.001+10:00

Ride - Leave Them All Behind from 43hk0804c26qsi8w on Vimeo.

A quick solution to the debtlocked Congress

2011-07-30T13:42:00.001+10:00

It involves finding an average between the three constitutional bodies - the House, the Senate and the Executive.

The first thing to do is discern how much the difference between revenue and expenditure currently is. In 2011 Q1 it was $2.5231 trillion revenue and $3.7290 spending, a difference of -$1.2059 trillion. If we assume that that number has to be reduced to zero it should come as a result of spending cuts, taxation increases or a combination of both.

So what happens is that each member of the House is given a piece of paper. On that piece of paper they write down what percentage of this -$1.2059 Trillion should be paid for by spending cuts and what percentage by tax increases. I'm sure that right wing extremists are likely to nominate 100% cuts and 0% tax increases, while some lefties are likely to nominate 0% cuts and 100% tax increases. At the same time as members of the House do this, members of the Senate do as well. President Obama also does it.

Equal weighting is given to each of the three bodies (House, Senate, Executive) because they are equally weighted under the Constitution. The "averaging out" process would essentially be enforcing a mathematically based bipartisan compromise.

What happens then is that the average for cuts and tax increases is determined for the House. Let's say it is 61% cuts and 39% taxes. Let's say the Senate average is 46% cuts and 54% taxes. Now let's say that Obama goes for 40% cuts and 60% taxes.

This would mean that an average 49% of the three constitutional bodies say spending cuts while 51% want higher taxes. This would translate to $590.891 billion in spending cuts and $615.009 billion in new taxes (in annual terms). If you do the math, that would result in $3.138109 trillion revenue and $3.138109 trillion spending - a balanced budget.

Of course this voting structure would mean that the final number would have to be accepted by all parties before the vote is cast. This will allow members of congress to vote according to their ideology and please their voters, while at the same time creating a compromise solution.

It goes without saying that an increase in the debt ceiling would also accompany the bill.

America and the terrible, horrible, no good, very bad GDP data

2011-07-30T11:26:00.001+10:00

The recent GDP figures paint a bleak picture. My spreadsheet does too:

There was a revision of past GDP performance and it was very bad. The graph above shows quarterly changes in Real GDP per capita, annualised. Of course the big hit was 2008 Q4 but notice that 2011 Q1 has gone negative. I don't think this is the beginning of an annual decline of Real GDP per Capita but it can certainly be seen to presage one later on.

A very sad thing to notice about the new release of these GDP figures is that Real GDP hasn't yet passed its previous peak yet.

Real GDP peaked in 2007 Q4 at $13.326 trillion, then bottomed out in 2009 Q2 at $12.6413 trillion and has grown since then to reach $13.2701 trillion in 2011 Q2. 15 quarters - nearly 4 years - in which real GDP remained below the peak. As far as my spreadsheet tells me, there is no other period in postwar US history where it has taken this long (and counting) for the economy to at least equal its previous peak. Both the 1974 and 1982 recessions took 9 quarters to reach this level.

On a side note, measuring per capita figures has been harder this year due to the work of the US Census. Monthly population figures have not been updated since December which has meant that 2011 per capita figures have had to rely upon mid monthly figures. Caveat Cognitor.

The 14th Amendment and the potential for economic disaster

2011-07-28T12:49:00.001+10:00

The 14th Amendment of the US Constitution is currently being examined and touted as an important factor in the current debate about the government debt limit. I've blogged about this recently but I've had some more ideas about it. Here is the text again:

The validity of the public debt of the United States, authorized by law, including debts incurred for payment of pensions and bounties for services in suppressing insurrection or rebellion, shall not be questioned. But neither the United States nor any State shall assume or pay any debt or obligation incurred in aid of insurrection or rebellion against the United States, or any claim for the loss or emancipation of any slave. But all such debts, obligations and claims shall be held illegal and void.

Okay, the background of this amendment was post civil war. In its original context that first sentence guarantees the payment of debts incurred by the Federal Government in fighting and defeating the South. The second sentence, however, absolves the Federal Government from having to pay debts incurred by the Confederate States of America. The third sentence spells this out even more, permanently settling the question of Confederate debt.

It's the first sentence that applies in this current situation. Obviously the framers of the amendment thought it important not just to guarantee payment of debt by the Federal Government in the successful waging of the civil war, but to make it part of the constitution itself via an amendment. This means that they intended the principle behind this amendment to have an ongoing application.

The question is, what does it mean by debt? Obviously this debt is public meaning that it is owed by the Federal Government. In short it is money owed, and money owed that has been authorized by law. In other words, it is money that the Federal Government owes creditors - so long as it has been authorized by law.

As I pointed out in my recent article, this naturally applies to government bonds. As of the 26th July 2011, the US Government owes $14,342,830,116,551.28 in public debt. But is "Public Debt" in 2011 the same as "Public Debt" in 1868? There is a broader application of this term: there is debt accrued by borrowing, and there is debt accrued by buying. For example, if a government office gets a local company to mow their lawns, they naturally have to pay this local company. If we expand this idea outwards, we see that the Federal Government has legal obligations to pay for goods and services delivered to them by private industry.

But what about entitlements? Are entitlements considered debt? I think not. Entitlements such as Medicare and Unemployment benefits are probably not considered "debt" in this situation. Sadly this means that the 14th amendment does NOT cover money spent on Medicare or other social services.

"Public debt authorized by law" has also been interpreted by various bloggers and experts recently as to apply simply to spending bills authorized by congress. Essentially it means that if congress has authorized spending, then this cannot be invalidated by a debt ceiling... hence the debt ceiling as it stands is unconstitutional. I'm not sure of this broad definition for a number of reasons. The first is that the amendment itself doesn't specify it. The second is that we are talking here about Public debt - debt owed to the Public, ie not the government.

If you take this second definition to be important - PUBLIC debt - then what to make of government spending bills authorized by law? Well so long as the PUBLIC get what they are owed, the 14th amendment will not be broken. But if the Federal Government decides to stop paying its own employees, that is completely different because the money owed to their employees is not public. There are approximately 2.8 million people employed by the Federal Government.

Here's a summary of my thinking on this issue:

"Public Debt" means money owed to non Federal Government creditors.
These creditors include those holding government bonds, as well as those who have sold goods and services to the government.
The 14th Amendment prevents the Federal Government from defaulting on money it owes to bond holders.
The 14th Amendment does not specify whether payment of money to bond holders needs to be paid "on time" or "later"
The 14th Amendment prevents the Federal Government from defaulting on money it owes to private businesses and individuals for goods and services provided.
The 14th Amendment does not specify whether payment of money to these private businesses and individuals needs to be paid "on time" or later".
Money for those who qualify for government services and entitlements - such as unemployment benefits and Medicare services - are not considered "Public Debt" since they are not "owed" money they have directly invested or money they owed through the provision of goods and services.
Under the constitution, Congress is responsible for all spending bills.
A self imposed limit on the amount of debt the Federal Government can borrow is within the constitutional powers of Congress.
The 14th Amendment does not prevent the Federal Government from defaulting on money it owes to itself on the bond market. Intragovernmental debt is not "Public Debt".
The 14th Amendment does not prevent the Federal Government from defaulting on money it owes to itself via spending bills.
Money owed to government employees and government departments is not "Public Debt".

So given that these are true, what happens if the debt ceiling is not passed? We need to assume here that without a debt ceiling, the Federal Government will be forced to spend only as much as it gets in tax revenue. Specifically what might happen here?

The Federal Government will not default on paying back interest and principal on bonds owed to the Public.
Social Security payments are likely to be defined as money owed to the Public, so payments will continue.
The Federal Government will not default on paying back money owed to private businesses and individuals for goods and services provided.
Delays in payments nevertheless may occur.
The ordering of future goods and services from private businesses and individuals may be cut.
Money for entitlements (Health Care, Unemployment benefits, etc) can be cut.
Money for defense can be cut.

As I have pointed out, I don't think an arbitrary self-imposed debt limit set by Congress is somehow unconstitutional since Congress is responsible under the constitution for spending government money. Also, it won't be a case of a law passed earlier (the debt limit) being superseded by a law passed later (spending bills) since the earlier law was specifically designed to prevent something happening in the future.

So if the debt limit is not passed and is not declared unconstitutional, what we won't see is a default on government bonds but there is a chance that these payments might be delayed. This would be viewed by the market as a form of selective default. Similarly Social Security payments might end up being delayed, as would be money owed to government suppliers for goods and services owed.

But in order to ensure that these obligations are met (either straight away or over time), certain government departments would have to undergo a drastic reduction in spending. We would see the government either retrench or put on furlough tens of thousands of its employees, if not many, many more. Those with unemployment benefits would have them reduced or postponed indefinitely. Those awaiting or needing medical procedures covered by Medicare will have them delayed indefinitely with priority given only to the most severe cases.

As I pointed out in my previous post on this subject, the US Federal Government currently takes in revenue equivalent to 15% of GDP while its spending is equivalent to 25% of GDP. The 10% gap between revenue and spending is shored up by borrowing. If the debt limit is not raised then the Government will have to reduce its spending to meet its revenue. We would see a reduction in spending from 25% or GDP to 15% of GDP, which is a 40% cut in spending. If we assume that bondholders, social security recipients and government suppliers are protected by the 14th amendment then everything else covered by government spending will be cut.

Needless to say this will have a hugely negative effect upon the economy. With 10% of the economy suddenly halting, you could assume that GDP would drop by at least 10%. The knock-on effects, caused by the money multiplier going into reverse, could conceivably double this impact. And this would be the case even without defaulting.

Peak Oil: All signs point to yes

2011-07-26T19:11:00.001+10:00

This diagram comes from The Oil Drum:

I was initiated into the world of Peak Oil some time in 2004. Initially I thought it was a bunch of scary tinfoil hat wearing nonsense - partly because some tinfoil hat wearing people were promoting it (not you Dave!). The deeper I dug, however, the more the evidence piled up. The tinfoil hats were replaced by serious looking academics with qualifications from reputable universities and experience working in petroleum geology. They pointed out that data consistently showed that individual oil fields had an oil production rate like a bell curve, and that less and less oil comes out once the "peak" of the curve has been reached - which usually comes when the oil field is half empty.

The problem was, and still is, that many are under the false understanding that oil supplies will simply run out suddenly. They are buoyed by market reports showing that oil reserves have another 100 years production left in them. Thus they are ignorant of the fact that, when the majority of the world's oil fields reach 50%, worldwide production will drop.

The graph above shows very clearly that this moment has arrived. Depending upon which metric you use, oil production has either reached a plateau now, or reached one about five years ago.

Being an econophile before I understood Peak Oil, I naturally assumed that price signals would motivate the market to increase production. Yet if an increase in production is geologically impossible what happens when demand increases? When supply is constrained and cannot rise to market demands, what happens?

Simple: Production remains the same, while prices skyrocket. The graph above shows this phenomenon so clearly that you would have to be cognitively deficient not to notice. Some time in 2004 the price of oil begins to rise due to increased demand. This demand was not met by an increase in production, as the graph shows. Oil production then simply sits at the same level for some years. Oil producers are literally unable to pump the stuff out fast enough to meet demand. Oil prices double from their 2004 levels. Then they triple. Then they reach a peak in 2008 before demand destruction hits - the Global Financial Crisis.

Since then prices have dropped. But notice that they have begun skyrocketing again.

Many years ago I blogged about a "perfect economic storm" to hit the US. While I didn't know the date I knew that it would happen. I knew that Peak Oil would be the major cause. What I didn't realise was the extent by which the US economy had over-geared itself and when this occurred I became far more worried than I had before. It was as though I had predicted the arrival of the largest category 5 hurricane in history, only to realise that it would be a category 6 hurricane (which doesn't exist of course, but that's not the point).

If there's anyone out there who is still doubtful about Peak Oil, remember this: If an increase in price doesn't lead to an increase in production, then there is something preventing an increase in production. If this phenomenon is experienced worldwide by many different and disparate sources, then production must be limited by more than just human choices.

Scientists have proven the existence of Peak Oil. The evidence is clear and unambiguous. Moreover it has been experienced by the entire world economy for the past 7-8 years. What more evidence is needed?

And until we wean ourselves off oil, the lag on economic growth will continue. Policy decisions needed to be made in 2004 and weren't. They need to be made NOW.

Some simple facts about the Utøya shooting

2011-07-25T16:58:00.001+10:00

The perpetrator:

Opposed Muslim immigration.
Was once a member of a dominant conservative political party.
Espoused anti-government sentiments.
Hated Marxism.
Detonated a bomb near the office of the Prime minister, who belongs to a left-wing political party.
Shot and killed at least 86 young people who were members of the left-wing political party.

In short, he is a classic right-wing extremist in the same mould as Timothy McVeigh.

While I don't deny that left wing extremists exist and have also perpetrated violence upon people, I would just like to point out the simple fact that, at least in the West, violence caused by left-wing extremists has been dwarfed by the violence of right-wing extremists. And when you consider the fact that it is the right-wing who are espousing all sorts of radical views using violent rhetoric, you can understand why.

Note: The words "Marxist Hunter" appear on the patch on his left arm in the picture above.

It's so gratifying to leave you wallowing in the mess you've made

2011-07-23T12:45:00.000+10:00

Not good news:Negotiations over a broad deficit reduction plan collapsed in acrimony on Friday after House Speaker John A. Boehner suddenly broke off talks with President Barack Obama, raising the risk of an economy-shaking default.

The epic clash between the White House and Congressional Republicans came a week before the government hits its borrowing ceiling, and set off sharp accusations from both sides about unwillingness to compromise.

A visibly angry President Obama, in a hastily scheduled White House news conference, demanded that Congressional leaders come to the White House on Saturday morning.

“I want them here at 11 a.m. tomorrow,” Mr. Obama said. “They are going to have to explain to me how it is that we are going to avoid default.”
Anyone who has played Sim City 2000 will remember the importance of maintaining a tight budget. But if your city in the game gets to a point where you're running out of money you have a number of serious choices to make in order to balance the budget. One option you have is to cut funding to roads. When you do so, this guy (your roads and transport secretary) pops up and yells at you:

What happens then? As time goes by your roads begin to crack up and become unusable. This is turn reduces economic activity and your own tax revenue even further. It's a short term solution but ends up costing you far more in the longer term. It's a sure fire way to lose to game.

Then, of course, there is that Simpsons episode where Homer becomes the town's sanitation commissioner. He manages to gain this position through an election campaign where he simultaneously lies about the incumbent (and even defames him) and gives outrageous promises to the voters, all with Bono's consent. When the scheme blows up in his face (the yearly sanitation budget is used up in a matter of weeks) he resorts to a scheme whereby funds are generated by taking the trash from various US cities and storing it underneath Springfield. This, of course, turns the town into a smelly, garbage infested hell hole. An emergency meeting is held in the town hall and the people unanimously vote for the previous commissioner (Ray Patterson, voiced by Steve Martin) to retake the job. Patterson saunters on stage to music and then says this:

Oh gosh. You know, I'm not much on speeches, but it's so gratifying to... leave you wallowing in the mess you've made. You're screwed, thank you, bye.

I have to say that part of me wants to call the Republicans' bluff and not raise the debt ceiling. To be honest with you it would be the easiest and quickest way for them to achieve their ideological ends. I have already pointed out that such an action would cut federal government spending by around 40% and represent a cut in spending from about 25% of GDP to around 15% of GDP. According to historical notes on the US budget, the last time the US government was that small was 1951 - in other words the Republicans have a once-in-a-lifetime chance to shrink the government to its lowest level in 60 years. Moreover, this would not lead to debt default, as the 14th Amendment protects bondholders.

And it's not as though such a move wouldn't be popular, at least initially. There are many in the US who claim that the Federal Government has no real input into the economy. "Let's shut her down!" some would say, confident that such a move would have no real impact upon the economy and society in general. And as for all those pesky civil servants out of a job, well they weren't doing anything really important anyway. And it's not as though we can't afford to pay them unemployment benefits since such benefits would disappear anyway for everyone once the great spending cut occurs. And with so many people unemployed and not receiving benefits, they would then be able to get off their collective lazy asses and find jobs. Then the economy would start booming again.

Of course these sentiments are nonsense. Anyone with any understanding of the complexity of economics, the effect of government programs and the problems besetting the unemployed would know that such a gigantic cut in government spending would have only a negative impact upon the US. It would cause social and economic pandemonium.

And yet part of me wants to the GOP to do it. I do admit that there is some perverse pleasure in watching an economic collapse unfolding, in the same way that people hang around and watch the aftereffects of an accident.

Nevertheless I do have a rather pragmatic reason for wanting this to occur - the disaster that it brings on the nation (and the rest of the world) will be so damaging that no one would take hard-line conservatism seriously ever again. The disaster would be so horrible that Obama would be re-elected by a landslide and the Republicans would be utterly humiliated in Congressional elections. More than that, hard-line conservatism throughout the world would be discredited in the same way as communism was discredited after the collapse of communism.

And why? Conservatives have painted themselves into a corner. They are just so angry that things like Medicare, NASA, unemployment benefits and the Department of Education exist. It's not just that they don't like big government, it's that they so strongly believe that their understanding of limited government was the same thing believed by the founding fathers that anything, anything which suggests slightly higher government tax revenue or spending is immediately cause for revolution and "watering the tree of liberty". In the words of Grover Norquist, "I don't want to abolish government. I simply want to reduce it to the size where I can drag it into the bathroom and drown it in the bathtub."

Of course I see such people as not just hard-line but extremist. Their ideology has regressed so far that even Ronald Reagan, patron saint of Conservatives, would be labeled a "Republican in Name Only" for many of his policies.

And so this is why part of me wants the Republicans to follow through with the extremist ideology that now controls their party - it would allow them the chance to finally do what they've always wanted to do while simultaneously proving to the rest of America and the world the utter stupidity and unworkability of their policies. Their fate would be to disappear from the political landscape for a long, long time. The world would then become a much better place.

And as their doom descends and the party faithful shrink in horror at what they've done and seek to make amends, the voice of Ray Patterson calls out to them:

It's so gratifying to leave you wallowing in the mess you've made. You're screwed, thank you, bye.

A response to New Deal Democrat

2011-07-21T11:52:00.001+10:00

"New Deal Democrat" at the Boondad blog took the time to examine my latest recession indicator and question some of the methodologies and outcomes. NDD actually contacted me a while ago and expressed some of his opinions over these issues so the fact that he has blogged about it is not only welcome but also allows me a chance to respond.

NDD specifically has an issue with using real 10 year bond rates as a recessionary indicator. The reason is that the relationship between negative real 10 year bond rates and an eventual recession appears to break down in before 1953. Now the reason why I did not use any pre-1953 data in my study is because the 10 year bond rate series (GS10) available at the St Louis Fed only starts in 1953, while seasonally adjusted inflation (CPIAUCSL) starts in 1947. NDD, however, has pointed out that a discontinued government bond data series called LTGOVTBD has data going back to 1925, and that because both GS10 and LTGOVTBD follow each other closely from 1953 to 2006 (when the series was discontinued) it is therefore a good proxy. Add to the fact that non-seasonally adjusted inflation figures (CPIAUCNS) begin in 1913 and you have the beginnings of a pre 1953 data series that could confirm or deny my assertion that negative real 10 year bond rates will always lead to recession.

And the conclusion that NDD has come up with is that they don't always lead to a recession. And here is the salient graph:

When looking at this graph, understand that whenever the red line is higher than the blue one, then that is an example of negative real 10 year bond rates (or, more specifically, negative real long term bond rates). As you can see, there are seven instances since 1925.

Now of course what I have done is to average out the results over three months. This is what we get in the first instance:

1925 and 1926 see some low rates but the only negative result occurs in January 1926. So what happens after? A recession in October 1926. Hmmm.

The second and third instances occur during the New Deal era:

Actually what is notable from this graph is the sheer height that real long term bond rates hit during the depression - peaking at 14.27% in March 1932. If anything this is pretty solid evidence that real 10 year bond rates can operate as a "window" for the economy to grow: too low and the economy crashes, too high and the economy crashes.

As you can see, real bond rates return to more reasonable levels around 1934. The key date here is March 1933 when the Emergency Banking Act was passed. Another important date was June 1933 when Glass-Steagall was passed. Both of these acts resulted in an increase in the money supply and a subsequent move out of deflation. By December 1933, prices began inflating again. This is important to realise in the data in the graph above since the presence of inflation again reduced real long term bond rates from the stratosphere of 14% to around 3% by December 1933.

Of course the graph then shows that in 1934, inflation had reached a point where real long term bond rates had turned negative. They turn negative again for a short time in 1935, and then negative again 1937... which, um, then turns into another recession.

I suppose I could argue that the instances of negative real long term bond rates in 1934, 1935 and 1937 were the cause of the 1937 recession. I think that is not an unreasonable assumption to make, especially the 1937 instance. We need to remember though that the massive hangover of debt and deflation that typified the great depression's stratospheric real long term bond rates needed a little bit more than a few months of negative long term rates to balance against. Nevertheless, if my "window" theory is true, then it could possibly be said that the US economy might've avoided the 1937 recession had real ten year bond rates always remained positive from 1934 onwards. In short, too much inflation was created.

After all, you could put out a house fire with a fire hose, but if you immerse the burning house in the sea, you still end up damaging it badly.

Okay, so let's move on to the war and post-war years:

So as you can see, the war brought about a huge drop in real 10 year bond rates. A recession occurs in February 1945, and then another huge drop in real ten year bond rates occurs during 1946-1949. In fact that period has the deepest recorded period of negative real long term bond rates (which peaks at -16.96% in April 1947). Then another recession hits in November 1948. Then another period of negative rates hits between 1950-1952, followed by a recession in 1953. Beyond this point my data series kicks in.

The first thing to look at here is the effect of the war, specifically the effect of a Total war economy upon the United States. This graph shows what I'm talking about:

source

Between Japan's attack on Pearl Harbor and the demobilisation of forces in 1946, the US government effectively quadrupled in size. This was due to massive spending to create a war machine capable of defeating Japan and Germany. The growth in the size of government was not "added onto" the economy, but effectively "crowded out" the private sector. The US government increased taxation and went on a massive borrowing spree to fund the war.

Now this is very important for us to understand. In my analysis of real long term bond rates, we're not just looking at causal relationships but also the effect of such causal relationships to the wider economy. Long term bond rates are an indication of how the market is acting at a certain time. If the government is 10% of the economy then the private sector is 90% of the economy, which means that any negative long term bond rates are being experienced by that 90%. But in the war years we see an increase in the size of government and a decrease in the size of the private sector. This means that the negative real long term bond rates during this period are only experienced by around 55% to 60% of the economy. Thus the effect would be less - hence the lack of recession until 1945.

As for the period of negative real long term bond rates between 1946 and 1949, these end up presaging the 1948-49 recession.

In short while the pre-1953 data is essential to examine, I do not think that it rules out the correlation and causation effect at all. Two huge events - The Great Depression and World War 2 - are enough to affect the quality of the data under examination.

There is another issue: Is LTGOVTBD a good proxy for GS10? Just because they correlate when they are measured concurrently doesn't mean that the same correlation existed pre-GS10. Long term government bond rates hardly move much at all between 1925 to 1956, despite the huge swings in inflation and deflation in this period. They do not exhibit the same ups and downs which typify GS10 rates. this makes me think that LTGOVTBD rates, at least in the early days, were pegged by government order. GS10, especially from the 60s onward, seem to move according to the actions of the market.

And finally an answer to a commenter at Boondad who points out:

You cannot calculate CURRENT "real long term interest rates." It's a fallacy.

To calculate a CURRENT "real long term interest rate," you would need to know what "inflation" (CPI, whatever) WILL BE over the next TEN YEARS while you collect your 10-Year Treasury Coupons. You don't know that.

I think this commentator has got it wrong because the interest rate, while certainly applicable over a ten year period, is determined by what the market wants at the time. So while it has a long term function it also has a short term indicative effect. Bond rates go up when investors see bonds less as less attractive to other investments (such as shares) and go down when the market is running away from something. This can be seen during late 2008 when bond rates plunged to 2.42% during the credit crunch after being 4.1% 5 months before. The idea is that the interest rates of government bonds is a way of measuring market sentiment and activity. 10 year bonds are thus a good measurement of what is going on at the time that they are invested in.

And my argument is that when investors put money into ten year bonds they are essentially investing in something "safe". But when inflation exceeds that "safe" investment, things go wrong and a recession follows. This will be because a calculation of your return on interest will be less than the increase in consumer prices. In other words, the amount of money you gain from such an investment will be less than your increase in spending. Thus a recession. And if my "window" theory is correct, a recession will also occur when the amount of money you gain from an investment will be more than offset by a decrease in income from other sources.

US Recession Indicators - July 2011

2011-07-20T20:50:00.001+10:00

According to data from negative Real Interest Rates, another US recession is likely to occur between 2011 Q4 and 2012 Q4, with 2012 Q1 the most likely... See below.

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Net Monetary Base vs Inflation (spread)

The growth of the Net Monetary base (M0 minus excess reserves) over inflation has been above the historical average since September 2010 and has increased even further with a June reading of 598. This is an increase from last month's reading of 540.

Since the introduction of QE2 in November 2010, the net monetary base has increased faster than inflation.

Note: A negative result implies that inflation is growing faster than the money supply, an event which indicates that a recession will occur within 1 to 36 months (with an average of 12 months)
Note: All recessions are preceded by a negative result.

Data Series:
St Louis Fed

AMBNS
EXCRESNS
CPIAUCSL
GDPC1
POP

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Federal Funds Rate vs 10 Year Bond Rate (spread)

The 10 Year Bond Rate has decreased markedly from 3.46% in April to 3.17% in May and 3.00% in June. The Federal Funds rate remains at near zero. As a result the June spread comes in at 291 basis points, well above the historical average but a decrease from the previous readings.

Note: A negative result implies a highly restrictive monetary environment, an event which indicates that a recession will occur within 4 to 39 months (with an average of 22 months).
Note: If both the first and second graphs are negative at the same time it indicates that a recession will occur within 1 to 21 months (with an average of 11 months).
Note: All recessions are preceded by a negative result.

Data Series:
St Louis Fed

FEDFUNDS
GS10
GDPC1
POP

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Real 10 Year Bond Rates Rates

Again a tweak to my reporting in this area after discovering that a three monthly average was better than a monthly result. I have also decided to call this indicator "Real 10 Year Bond Rates" rather than "Real Interest Rates" since the latter term can be used to refer to the Federal Funds Rate.

Real ten year bond rates came in at -0.12% in June. As I have pointed out before, all experiences of negative 10 year bond rates since the 1950s have resulted in an eventual recession.

If we take previous instances of negative real bond rates into account, a recession will start between 2011 Q4 and 2012 Q4, with 2012 Q1 the most likely. These previous experiences also indicate that unemployment will also likely peak between 12.1% and 18.7%, with a result around 16.9% the most likely.

Note: Real Interest Rates based upon 10 year Bonds can indicate how the value of money is determined in comparison with the market's safest investment. A negative result implies that inflation is eroding the savings of those who have invested in 10 Year Bonds. A negative result over a three month average indicates that a recession may occur between 4-18 months, with an average of 8½ months and a median of 6 months.
Note: Not all recessions are preceded by negative real 10 year bond rates. Nevertheless all instances of negative 10 year bond rates (since the 1950s) have been followed by a recession.

Data Series:
St Louis Fed

GS10
CPIAUCSL
GDPC1
POP

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Archive of Historical graphs.

Real Interest Rate historical graph archive.

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Why invest in investment when you can invest in growth?

2011-07-18T22:39:00.001+10:00

Come with me to the fictional economy of the future.

The year is 2030. The price of gold has passed $1 million (in today's dollars) per ounce. Nevertheless the world economy is shrinking badly. There are high levels of unemployment, massive poverty and starvation everywhere.

So how did we get to the point of $1 million per ounce? It could be argued that with the economy tanking so bad, investors have taken refuge in the only thing worth investing in. Why invest in companies that produce goods and services? No one is buying! Everyone is poor! It makes no financial sense to invest in such a scheme because the returns are just so low.

But the reality is that investors have gotten it backwards: It isn't that the economy is bad so we need to invest to gold, it's because we invested in gold that the economy is bad. Gold in the fictional world of 2030 has become another Tulip mania phenomenon - a massive investment bubble that drives itself bigger and bigger because people with money make rational decisions about where to invest it - and anything which rises in value should be invested in. Of course we would expect that, just like Tulip mania, this gold bubble would've burst, except that in the year 2030 the entire financial world has become so dependent upon it that any drop in the gold price is fixed simply by loose monetary policy. It isn't as though the central banks in the year 2030 are creating inflation - they're not - they're increasing the money supply via quantitative easing and keeping inflation within acceptable levels. Governments, sadly, have cut spending in line with their receipts, which have dropped faster than their country's GDP.

The problem here is simple. Past occurrences of investment bubbles have oftentimes resulted in huge busts. These days they do not. Instead, the investment bubble gets re-inflated because the ones who inflated it in the first place have not been removed from the financial system. Why is this? It is because any losses incurred by the bubble's deflation have been minimised through monetary policy - an increase in the money supply due to stimulation enacted by a central bank.

But there's something rather insidious about an investment bubble that has been going on for decades. The problem is not whether the investment itself gives a return to the investor (as is the common belief), but whether the investment itself actually creates economic growth.

Say you have $20 million to invest. You could invest it in gold. Alternatively, you could invest it in a biotechnology company that grows human body organs in a factory to be used in transplants. Now if the return on gold is higher than the biotech company, you would naturally invest in gold. But what growth comes from gold? Well apart from gold mining companies employing workers to mine the stuff, there is very little growth at all. Of course there will be a knock-on effect as gold mines are begun and people get employed and secondary industries and retail enterprises start up - but with everyone investing in gold, very little of the wealth created gets turned into economic growth. Investing in the biotech company, on the other hand, does the same thing in employing people directly and indirectly, but has the added feature of creating economic growth. How? With transplants cheap and plentiful, people will live longer and happier and be more productive.

So on the one hand you could invest in something that will make you money. Or you could invest in something which makes money for you and a whole bunch of people. We could, of course, choose to "invest ethically" but most investors simply throw their money at whatever is performing.

Now understand that I'm not having a go specifically at gold investors here (though to be honest with you I see absolutely no reason for people to value something that has no real usefulness). Instead I'm being critical of the entire financial system itself which values rising equity prices far more than returns - and whose "returns", by the way, are simply the result of accounting tricks and high equity prices traveling through the broader system.

Try to understand it like this. You give $1000 to investment company A so you can see a return on your investment. Investment company A invests it with industrial manufacturer B, who in turn decides not to use it to make anything but gives it to its own financial department to invest in Investment Company C. Company C then places it in Bank D, who lends it out to Investment Company E. Company E, a small financial company, then hands the money back to Investment Company A as part of an industry investment fund... and then the process begins again.

From a fractional banking system you can see here that each step of the way from A to B to C to D to E back to A will increase the money supply and the money velocity. Yet nothing of value has actually been created in this process. In the past such situations would quickly result in financial crash - but these days central bank monetary policy has moderated any damage and ended up perpetuating the growth of the bubble.

You see it is my belief that most western countries have been building a huge, unsustainable investment bubble for the past 30 years. The world of finance has grown exponentially in that time but economic growth itself has begun to slow down. Even when you account for the effects of lower birth rates, GDP per capita in most western nations has significantly slowed down since the mid 1970s and early 1980s. Credit market debt in the US over this period has grown from about 150% of GDP in 1976 Q1 to a peak of 375% of GDP in 2009 Q1 (it has fallen slightly since then to around 250% in 2011 Q1).

So what should the solution be? I have pointed out recently that, in the US at least, there should be a higher level of government spending along with increased taxes to support it. Yet the current economic malaise is not just suffered by America but also by the European Union, whose governments have already spent up big. This is where regulation needs to come in. There needs to be firm and easily enforced financial regulation to prevent the growth of investment bubbles:

A market capitalisation tax should be instituted so that publicly traded companies are forced to pay higher taxes when their value goes up - which would also punish companies with high p/e ratios (in fact the market cap tax rate should be increased across all public companies when the p/e ratio average for the whole sharemarket increases, with a commensurate decrease in the tax rate when the average p/e ratio drops). The idea here is that the market should be punished whenever signs of over-investment become clearer.
The property market needs to be subject to the same investment regulations as the financial market. It may even be necessary for a government agency to be created that will enter the market directly to buy and sell properties in order to keep house prices at a reasonable level (buying up houses when the housing market drops, selling houses and/or building houses when the market rises)
The financial industry needs to stop profiting from investing in the financial industry. The important thing to remember is that financial companies need to invest in companies that produce goods and services - but not invest in companies that produce financial services. One way to do this would be to remove financial companies from major stock indices. Another solution would be to prevent financial companies from being publicly tradeable altogether, forcing them to become private companies or even non-profits. In any case, stricter regulation and tax disincentives should be enacted to ensure that financial companies divert their funds towards industries that actually produce things.
Ensure that monetary policy keeps prices low. Even though I have criticised monetary policy in this article it is only because the current system has been able to take advantage of it. Once financial regulations have been improved (as per my suggestions here), monetary policy will be more effective. I still believe in "hard money".
Ensure that government debt does get paid off. Better regulations and more investment in industries that actually produce things will create economic growth - growth that will be accompanied by higher tax revenues to pay off debt. Governments need to be restrained once a sustainable recovery gets underway (which is unlikely for some time now that the US is about to go into recession again). Instituting a market capitalisation tax would help increase revenue too.
Higher taxes on the rich. It has been the rich who have driven much of the investment bubble since the early 1980s. Tax cuts for the rich since that time have led to great wealth amongst the wealthy but little in the way of economic growth.

Read this.

Treating Rail Transport as The Commons

2011-07-17T11:24:00.001+10:00

As a child in Northern Sydney in the mid 1980s, I lived near a railway line. On the way to school each morning I would see the regular-as-clockwork XPT pass by, New South Wales' newest high speed train. I remember feeling a sense of pride that we had built and operated such a great piece of machinery.

Since then neoliberal economics has made rail transport difficult to maintain or expand or promote. The idea of "user pays" and government departments (such as Countrylink) being corporatised and made to run profits was turned into policy. Of course there's nothing wrong with such policy if it can indeed create more efficient services - but in the case of rail it has not. As a result, rail has been seen as an increasingly obsolete and expensive infrastructure.

Yet there are two important factors we must keep in mind when looking at rail transport.

Firstly, the long distance delivery of bulk grain and bulk ore needs rail. In Australia (as in other countries) ore from mines and grain from farming areas can only be transported to ports by rail. Using trucks to carry that much material would be prohibitive. As a former Newcastle resident I can testify to the power and presence of trains transporting coal to the port from up to 100km inland.

Secondly, studies have shown that the total cost of rail-based public transport is less than the cost of running a car. I blogged about this in 2006 and subsequently argued for free rail-based public transport paid for by taxes.

Given that these two facts are true, why has rail been relegated to the "expensive and unprofitable" category? Simple. It's because the neo-liberal doctrines of "user pays" does not work.

A good way to think about this issue is to compare the rail system with the road system. While there are certainly toll roads run by private corporations, the vast majority of road infrastructure is owned by government and maintained via tax revenue. The NSW government sought some years ago to approve private tollways, but the result has been less than impressive with some consortiums going insolvent due to financial losses. In short, running private tollroads in NSW has been problematic. This is because it is almost impossible to impose a direct "user pays" system whereby users of a certain road pay for the upkeep of such a road. At a tollway level there is still a chance that it might work. But for ordinary suburban streets the idea is simply ludicrous.

So if the road system should be maintained by government and funded by tax revenue, then why shouldn't the rail system?

At present, mining and agriculture companies pay enough for rail freight to exist solely upon a user pays system. But what about suburban public transport? Since a user pays system has been in place for over a century in most places in the world and has not worked, and since studies have shown that rail is more efficient a transport system than road (in terms of money spent on travel) maybe we should see the rail system in the same way as we see "The Commons" - a resource that is collectively owned. Of course for most rail systems this is technically true - the rail system is owned and funded by government, who act on behalf of the people. Yet the problem does not seem to be its ownership, but how people can use it. Charging people a ticket fee for traveling from A to B, while seemingly common sense, is what seems to cause the problem.

In short, making rail-based public transport free and funding it entirely by tax revenue is the policy governments should take. While it might "reek of socialism" the reality is that it will make transport cheaper, which means that it is a type of microeconomic reform which, ironically, is what neoliberalism preaches as an important goal.

US Downturn for 2012 now assured

2011-07-15T22:42:00.001+10:00

The Real 10 year bond rate average over 3 months has now dropped below zero to -0.12%. As I have been pointing out for the last month, this presages another economic downturn for the United States.

Inflation just came in at 3.4%. Even though June saw a monthly deflation, it wasn't enough to prevent a move into negative real bond rates.

The monthly Real 10 year bond rate also had its second month in negative territory at -0.43%.

The 14th amendment and the possible government shutdown

2011-07-15T11:48:00.001+10:00

Oh dear:

Crisis talks on the United States' debt limit remained deadlocked overnight as negotiations led by US president Barack Obama degenerated into a slanging match.

The president is said to have stalked out of the latest debt talks, which both sides have acknowledged as the most heated yet.

"This may bring my presidency down, but I will not yield on this," Mr Obama is quoted as saying.

The prospects of politicians reaching a deal to raise the debt ceiling are still in question after fifth straight day of talks.

Some econ bloggers have pointed out that the 14th Amendment of the United States renders the "debt ceiling" unconstitutional:

The validity of the public debt of the United States, authorized by law, including debts incurred for payment of pensions and bounties for services in suppressing insurrection or rebellion, shall not be questioned. But neither the United States nor any State shall assume or pay any debt or obligation incurred in aid of insurrection or rebellion against the United States, or any claim for the loss or emancipation of any slave. But all such debts, obligations and claims shall be held illegal and void.

My view is that the "debt ceiling" is not unconstitutional. What is unconstitutional is to default on this debt. Let me explain.

All the "debt ceiling" does is prevent the government from borrowing any more money beyond the previous predetermined limit. Since congress has the power under the constitution to legislate borrowing and spending bills, any self imposed limit on the amount of money the federal government borrows is entirely within their purview.

So what happens when congress doesn't increase the debt limit a "government shutdown" is initiated?

All it means is that the government will have to cut spending in order to fit into the amount of money they do receive. Spending must be cut. And if we believe that the 14th amendment will be followed, then we can assume that paying back interest and principal on money borrowed will not be affected at all. Instead, spending cuts will be made to other areas of government control. Spending on health care will be cut drastically. Military spending could possibly be cut. Social Security spending cuts would only occur if the spending is not considered "government debt".

My spreadsheet tells me the following about US government debts and receipts:

So if revenue represents 16.61% of GDP and spending represents 25.29% of GDP, then any failure to increase the debt ceiling will force the federal government into spending only as much as it gets. This would mean 16% spending instead of 25% spending. In short, it would reduce the spending size of government by around two-fifths. You can imagine how devastating such an action would be upon the economy.

But what about government debt? The last time I checked, interest paid on government debt made up around 2.8% of GDP. Even after a potential failure to increase the debt ceiling, interest on treasury bonds and other debts will have ample room to be paid back.

A failure to raise the debt ceiling will most certainly shrink government spending, but it will not result in debt default. The unemployed will no longer be given payments, Medicare will grind to a halt, NASA will disappear, even social security has the potential to be scaled back... but at least those who lent the government money will get their interest - hardly a cause for celebration.

To summarise the 14th amendment on this issue: The amendment doesn't invalidate a debt ceiling, it just ensures that government debt will be paid off even if any debt ceiling isn't increased.

A reminder

2011-07-14T14:44:00.001+10:00

I still consider myself an "Austerian" in the sense that strategies must be put in place to reduce US government debt. My solution is not to cut spending, though, but to increase spending and to increase taxes even more.

So do I like the idea of the Republicans and Obama working together to lower taxes and cut spending? No. Taxes need to be raised. The only thing that needs to be cut is military spending.

So do I like the idea that the US Federal Government should just spend more in stimulus packages? No. Any increase in spending must be over the long term rather than the short term, and no spending increases should be implemented without tax increases.

Bigger government is needed for the US economy - OSO's New Deal

2011-07-09T11:51:00.001+10:00

This graph from Calculated Risk has been worrying me for a while:

The most noticeable thing about this particular recession is just how long it has taken for unemployment to recover - or not recover as the case is. But this is not an isolated case. The 2001 recession took ages for unemployment to recover, as did the 1990 recession. Obviously something has happened to the US economy that has prevented quick employment recovery even while GDP recovers.

I'm still trying to work out what that is. I have at theory but that will come in another posting.

What is obvious though is that the market is just not creating enough jobs. While the cause might be debatable, the result is not.

But what is needed to fix this is not just another round of stimulus packages. What is needed is a structural expansion of government spending. In essence, the US government needs to spend more.

Of course readers of this blog might wonder if I have changed my mind from recent times when I advocated austerity. The problem is that the word "austerity" has ended up becoming synonymous with spending cuts - which is the favoured position of conservatives. While I have advocated spending cuts in the area of military spending I came to the conclusion that the only way the US could ever hope to cut enough spending to make any difference would be to destroy Medicare or Social Security (and I don't use the word "destroy" lightly - you'd be looking at cuts of over 50% to make any difference). The alternative is to raise taxes - and that is the option I have always promoted. I still define this as "austerity" since it causes pain, but it is not the preferred description of the word in these times.

What I have done, though, is change my position on the market's ability to recover properly. I would've been happy for Obama to cut military spending and raise taxes in order to run a small deficit (at the least) but do little else while the economy stumbles, falls and eventually recovers from my austerity package. Now I realise that the economy wouldn't recover - at least not quick enough to make any difference.

So here's my big government solution:

More government spending.

I would create the following long term or permanent programs:

Universal Health Care. This would involve "Medicare for all" and would probably increase the size of government by 4-5% percent of GDP. So you're looking at an increase in government spending from around 25% of GDP to around 29-30% of GDP. This would naturally have the effect of Keynesian stimulus but the result would be healthier citizens - something that would boost the productivity of workers. The increase in spending relative to GDP would be permanent.
Building a renewable energy infrastructure. This would involve the eventual shutting down of all coal and gas powered power stations and the building of renewable alternatives to replace them. Developing nuclear reactors based on the Thorium & Molten Salt technologies would be acceptable but I can't get over the sheer availability of deep geothermal power: they would be expensive to develop and build but once they're there they will last for many decades. To fast-track the building of these, a renewable energy sector would take at least 10 years to complete. But as we can see from the military buildup during world war 2, all it takes is the will to do it. This would radically reduce America's carbon emissions. An upgrading of America's electricity grid would also accompany this. You're looking at adding another 1-2% of GDP being spent on this over a ten year period.
Mandate and support an electric car industry. This would involve a legal framework preventing the sale and registration of carbon-emitting cars by a certain date (say 10 years in the future) but would also need substantial government investment in battery technology. The Nissan Leaf, the first real "electric car" sold to the market, still has only a short range. Inventing batteries that hold more power is essential if electric cars are to effectively replace their petroleum or lpg powered competitors. Spending on this program would also build a nationwide network of recharging stations to ensure that no electric car is out of recharging range. Not only would such a program reduce carbon emissions, they would also reduce America's dependence upon oil and mitigate the problem of Peak Oil. Add another 1% to GDP being spent on this over a ten year period.
Set up a national water grid. This would involve potable water being distributed over all states and towns throughout a national network of water pipes and purification plants. This would ensure that any future droughts in the US (brought on by global warming) would not affect town and urban water supplies. It would theoretically mean water sourced from Seattle finding its way to Texas through this proposed water grid. While this would require a huge amount of work, a lot of the work would simply involve connecting up disparate water infrastructure and bringing standards up to a national level. You could probably add 0.1% to 0.5% of GDP on this over a ten year period.
Provide a national child tutoring strategy. This would involve the hiring of personal tutors to deliver numeracy and literacy skills to the nation's Kindergarten,1st and 2nd grade students. Each student would receive one hour of personal tutoring per week at the school they attend during the school year. While this will not have any immediate economic benefit apart from increasing the money velocity, it will eventually produce adults who are better educated and more likely to succeed at employment and less likely to end up in jail. All economic benefits. I'm not sure how much this would cost but you'd be looking at at least 0.1% of GDP being spent on this program on an ongoing basis. Additional tutoring, say in 3rd grade and above, would increase this effect even further.

Less money on Defense

America does not need to spend huge amounts on national defense. Of course it is important that some level of defense spending exist to defeat any potential attacker, but I am convinced that the most bloated, most inefficient and most corrupt sector in government spending is in defense contracting. Reducing military expenditure may not even reduce America's military strength, it will make the whole contracting system better.

In fact I would suggest a change in the way the whole contracting thing works. Rather than contracting out to companies who design weaponry and other military items, the government should actually do this themselves. Let's say we want to build the fictional B-5 supersonic stealth bomber. Instead of contracting out the design to Boeing, the design is actually made by government employees working in a government building somewhere. Once the design is complete, they then contract out the parts building to the defense companies - and ensure that common parts can be made by many different manufacturers in order to reward the productivity and profitability that would arise in a competitive environment. The B-5 could even be manufactured by different aerospace companies, with Boeing manufacturing some, Northrop Grumman some more, and Lockheed Martin the rest.

Higher Taxes - especially for the rich and corporations

Alongside this substantial increase in spending should be a substantial increase in taxation. I don't believe that deficits don't matter and there is a need for the debt to be paid down. Since we can no longer rely upon the market to provide enough economic growth to increase tax revenue, the government will simply have to step in, increase spending and increase taxation. In fact I would argue that the increase in taxes should be substantially higher than any increase in spending. I would advocate not only an increase in spending (outlined above) but an increase in taxes so high that a budget surplus is created. It is expected that any economic pain generated by this increase in taxation would be matched by the economic gain of the increase in government spending (above)

There are many ways to achieve this - one way is to increase the highest marginal tax rate. Another is to introduce a Tobin Tax.

My preferred method of taxing the financial market would be to create a market capitalisation tax: public companies being taxed incrementally on a daily basis according to their market capitalisation (share price multiplied by amount of shares). In fact I would adjust the tax according to the average p/e ratio in order to punish over-investment - if the p/e ratio of the whole sharemarket is too high, then there will be an increase in the market capitalisation tax. If the p/e ratio falls down low, then the tax would also be lowered. This system would not only generate income for the government to balance its finances, but would also act as an "automatic stabiliser" for the financial industry - punishing the market if it approaches unsustainable investment bubbles, encouraging the market if it there is not enough investment.

OSO's New Deal

Of course once the spending I have outlined above runs out over ten years (with the exception of Medicare and the tutor system), we would also assume that government debt would have been paid off by the increases in tax revenue. What then? Well I'm happy, once America has reinvented its energy, transport and water infrastructure, for taxes to drop. Hopefully the success of my "New Deal" would see so much economic and social success that Norquisters, Randians and Supply Siders would descend into obscurity. It would also force political conservatives to be more centralist, where they can be far more effective at promoting non-extremist conservative policies and ideas (conservatism does, after all, still have many considerable strengths once the extremism is removed from it).

So what are the chances of this occurring? Probably none. Rather, I expect the coming downturn to turn people against Obama and vote for a crazy Republican in 2012, ensuring a Republican controlled congress as well. What they would do from there is anyone's guess, but I doubt that any polices they do enact will do anything except make things worse.

The chance of avoiding another downturn is now almost impossible

2011-07-07T15:08:00.001+10:00

10 Year bond rates for June 2011 came in at 3.00%. Inflation figures for the same month are due on 2011-07-15 (Friday next week).

In order for the US Real 10 year bond rate to remain positive, June inflation needs to have an index reading of 223.496 - which implies a monthly deflationary result of -0.6%. At this point there is very little evidence of a deflationary hit in June (eg soaring US dollar, credit crunch, large drop in sharemarket value).

Take a look at my spreadsheet.

June's potential recession avoiding index result of 223.496 is shown there in green. Any inflation index result of 223.497 or higher will result in column N (real 10 year bond rates averaged over three months) moving into negative. This presages a recession. When the inflation data comes out Friday next week, a coming downturn will be confirmed.

For those of you who are spreadsheet minded, here are the details:

Column C data from here.
Column D equation (at 701) is =PRODUCT(((C701-C700)/C700)*100).
Column E equation (at 701) is =PRODUCT(D701*12).
Column F equation (at 701) is =PRODUCT(((C701-C689)/C689)*100). (This is the "headline inflation" result).
Column I data from here.
Column J equation (at 701) is =SUM(I701-F701).
Column N equation (at 701) is =AVERAGE(J699:J701).

Recession Measurement

2011-07-06T10:58:00.001+10:00

A while ago I chose to use as my recession indicator a decline in annual real GDP per capita. The reason for this is twofold. Firstly it can be derived from official figures (ie St Louis Fed) as opposed to the more nebulous proclamations from the NBER. The second reason is that simply measuring real GDP doesn't cut it in an annualised form since, by that measurement, there was no recession in 2001 and the 1970 recession wasn't too bad at all.

The thing is that population always affects economic growth. If an economy is expanding and population along with it, chances are that economic growth is being driven by an expanding consumer and producer base - more people means more potential consumers and more potential producers.

Nominal GDP = the actual numbers. This ignores inflation and population.
Real GDP = nominal GDP adjusted by inflation. This ignores population.
Real GDP per capita = Real GDP per head of population.

Of course the question arises as to whether you should measure annual changes or quarterly changes. Again there is nothing really "wrong" with doing this, but it does create problems in defining recessions. If we measured quarterly declines in real GDP per capita, we would end up having recessions in 2005 Q2, 2003 Q1, 2000 Q1, 1988 Q3 and 1986 Q2 amongst many others. So while I don't measure with the NBER I do listen to what they say - and measuring declines in annual Real GDP per capita do match up quite closely with NBER proclamations. The exception to this relationship appears to be a single quarter recession in 1956 Q3 which the NBER doesn't include on their list.

As you can see there are very close correlations between the NBER pronouncements and annual declines in real GDP per capita. The differences (apart from the 1956 Q3 blip) seem to be in measuring the start date - the NBER measurements always start between 1-3 quarters before annual declines in real GDP per capita - and in measuring the length.

The events leading up to the coming downturn

2011-06-30T11:22:00.001+10:00

Further to my thinking from last post, I began to consider the two other recession indicators I have discovered - obviously they will both turn negative in time for the next downturn. This means there is a possibility that we can predict what may occur.

In short we have two potential outcomes leading up to the downturn: an inflationary one or a deflationary one.

Net Monetary Base vs Inflation (spread)

This measures the growth of the net monetary base (M0 minus excess reserves) over inflation. My original study is here. If we assume that a recession is due, what will happen to this indicator as it approaches? For the spread to turn negative, inflation must exceed the growth of the net monetary base. This can happen one of three ways: An increase in inflation; a decrease in the Net Monetary Base; a combination of the two.

An inflationary outcome would result in inflation outstripping the new monetary base. This would mean that, in the time leading up to the recession, inflation would increase. If the Fed does not instigate any Quantitative Easing, the chances are that this increase in inflation won't necessarily be big. Although a Latin America style inflation increase is possible, it's probably likely for inflation to get close to 10% and not much more before the recession hits. The only reason I use for this is that, historically, the US hasn't experienced a hyper-inflationary hit.

We need to also understand that the Fed has probably pushed the inflation limit to around 6%. I remember Krugman talking about this and the Fed's reluctance to increase the Federal Funds rate (currently 0.09%) in the face of growing inflation (now 3.4% - the last time inflation increased to around this level in October 2007, the Federal Funds rate was 4.76%) speaks for itself. So we're probably looking at inflation increasing to beyond 6% and up to around 8% before the Fed begins to push rates up again. By that stage inflation would have increased beyond the growth of the Net Monetary Base.

An increase in the price or oil and/or a decrease in the value of the US Dollar (the USDX) is likely to accompany this inflationary growth.

For a deflationary outcome, this would mean that the Net Monetary Base would be shrinking faster than the inflation rate - which would remain benign or turn into deflation. Only once in postwar history has the Net Monetary Base declined: in December 2000 and January 2001, a decline which presaged a recession later in the year.

The deflationary outcome, like the inflationary one, won't have to be sudden or substantial to presage the recession. If inflation sits at 1% and the Net Monetary Base grows as 0.5% - both near zero but slightly inflationary - the result will still be a negative spread and an upcoming recession.

A decrease in the price of oil and an increase in the value of the US Dollar (the USDX) is likely to accompany this deflationary outcome.

The May 2011 result for this indicator was 540, still in positive territory. As the recession approaches this number will drop quite substantially. Moreover, considering the time it will take for this result to drop, a 2011 Q3 recession start date (next quarter) is highly unlikely.

Federal Funds Rate vs 10 Year Bond Rate (spread)

This measure the difference between the 10 year bond rate (GS10) and the Federal Funds Rate (FEDFUNDS). When the 10 Year bond rate drops below the Federal Funds Rate, the data indicates that a recession will follow.

The 10 Year Bond rate is, according to my stock ticker, 3.11%. The Federal Funds Rate is currently 0.09%. In order for this spread to turn negative, the Federal Funds Rate must increase, or the 10 Year Bond Rate must decrease, or a combination of the two must occur.

The only way the Federal Funds Rate will be increased is when the Fed decides that the problem of inflation is greater than the problem of high unemployment and low economic growth. As I stated above this thinking seems to hover around the 6% inflation level, so chances are that the Fed will begin to raise the Federal Funds rate once inflation begins to increase beyond 6%. As these rates go up in response to more inflation, it will inevitably exceed the 10 Year Bond Rate, thus presaging the downturn. This is the inflationary outcome.

The deflationary outcome would mean that the Federal Funds Rate remain low while the 10 Year Bond Rate crashes down to similar levels. This, in turn, would mean that the Bond Rate would be 0.09% or below. This, of course, would indicate massive financial distress that would be accompanied by a sharemarket crash of epic proportions and a credit crunch that would make 2008 look like a picnic. A soaring US Dollar is likely to accompany such a crunch (as it did in 2008).

So what will happen?

The most likely scenario in my mind is one in which inflation increases beyond 6%, forcing the Fed to increase the Federal Funds Rate. This growth in inflation will exceed any increase in the Net Monetary Base. The increase in the Federal Funds Rate will also allow the spread between it and the 10 Year Bond Rate to narrow and eventually turn negative.

The reason why this is the most likely scenario is that inflation is already increasing, and the Fed has chosen a deliberately inflationary policy (Quantitative Easing). Peak Oil ensures that oil supplies will be harder to maintain, thus forcing an increase in oil prices and thus inflation.

So when will this happen?

As I have pointed out in my last prognosis, the next downturn will begin any time between 2011 Q4 and 2012 Q4. In the 6-18 months prior to this, we will see inflation increasing beyond 6%.

It's important to keep an eye on the recession indicators over the coming months. Watch as the Net Monetary Base / Inflation spread begins to drop towards zero. As inflation increases keep an eye on Fed announcements on monetary tightening, with the knowledge that an increase in the Federal Funds Rate will inevitably lead to a negative spread between the funds rate and the 10 Year Bond Rate.

Can the downturn be avoided?

No. I'm fairly certain that it will happen within the timeframe that I predict. The only thing that would save us is a return to positive real interest rates in June, a result that would imply an increase in bond rates and/or deflation.

What would OSO do if he were Ben Bernanke, armed with this knowledge?

Raise interest rates / tighten monetary policy. Get the recession over and done with. Set a tighter inflation target (preferably "zeroflation"), rather than a looser one.

What will we learn from this experience?

The 2008 crisis caused a rethink in inflation expectations - specifically whether current inflation targets weren't working. I agreed with this rethink but suggested that future policy be aimed at what Krugman calls "Hard Money". My argument was and still is that prices need to remain constant, neither inflating nor deflating over the long run, and that the best way to measure success at this level is to have the GDP deflator at zero over the long term. Unfortunately current thinking is that inflation targets need to be looser rather than stricter (eg Krugman, Stiglitz). I believe that these loose policies have created the conditions for negative real interest rates which will now doom the US economy to another downturn. Had "Hard Money" policy been enacted (by which inflation was controlled), there is no doubt that the current recovery would be slower but at least it would be sustainable. As it is, the loose money policy will simply create another bust and make things even worse.

I've also believed that national debt needs to be paid off rather than inflated away or defaulted. Using the policies we already have at hand I have suggested that the best way to turn around government finances is to raise taxes on the rich rather than cut spending. Taxing an overinvested share market through a Tobin Tax or a market capitalisation tax would serve to both punish financial bubble formation and create revenue to pay back debt. As for new policy, I would suggest someone seriously implement part of my zero tax economic system and simply pay off debt through money printing (what is now known as Quantitative Easing) while increasing the reserve ratio to prevent any resulting inflation. And as for reducing unemployment... set up a universal employment subsidy that makes it cheaper for firms to employ people while simultaneously raising wages - all at the expense of higher taxes (or more QE).

Real Interest Rates are predicting an upcoming recession

2011-06-29T21:17:00.001+10:00

Best to read this first. Then read this.

Also remember that while recessions can occur without negative real interest rates, whenever negative real interest rates do occur, they are always followed by an eventual recession.

I played around with my spreadsheet even further and averaged out the real interest rate (10 year bond rate minus inflation) over a three month period to see what that would achieve. The results seem far more promising than merely measuring monthly results:

July 1954 - May 1961

Fairly clear here in the fifties. Our first result is a negative reading measured in March 1957 and lasts for three months. A recession follows in October of the same year. A further deterioration in the real interest rate occurs during the recession and it is possible that this may have prolonged the recession already in swing.

May 1961 - May 1971

Nothing here in the sixties to help us. The Beatles were probably responsible.

May 1971 - May 1981

Two huge results for the disco decade. Our second negative result in October 1973 leads to a recession in January 1974. There is a long period of recession and negative interest rates that lasts until October 1975. Rates remain positive for a while but return to negative again in November 1978, which is our third result. A long period of negative interest rates follows before a recession hits in April 1980. As with the previous recession, as soon as the rates return to positive the recession is over.

May 1981 - May 1991

Nothing here in the eighties to help us.

May 1991 - May 2001

The nineties doesn't help us either.

May 2001 - May 2011

The 2000s provides us with the fourth and last result. Rates turned negative in January 2008 and a recession follows in April.

2005 does provide us with a near negative result: 0.06% in October that is most likely associated with Hurricane Katrina (the monthly inflation increase in September 2005 was the 5th highest on record). In fact it is this 2005 result which forced me to reassess my study two weeks ago on real interest rates based upon the 10 year bond rate (which is not averaged out over three months) and caused me to predict a recession in 2012 Q4.

From the four results, I have deduced the following information:

Once the results turn negative, a recession occurs, on average, 8½ months later.
The median is 6 months.
Results vary between 4 months and 18 months.
The highest unemployment rate during the recession is, on average, 1.8 times the unemployment rate of the month when real interest rates turn negative.
The lowest increase is 1.32 times; the highest increase is 2.03 times

As you can see from the final graph, above, real interest rates have plummeted in recent times. Here is a graph encompassing the past three years:

The final result - May 2011 - has a reading of 0.26%. This is very close to a negative reading and, therefore, another recession.

In order for a recession to be averted, ten year bond rates must increase or annual inflation must drop. Playing around on my spreadsheet shows me that if the Ten Year Bond rate is 3 basis points lower than the annual inflation rate (eg Bond rate of 3.17%; Inflation rate of 3.2%), then US real interest rates (10 year bond rate minus annual inflation, averaged over three months) would sit at 0.01%, still a positive result. Any result of 4 basis points lower or more would end up giving an negative result.

What are the chances of a negative result for June? Fairly high. 10 Year Bond Rates are, according to my stock ticker, at 3.04%. If bond rates stay at May's result (3.17%), then the inflation index would have to read 223.74 for a positive June result. This would imply a 0.5% drop in prices from the previous month.

Realistically, therefore, we are looking at a negative June result. Which would mean the following:

A recession starting between 2011 Q4 and 2012 Q4, with 2012 Q1 the most likely.
If unemployment remains at 9.1% in June, then the new unemployment peak during the upcoming recession will be between 12.0% and 18.5%, with 16.7% being the most likely result.

Disclaimer:
Of course I need to point out that all the information I have extrapolated is based upon four results of negative real interest rates occurring between 1957 and 2008. It may be that this time around things might be different: the recession may take a much longer time to occur; the rise in unemployment may be lower than anything beforehand; the length of the recession may only be short. Nevertheless I do believe that the data is on my side and that, barring any miraculous June result that would turn conditions around, another recession is highly likely to occur, with an unemployment peak higher than any other postwar period.

Sources and methodology

For negative real interest rates:

St Louis Fed: 10 Year Bond Rate GS10
St Louis Fed: Inflation Index CPIAUCSL

For Recession:

St Louis Fed: Real GDP GDPC1
St Louis Fed: Population POP

I define a recession as an annual decline in real GDP per capita.

Here's a screenshot of part of my spreadsheet to help make sense of it all (my methodology)

US Recession Indicators - June 2011

2011-06-24T10:53:00.001+10:00

According to data from negative Real Interest Rates, another US recession is likely to occur between 2012-Q1 to 2014-Q1, with 2012-Q4 being the most likely. See below.

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Net Monetary Base vs Inflation (spread)

The growth of the Net Monetary base (M0 minus excess reserves) over inflation has been above the historical average since September 2010 and has increased even further with an April reading of 540. This is an increase from last month's reading of 536.

Inflation readings in May continue to grow. The index reading of 224.804 implies annual inflation of 3.4%. Prices since December (220.186) have increased by 2.1%, which implies an annualised inflation rate of 5.0%, still uncomfortably high. As 2011 continues the momentum of these high monthly figures will translate into higher annual inflation.

Since the introduction of QE2 in November 2010, the net monetary base has increased faster than inflation.

Note: A negative result implies that inflation is growing faster than the money supply, an event which indicates that a recession will occur within 1 to 36 months (with an average of 12 months).

Data Series:
St Louis Fed

AMBNS
EXCRESNS
CPIAUCSL
GDPC1
POP

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Federal Funds Rate vs 10 Year Bond Rate (spread)

The 10 Year Bond Rate has increased over the past few months while the Federal Funds rate remains at near zero. The April spread comes in at 308 basis points, well above the historical average.

Note: A negative result implies a highly restrictive monetary environment, an event which indicates that a recession will occur within 4 to 39 months (with an average of 22 months).

Note: If both the first and second graphs are negative at the same time it indicates that a recession will occur within 1 to 21 months (with an average of 11 months).

Data Series:
St Louis Fed

FEDFUNDS
GS10
GDPC1
POP

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Real Interest Rates

As a result of recent discoveries in this area of Real Interest Rates, I have chosen instead to report the monthly results of 10 Year Bonds Rates minus inflation, rather than the previous method of the Federal Funds Rate minus inflation.

As this recent discovery noted, real interest rates in the US dropped to -0.27% in May 2011, which means that a recession indicator has been triggered. Since recessions have occurred between 5-32 months after negative readings, we can expect another recession to begin between 2012-Q1 to 2014-Q1, with 2012-Q4 being the most likely.

Note: Real Interest Rates based upon 10 year Bonds can indicate how the value of money is determined in comparison with the market's safest investment. A negative result implies that inflation is eroding the savings of those who have invested in 10 Year Bonds, and indicates that a recession may occur between 5-32 months, with an average of 16.5 months and a median of 14.5 months.

Data Series:
St Louis Fed

GS10
CPIAUCSL
GDPC1
POP

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Archive of Historical graphs.

Real Interest Rate historical graph archive.

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A Recession indicator has been triggered

2011-06-17T17:23:00.001+10:00

One measure of real interest rates went into negative territory after the release of last week's inflation figures. The history of this measurement clearly shows that a recession will follow. If my estimations are right, a US recession will occur in probably 16½ months (2012 Q4), with anything from 5 to 32 months possible.

This measurement of real interest rates is not the one I have been studying in my monthly recession watches, but another one which I have mentioned before on this blog.

The "Real Interest Rate" is usually defined as the nominal interest rate minus inflation. In the case of the US, this is usually measured as the Federal Funds Rate minus the annual inflation rate. Yet this measurement can be problematic since the Federal Funds Rate is controlled not by the market, but by the Federal Reserve Bank. So instead of using the Federal Funds Rate, I have often used the 10 year bond rate as the interest rate part of the equation. So in this case, it would be the 10 year bond rate minus annual inflation.

I initially dismissed this measurement of real interest rates because a quick glance at its history showed that recessions have occurred without this real interest rate turning negative. But after last week's inflation report, and the subsequent negative result for this real interest rate on my spreadsheet, I began to study it a bit more. Here is the data since 1954:

It's clear that there are a lot of recessions since 1954 that didn't involve this negative real interest rate. Recessions in 1954, 1956, 1970, 1982, 1991 and 2001 all occurred when real interest rates were positive. Yet this is not the whole story. What I discovered from this analysis is that while recessions can occur without negative real interest rates, whenever negative real interest rates do occur, they are always followed by an eventual recession. This occurred in 1957, 1974, 1980 and 2008.

The longest period between a negative real interest rate result and an eventual recession is 32 months, and that occurred in 2005, with the 2008 recession following it. The 2005 result may seem to be an exception to this rule, but when compared to similar recession markers from that period, the 2005 result pretty much correlates with the inflationary surge caused by Hurricane Katrina.

So what about the present? Last week US inflation for May 2011 came in at 3.4438% while Ten Year Bond Rates for that month were 3.17%, which meant that real interest rates dropped to -0.2738%. You can see this on the last graph above, with the line dropping below zero. If real interest rates rebound into positive territory for June, thus giving it a single negative month, it will be similar to the 2005 result (September 2005 came in at -0.54%, but with over 24 months of positive results after it). But if the June result continues to be negative, and if this continues into July, then the chances are that a recession will be sooner rather than later.

Of course despite the fact that data goes back to 1954, there is just not enough historical correlation to make a 2012 Q4 recession (or thereabouts) an absolute certainty.

As a tl;dr, remember this:

Whenever Negative Real Interest Rates (10 year bond rate minus annual inflation) do occur, they are always followed by an eventual recession.

Credit Market Debt as percentage of GDP

2011-06-11T10:45:00.001+10:00

Sources:

Credit Market Debt: TCMDO

GDP: St Louis Fed.

All figures are quarterly.

Cost of oil consumption to US economy

2011-06-09T09:11:00.001+10:00

Sources:

Oil Consumption: EIA

Oil Price: St Louis Fed.

GDP: St Louis Fed.

Recession defined as decline in annual real GDP per capita.

All figures are quarterly.

US Recession Indicators - May 2011

2011-05-21T11:12:00.001+10:00

Net Monetary Base vs Inflation (spread)

The growth of the Net Monetary base (M0 minus excess reserves) over inflation has been above the historical average since September 2010 and has increased even further with an April reading of 536. This is an increase from last month's reading of 529. Despite the high reading of 2011 Q1 over the average, GDP growth for this period was only moderate (confounding my own predictions of substantial growth).

Inflation readings in April continue to grow. The index reading of 224.433 implies annual inflation of 3.1% but the annualised monthly figure was 5.1%. Prices since December (220.186) have increased by 1.9%, which implies an annualised inflation rate of 4.6%, still uncomfortably high. As 2011 continues the momentum of these high monthly figures will translate into higher annual inflation.

Since the introduction of QE2 in November 2010, the net monetary base has increased faster than inflation. This unconventional policy by the Fed continues to provide the conditions for good economic growth.

Note: A negative result implies that inflation is growing faster than the money supply, an event which indicates that a recession will occur within 1 to 36 months (with an average of 12 months)
Note: A Decline in annual Real GDP per Capita is my definition of a "recession"

Data Series:
St Louis Fed

AMBNS
EXCRESNS
CPIAUCSL
GDPC1
POP

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Federal Funds Rate vs 10 Year Bond Rate (spread)

The 10 Year Bond Rate has increased over the past few months while the Federal Funds rate remains at near zero. The April spread comes in at 336 basis points, well above the historical average and safely in positive territory.

Note: A negative result implies a highly restrictive monetary environment, an event which indicates that a recession will occur within 4 to 39 months (with an average of 22 months).

Note: If both the first and second graphs are negative at the same time it indicates that a recession will occur within 1 to 21 months (with an average of 11 months).

Data Series:
St Louis Fed

FEDFUNDS
GS10
GDPC1
POP

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Real Interest Rates

Inflation in the past four months has picked up considerably, which means that Real Interest Rates in April dropped further to -3.0% - well below the historical average of 1.6%. This is now the 18th negative month in a row.

Since 1955 there have been five long periods of negative Real Interest Rates:

1957-12 to 1958-10: 11 months (average -1.4%)
1974-09 to 1977-09: 37 months (average -1.9%)
2002-10 to 2005-04: 31 months (average -1.1%)
2008-01 to 2008-11: 11 months (average -2.1%)
2009-11 to 2011-04: 18 months (average -1.7%)

Note: Real Interest Rates are another way of measuring monetary conditions. While inflation implies that cash by itself is losing its value, a negative real interest rate implies that cash accounts in banks are losing value as well (even while earning interest). The IMF strongly recommends that economies keep real interest rates positive to preserve the value of money and to prevent investment bubbles from occurring.

Data Series:
St Louis Fed

FEDFUNDS
CPIAUCSL
GDPC1
POP

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Archive of Historical graphs.

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Preliminary US Recession Indicators - May 2011

2011-05-07T11:04:00.001+10:00

AMBNS

2010-04-01 2037.571
2011-03-01 2418.200
2011-04-01 2523.330

EXCRESNS

2010-04-01 2037.571
2011-03-01 2418.200
2011-04-01 1452.131

Net Monetary Base (AMBNS minus EXCRESNS)

2010-04-01 987.344
2011-03-01 1055.515
2011-04-01 1071.199

CPIAUCSL (Inflation index)

2010-04-01 217.625
2011-03-01 223.490

Inflation warning zone (month on month decline in index)

2011-04-01 226.813 - 4.2% inflation

Recession zone (year on year decline in index)

2011-04-01 226.130 - 8.5% inflation

House price stability via direct government intervention

2011-04-21T10:34:00.001+10:00

A comment I made here about the Australian housing bubble:

If the government is serious about cooling off house prices they need to be a little bit more proactive and not just focus on demand but also on supply. If the government can enter a market on the demand side by fiddling with tax laws and tax rates and, through the Reserve Bank, interest rates and the money supply, then perhaps they should also enter a market on the supply side as well.

This would mean that the government (at all levels, but mainly Federal) would actively build properties for the purpose of selling on the open market. With an increase in property supply, prices are more likely to cool off. Moreover, government built and owned housing could be refrained from sale in order to prop the market up if it ends up crashing. This would require counter-cyclical economic behaviour by the government since it would involve selling properties when prices are high and holding back on sales when prices are low. The government could even choose to purchase private properties on the open market.

Of course the goal of such an ongoing intervention in the housing market would be to maintain price stability and to prevent booms and busts. We don't want overpriced housing but we don't want a crash either. In a sense such an intervention would be akin to monetary policy except it is aimed at a specific market rather than the entire economy.

Nevertheless, affordability should be a major goal. House prices at the moment are ridiculous and a correction is needed. Two metrics would need to be used to determine fair property value. The first being the rent/house price ratio which, according to The Economist, shows Australian houses to be 50% or more overvalued. This metric is similar to the p/e ratio used in the share market. The second ratio should be a wage/house price ratio to ensure that house prices do not overshoot the owner's ability to repay it.

Of course such an intervention would be a radical departure from policy since the 1980s, yet in essence it is simply another way to maintain price stability by intervening in the market. Similar interventions in other parts of the economy (eg the share market) could also be made to prevent boom/bust cycles in specific markets.

This is an idea that's been floating around my head for a while: Price Stability to prevent unreasonable booms and busts may not just be solved by monetary policy (changing interest rates) but also by direct government intervention in specific marketplaces that would aim at both supply and demand.

For example, to adjust demand, the government could offer tax incentives or subsidies for buyers - which is what Australia does with Negative Gearing and the First Homebuyers Grant. To increase demand, more subsidies/tax breaks could be given; to decrease demand, tax increases or levies could be put into place. The government could also adjust demand by direct purchases or direct selling.

To adjust supply, the government could enter the market and simply create more - in the case of the housing market this would mean the government buying up land, building houses and then selling them.

Replay Gain sounds good

2011-04-20T12:39:00.001+10:00

Just recently I converted all my music files to include Replay Gain. This now means that my music has been made "equal".

But allow me to explain just what is going on.

Have you ever noticed that one band/CD sounds "louder" than another? And that the "louder" music is actually newer? Well, welcome to the Loudness War.

Over the many years of the recording industry, bands and producers have had to make judgments over how loud music should be. Since increased volume comes at the expense of quality, earlier musicians tended to record their music at lower volume - even musicians and bands known for creating "loud" music. In the early 90s, however, the music industry discovered that albums/songs mixed at a higher volume stood out more on the radio and were more likely to sell. With the secret out of the bag, recorded music was released at higher and higher volume as the industry competed against each other to sound "better".

And those "remastered" CDs of classic albums from long past? They were simply made louder. That's all.

It occurred to me that something was up when one day I was listening to "Buy Me a Pony" by Spiderbait some years ago. The song is 1 minute and 36 seconds of searing, flammable rock'n'roll and was one of my more favourite JJJ songs back in the day. Following this song (on a compilation CD I had made of my own music collection) came "Anarachy in the UK" by The Sex Pistols. Back in 1976 this was an incendiary punk song but after listening to "Buy Me a Pony" it sounded pedestrian. More than that, it was soft. I knew that something was wrong. The same thing afflicted my Midnight Oil collection when played in comparison to Rage Against The Machine.

Numerous thoughts appeared in my head as to the explanation. One was that the recording techniques of newer bands were far superior to those from the past. Another was that the older music simply sucked more and the newer music was better. It came to a head when I bought Psychocandy by The Jesus and Mary Chain. I had heard that this was a seminal album, responsible for influencing all sorts of 90s grunge and alternative rock music. When I first began listening I was convinced that I had purchased a dud CD. The music was so soft that it sounded as though the band were playing underwater. I searched the internet, first to see if anyone else had bought a dud CD, then (once convinced that the CD was not a dud) anyone complaining of the bad mix. Nothing.

It was then I discovered the facts behind the loudness war, and I felt cheated. Increasing the volume on tracks made music unequal and made it appear "better" than what it was. Newer bands and musicians were "cheating" by not allowing their music to be listened equally to older music (though, to be fair, it was obviously record companies that were pushing this).

The workaround for this is simple: Turn it up. If I want to listen to Spiderbait and The Sex Pistols equally, then I turn down Spiderbait and turn up The Sex Pistols. If I want to listen to The Jesus and Mary Chain properly then I turn it up in comparison to other music. But of course this requires manual control - something not at all commendable in this day of digital music players. So. I thought. Surely there is a way for computer software to determine how loud a track should be and to simply add tags to the files, and have your music player adjust accordingly? Yes. Someone had thought it up years ago.

The first thing to do is to have software capable of analyzing the music files and then applying the Replay Gain tag to it. I have done this with easyMP3Gain, a free open source gui program that uses a variety of other programs with it to work (mp3gain, aacgain and vorbisgain). All I did was add the folders and tracks of my CD collection, analyze them and change them accordingly - a process that took quite a few hours but is now complete. Here's a screenshot of three tracks I've already mentioned:

As you can see, "Buy Me A Pony" has a track gain of -10.10, which means that in order to make the track equal, the program has lowered the volume by 10 dB. This is not a "permanent" change to the sound - all it does is add a small tag to the file. If you listen to the file on equipment that uses Replay Gain, it will automatically lower the volume. If you turn Replay Gain off, or if your media player does not support Replay Gain, the song's volume will be unchanged. You can also see there that "Anarchy In The UK" and especially the song by "The Jesus and Mary Chain" have very low track gains, which mean that they would've sounded "soft" in comparison to "louder" tracks.

Of course if you're going to try this out you also need a media player capable of Replay Gain. I use Amarok on my PC and use Rockbox on my Sansa Fuze and both have Replay Gain. If your media player does not have this feature then, as I've pointed out, the sound of your media files will be unchanged even after having the tags added to the file.

So what's it like to listen to? It's great. Suddenly Bob Dylan is competing with Them Crooked Vultures and The Rolling Stones are competing with The Eagles of Death Metal. Dylan especially is doing well in grabbing my attention - something he always struggled to do.

At this point in time I have no desire to go back to what it was like before. I am enjoying very much the experience of listening to music that has been adjusted by Replay Gain.

Note: easyMP3Gain has a number of annoying bugs which I was able to work around. The key to using it is to never "scroll down". And that guy with the bass is Steve Queralt.

US Recession Indicators - May 2011

2011-04-16T10:34:00.001+10:00

Net Monetary Base vs Inflation (spread)

The growth of the Net Monetary base (M0 minus excess reserves) over inflation has been above the historical average since September 2010 and has increased even further with an April reading of 536. This is an increase from last month's reading of 529. Despite the high reading of 2011 Q1 over the average, GDP growth for this period was only moderate (confounding my own predictions of substantial growth).

Inflation readings in April continue to grow. The index reading of 224.433 implies annual inflation of 3.1% but the annualised monthly figure was 5.1%. Prices since December (220.186) have increased by 1.9%, which implies an annualised inflation rate of 4.6%, still uncomfortably high. As 2011 continues the momentum of these high monthly figures will translate into higher annual inflation.

Since the introduction of QE2 in November 2010, the net monetary base has increased faster than inflation. This unconventional policy by the Fed continues to provide the conditions for good economic growth.

Note: A negative result implies that inflation is growing faster than the money supply, an event which indicates that a recession will occur within 1 to 36 months (with an average of 12 months)
Note: A Decline in annual Real GDP per Capita is my definition of a "recession"

Data Series:
St Louis Fed

AMBNS
EXCRESNS
CPIAUCSL
GDPC1
POP

--------------------------------------------------------------------------------------------------------------------------------------------------------------------

Federal Funds Rate vs 10 Year Bond Rate (spread)

Note: A negative result implies a highly restrictive monetary environment, an event which indicates that a recession will occur within 4 to 39 months (with an average of 22 months).

Note: If both the first and second graphs are negative at the same time it indicates that a recession will occur within 1 to 21 months (with an average of 11 months).

Data Series:
St Louis Fed

FEDFUNDS
GS10
GDPC1
POP

--------------------------------------------------------------------------------------------------------------------------------------------------------------------

Real Interest Rates

1957-12 to 1958-10: 11 months (average -1.4%)
1974-09 to 1977-09: 37 months (average -1.9%)
2002-10 to 2005-04: 31 months (average -1.1%)
2008-01 to 2008-11: 11 months (average -2.1%)
2009-11 to 2011-04: 18 months (average -1.7%)

Note: Real Interest Rates are another way of measuring monetary conditions. While inflation implies that cash by itself is losing its value, a negative real interest rate implies that cash accounts in banks are losing value as well (even while earning interest). The IMF strongly recommends that economies keep real interest rates positive to preserve the value of money and to prevent investment bubbles from occurring.

Data Series:
St Louis Fed

FEDFUNDS
CPIAUCSL
GDPC1
POP

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Archive of Historical graphs.

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Market Cap heading for adjusted US dollar fall?

2011-04-02T21:02:00.001+11:00

I've adjusted the Russell 3000, an indice that measures market capitalisation, by the value of the US Dollar as measured by the USDX index, and I found this interesting thing:

Financial analysts have often used little thingys like lines of resistance or something like that. I don't fully understand it but it seems to show that a potential high has been reached and that maybe, just maybe, there'll be another drop. In the context of this particular graph, it would be either a drop in the value of the US Dollar or a drop in the value of the Russell 3000, or some combination of both.

US Recession Indicators - March 2011

2011-03-18T16:24:00.001+11:00

Net Monetary Base vs Inflation (spread)

The growth of the Net Monetary base (M0 minus excess reserves) over inflation is safely in positive territory with a reading of 424. This is an increase from last month's reading of 409 but is still way above the historical average of 255. The last six months have seen the spread nearly double in size, which indicates that 2011-Q1 GDP growth is likely to be substantial.

Inflation, however, is increasingly evident in numbers just released. Although February saw an annual inflation increase of 2.2%, the annualised monthly figure was 6.6%. I predicted recently that February inflation was going to be be "big" and it was. This was because early M0 figures showed an annualised monthly growth of over 97%. Once excess reserves were taken into account, the net monetary base increased by an annualised 15.4%.

Note: A negative result implies that inflation is growing faster than the money supply, an event which indicates that a recession will occur within 1 to 36 months (with an average of 12 months)

Data Series:
St Louis Fed

AMBNS
EXCRESNS
CPIAUCSL
GDPC1
POP

--------------------------------------------------------------------------------------------------------------------------------------------------------------------

Federal Funds Rate vs 10 Year Bond Rate (spread)

The 10 Year Bond Rate has increased over the past few months while the Federal Funds rate remains at near zero. The December spread comes in at 342 basis points, well above the historical average and safely in positive territory.

Note: A negative result implies a highly restrictive monetary environment, an event which indicates that a recession will occur within 4 to 39 months (with an average of 22 months).

Note: If both the first and second graphs are negative at the same time it indicates that a recession will occur within 1 to 21 months (with an average of 11 months).

Data Series:
St Louis Fed

FEDFUNDS
GS10
GDPC1
POP

--------------------------------------------------------------------------------------------------------------------------------------------------------------------

Real Interest Rates

Inflation in the past three months has picked up considerably, which means that Real Interest Rates have dropped to -2.0%

Note: Real Interest Rates are another way of measuring monetary conditions. While inflation implies that cash by itself is losing its value, a negative real interest rate implies that cash accounts in banks are losing value as well (even while earning interest). The IMF strongly recommends that economies keep real interest rates positive to preserve the value of money and to prevent investment bubbles from occurring.

Data Series:
St Louis Fed

FEDFUNDS
CPIAUCSL
GDPC1
POP

--------------------------------------------------------------------------------------------------------------------------------------------------------------------

Archive of Historical graphs.

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Hello all

2011-03-14T10:41:00.001+11:00

US Inflation for February will be big

2011-03-05T20:01:00.001+11:00

Here's a screencap of my spreadsheet.

Monthly M0 grew in February by 8.1%, which means an annualised increase of 97.24%.

There are only three other monthly results since 1954 (where my M0 figures begin) when M0 increased faster than this, and that was October 2008, November 2008 and December 2008 during the market panic of that period. Those three months were also beset with some very severe deflation. It was this huge increase in liquidity by the Fed which helped prevent a deflationary collapse. Put simply, the inflationary pressure caused by the increase in M0 was able to balance out the deflationary effect of the crisis.

Since we're not in a similar situation (ie not in an imminent credit crisis), February's sizable M0 increase (the fourth largest in history) would have a large inflationary effect.

On the surface, annual inflation is still benign:

November 1.1%
December 1.4%
January 1.7%

Yet these annual figures hide the monthly results which, annualised, are:

November 1.5%
December 5.2%
January 4.8%

All these figures you can see on the screencap link to my spreadsheet I've given. And if you have checked that out you will also see the notation "QE2" to the far right of the November row. QE2 is, of course, the announcement by Ben Bernanke that the Fed will create $600 billion of money by fiat and use it to buy back government bonds.

Oil prices have popped up, partly due to Libya but mainly due to supply issues (ie Peak Oil), which means that the inflationary effect of QE2 will run straight into the inflationary effect of high oil prices. Bad news for the recovery.

US Recession Indicators - February 2011

2011-02-18T20:08:00.001+11:00

Net Monetary Base vs Inflation (spread)

The growth of the Net Monetary base (M0 minus excess reserves) over inflation is safely in positive territory with a reading of 409. This is a decrease from last month's reading of 478 but is still way above the historical average of 255. The increase in the past six months has been substantial, which is likely to mean that US GDP growth will continue strongly in Q1 2011. However the January results saw an annualised increase in inflation of 4.8% which, compared with an annualised decrease in the Net Monetary Base of -1.6%, sees the spread in negative territory (-642). Nevertheless an occasional monthly decline is common and is not indicative of an oncoming recession.

Note: A negative result implies that inflation is growing faster than the money supply, an event which indicates that a recession will occur within 1 to 36 months (with an average of 12 months)

Data Series:
St Louis Fed

AMBNS
EXCRESNS
CPIAUCSL
GDPC1
POP

--------------------------------------------------------------------------------------------------------------------------------------------------------------------

Federal Funds Rate vs 10 Year Bond Rate (spread)

The 10 Year Bond Rate has increased over the past few months while the Federal Funds rate remains at near zero. The December spread comes in at 322 basis points, well above the historical average and safely in positive territory.

Note: A negative result implies a highly restrictive monetary environment, an event which indicates that a recession will occur within 4 to 39 months (with an average of 22 months).

Note: If both the first and second graphs are negative at the same time it indicates that a recession will occur within 1 to 21 months (with an average of 11 months).

Data Series:
St Louis Fed

FEDFUNDS
GS10
GDPC1
POP

--------------------------------------------------------------------------------------------------------------------------------------------------------------------

Real Interest Rates

Inflation in the past two months has picked up considerably. Index figures and summaries are as follows:

November 2009: 216.956
December 2009: 217.158
January 2010: 217.458
October 2010: 218.970
November 2010: 219.240, 1.1% yearly, 0.1% monthly, 1.5% monthly annualised
December 2010: 220.186, 1.4% yearly, 0.4% monthly, 5.2% monthly annualised
January 2011: 221.062, 1.7% yearly, 0.4% monthly, 4.8% monthly annualised

The Federal Funds Rate remains at rock bottom at 0.17%, which means that real interest rates are still negative at -1.5%. Last month was -1.2%.

Inflation has picked up due to a combination of higher oil prices, higher food prices, and the effects of QE2. It remains to be seen whether these inflationary conditions will continue, and/or have a negative economic impact.

Note: Real Interest Rates are another way of measuring monetary conditions. While inflation implies that cash by itself is losing its value, a negative real interest rate implies that cash accounts in banks are losing value as well (even while earning interest). The IMF strongly recommends that economies keep real interest rates positive to preserve the value of money and to prevent investment bubbles from occurring.

Data Series:
St Louis Fed

FEDFUNDS
CPIAUCSL
GDPC1
POP

--------------------------------------------------------------------------------------------------------------------------------------------------------------------

Archive of Historical graphs.

--------------------------------------------------------------------------------------------------------------------------------------------------------------------

The magical GDP Deflator

2011-02-14T20:39:00.001+11:00

I've just had a very important change in thinking. I'm no longer going to focus on the Consumer Price Index (CPI) as the main measurement of inflation, but the GDP Deflator.

When Gross Domestic Product (GDP) is reported, two figures are released. The first is called "Nominal GDP" and is essentially the latest measurement in current prices. Since prices are affected by inflation, a second figure is released called "Real GDP", which measures GDP after adjusting for inflation. A mix up in my understanding of this issue was quite embarrassing a few years ago, but it has remained in the back of my mind ever since.

The thing is that CPI measures consumer prices. It doesn't measure producer prices (which is a separate figure) or any other price movements. In my macro study of how inflation affects the money supply I searched for a more accurate representation of how inflation should be measured. The GDP deflator is the broadest measurement of inflation in an economy. If you want to measure the complete price change in the economy, look at the GDP deflator.

For instance. If you look at 2010 Q4, the CPI index moves from 217.224 in December 2009 to 220.252 in December, which implies an annual inflation figure of 1.39%. The GDP deflator index moves in the same period from 109.665 to 111.118, which implies an annual inflation figure of 1.32%. The GDP deflator and the CPI are rarely exactly the same, almost always move together, and only rarely is there a large disconnect between the two results. I suppose you could say that the CPI is an approximate measure of inflation, while the GDP deflator is the most complete figure we have.

Firstly, this has had broad implications with my recession predictions. The spreadsheets I have on this issue more than confirm my predictions when I replace CPI data with GDP deflator data.

Secondly, it has changed my opinion of what is going on in Japan. As someone who believes in Absolute Price Stability (neither inflation nor deflation over the course of the business cycle, with an inflation index averaging out at zero changes over the long term) I have often lauded Japan as being an example of what it could be like. Not any more. See here:

This index clearly shows that the GDP deflator in Japan has been negative since 1997. This is not price stability; it is deflation. If Japan had absolute price stability, the average result of the GDP deflator over the long term would not show much deviation, if at all. In 1997 the index was 103.115. If it was still around the 103 mark today, with movements between 101 and 105 in the intervening years, then that would constitute absolute price stability. As a result of this discovery, I have far less respect for the BOJ. Quantitative easing and an abandonment of mercantilist trade policy is what Japan should've done to prevent this deflation.

Here's another problematic graph.

2011-02-11T21:39:00.001+11:00

2011-02-05T20:36:00.001+11:00

US Recession Indicators - January 2011

2011-02-02T17:01:00.001+11:00

Net Monetary Base vs Inflation (spread)

The growth of the Net Monetary base (M0 minus excess reserves) over inflation is safely in positive territory with a reading of 480. The increase in the past six months has been substantial, which is likely to mean that US GDP growth will continue strongly in Q1 2011.

Note: A negative result implies that inflation is growing faster than the money supply, an event which indicates that a recession will occur within 1 to 36 months (with an average of 12 months)

--------------------------------------------------------------------------------------------------------------------------------------------------------------------

Federal Funds Rate vs 10 Year Bond Rate (spread)

The 10 Year Bond Rate has increased over the past few months while the Federal Funds rate remains at near zero. The December spread comes in at 311 basis points, well above the historical average and safely in positive territory.

Note: A negative result implies a highly restrictive monetary environment, an event which indicates that a recession will occur within 4 to 39 months (with an average of 22 months).

Note: If both the first and second graphs are negative at the same time it indicates that a recession will occur within 1 to 21 months (with an average of 11 months).

--------------------------------------------------------------------------------------------------------------------------------------------------------------------

Real Interest Rates

Low inflation and even lower interest rates mean that the current rate is still in negative territory at -1.21%. It remains to be seen whether the current situation encourages another investment bubble or simply encourages investors to reduce liquidity.

Note: Real Interest Rates are another way of measuring monetary conditions. While inflation implies that cash by itself is losing its value, a negative real interest rate implies that cash accounts in banks are losing value as well (even while earning interest). The IMF strongly recommends that economies keep real interest rates positive to preserve the value of money and to prevent investment bubbles from occurring.

--------------------------------------------------------------------------------------------------------------------------------------------------------------------

Archive of Historical graphs.

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Gold's Fooled

2011-01-27T17:33:00.001+11:00

This is a comment I made at Reddit:

(F)iat money has one unique inherent value: it is far and away the main method of exchanging goods and services.

Switching over the gold, silver or other precious metals that are physically held in vaults while "owners" have currency that is linked to these metals may sound good on paper (no pun intended), but there are problems:

1) Your currency goes up and down in value according to how much gold, silver or whatever is hitting the market. If Russia or China or some other nation suddenly ups production of precious metals, then your currency goes down in value, leading to inflation.

2) Mining companies become the world's central bankers, adjusting inflation according to their production levels but only ever looking after their shareholders.

3) If the economy grows faster than precious metal production, then the result is deflation and increasing levels of precious metal ownership, which would end up becoming a bubble.

4) If the economy grows slower than precious metal production, inflation results.

5) Precious metals are only "precious" because we as humans grant them worth and only do so for reasons of vanity - not because they are inherently useful (the usefulness of gold, silver and other precious metals as an industrial and practical material is minuscule compared to their value as jewelry and such). If we can arbitrarily assign worth to relatively impractical metals such as gold, silver and the like, then we can also arbitrarily assign worth to coins, notes and bank balances.

6) Fiat money is controlled ultimately by a national government (or supranational entity in the case of the Euro) who delegates that authority to a central bank. Commercial banks use fractional lending to create more money by fiat, but their operations can be curbed and influenced by central bank policy (such as raising interest rates, which constrains the money supply and is deflationary, or lowering interest rates, which increases the money supply and is inflationary). So long as price stability is maintained, fiat money has been and will always be more useful than a gold standard (or similar). It is only when central banks give up on price stability that money loses its unique usefulness as a unit of exchange.

($1 Billion will be paid to the first person who interprets the title of this post and the image that goes with it)

Big historical data post on recessionary indicators

2011-01-25T10:31:00.001+11:00

(This post will serve as a bit of a link back for future posts)

1960s

1970s

1980s

1990s

2000s

In defence of the Eurozone and its policies

2011-01-24T11:25:00.001+11:00

John Quiggan has written an interesting critique of the Eurozone that is far more objective and detailed than other critiques I have read. Nevertheless I believe it to be wrong.

One of the effects of the "great moderation" was the idea that (preferably independent) central banks should use monetary policy to keep inflation within a certain band. Now that neo-classical economics has been discredited, the time is obviously right for questioning this policy. To my horror, however, the consensus seems to be that the inflation band should be looser and higher - I have argued that it should be tighter and lower, and that absolute price stability be the goal.

The result of this debate is an eventual "Godwinisation" of each other's point of view. The new economic consensus of higher inflation is critiqued by those who yell "hyperinflation" and remind everyone of the 1970s, while the old economic point of view is critiqued by those who yell "deflation" and remind everyone of the 1930s. The result seems to be the assumption that anyone who reminds anyone else of a time period when prices either rose or fell as the basis of their argument automatically loses the argument (see Godwin's Law)

The lessons of the 1930s and the 1970s is very clear - price stability is essential. In the 1930s, deflation in the US hovered around 10%; this was not price stability since prices kept dropping. In the 1970s, inflation in the US hovered around 10%; this was not price stability either since prices kept rising. During the neo-classical revolution of the early 1980s, it was decided that inflation should be handled exclusively by monetary means (increasing or decreasing interest rates) in order to keep inflation within a "band".

Yet the desire for price stability - neither too much inflation nor too much deflation - has its roots more in the Wirtschaftswunder of post war Germany and its policies of Ordoliberalism than in anything post-disco or neo-classical. In fact I would argue precisely that a heavy dose of Ordoliberal policies is exactly what Europe and the US needs.

But then we need to add to this mix the theory of optimum currency areas proposed by Robert Mundell. Quiggan is the first econ-blogger I have seen who has actually mentioned this principle when critiquing the Eurozone. Others, including Krugman, have been railing recently against the existence of the Euro but have failed to even mention Mundell or his theories. Mundell, of course, was instrumental in creating the theory of an optimum currency area and his work eventually led the European Union to introducing a single currency.

But is an optimum currency area a neo-classical idea? That appears to be the assumption amongst critics of the Euro, which means that their dismissal of the Euro as a practicable idea neatly fits into their dismissal of neo-classicalism. Yet there are no neo-classical economists in the English speaking world who supported the Euro's creation back in 1999. We certainly didn't see neo-classical economists arguing for a unified North American Currency shortly after NAFTA. In fact, most neo-classical economists derided the Euro as yet another example of creeping socialism in western Europe, usually while writing words such as "inflexible" and "sclerotic" and "old" and "too generous".

My argument is that neither the Eurozone nor price stability is a result of (now discredited) neo-classical economics. I myself have come to the inevitable conclusion that neo-classicalism has run its course and ideas that "governments can't do anything right; the free market is more efficient; deregulate" are now subject to massive qualifiers (eg taxpayer funded universal health care is more efficient and more effective than a system dominated by the free market, such as in the US). Rather than minimising government influences upon the economy, policy makers must now reconsider re-regulation of certain industries to ensure that the market reaches its potential without causing harm to the society it exists in; to reconsider nationalisation of certain industries where it can be proved that government control is more efficient and serves society better. If that sounds like a good solution to neo-classicalism, you're right: it's Ordoliberalism, and Ordoliberalism applied across a continent of separate countries can achieve far more when prices are stable and when a single currency is used.

For us in the English-speaking west, we are quite ignorant of the hoops that nations have to jump through in order to become members of the European Union and to then, after time, adopt the Euro. A series of measurable outcomes must be met, called the Community Acquis. Many of these outcomes are neo-liberal in tone, such as free trade between member nations, and free movement of capital. Others are almost socialist in tone, including environmental laws, competition policies and employment policies. In short, Acquis is very Ordolibeal in tone, and offers the assurance of a level playing field for a single currency to operate in.

It is my opinion that many in the English speaking west desire the Eurozone to collapse, either to vindicate their positions or as a way to move their focus away from the US and its problems. Europe and the Eurozone certainly have major problems, not the least being the debt crisis that they are in. Yet those who have actually studied debt levels closely (such as myself) have argued that the US is in a worse debt situation than Europe, yet no one speaks about the breakup of the US or the rise of state based currencies - the US is, after all, its own optimum currency area. Since such an outcome is unlikely in the US it should be similarly, if not more, unlikely to happen in the Eurozone.

Europe's debt crisis will wane somewhat as the recovery continues. Germany is already posting strong GDP numbers (which contradicts Quiggan's statement that "in GDP terms, Germany's recovery has not been that strong") and this will help boost the economy of the Eurozone as a whole, including the problem PIIGS.

I'm sorry, but I agree with Eurozone economists on this issue: Price Stability must be maintained no matter what the economic situation, and a single currency will always be better than many.

I concur with Rebecca

2011-01-09T13:55:00.001+11:00

Rebecca Wilder at Angry Bear has pointed out that there is a large divergence between unemployment rates in the Eurozone.

Since I am a defender of the Eurozone I leaped at the chance to prove her wrong with data, which did not happen. I'm not going to post huge graphs here but I will post something directly from a spreadsheet.

The point I am always trying to make with Progressive Eurosceptics is that the Eurozone needs to be compared directly to the United States when it comes to comparing data. Just as the United States is a bunch of 50 states, so is the Eurozone a bunch of 17 countries (16 in 2010). Comparisons should therefore be made with US states when applicable.

Anyway, here's what my spreadsheet told me about November 2010 Eurozone unemployment statistics:

And here is a breakdown of the November 2010 unemployment figures for each US state (sorry for small font size):

The standard deviation of the Eurozone, 4.1, is nearly double that of the States of the US, 2.1. That indicates unemployment in the European Union is certainly diverging wildly, as is Rebecca's argument. Interestingly, median unemployment in the Eurozone (7.9%) is lower than the US (8.6%), but such a result needs to take into account equal weighting given to smaller states or nations like Alaska, Wyoming, Malta and Luxembourg.

More on using the Monetary Base as a recessionary indicator

2011-01-08T11:21:00.001+11:00

This is pretty much the same sort of thing I pointed out before, except this time I have replaced the NBER defined recessions with a method I think is better - an annual decline in Real GDP per capita. I've also adjusted the graphs so that they are the same length of time and using the same maximums and minimums, as well as adding the historical spread average of 254.44 as a green line.

Annual declines in Real GDP per capita occur at around the same times as NBER defined recessions, though with different start dates and different lengths of decline. One notable exception, which can't be shown on these graphs (due to limits of data) is that a decline occurred in 1956 Q3 but was not defined as a recession by the NBER.

Effects of the Kurnell Desalination Plant

2011-01-07T11:30:00.002+11:00

Sydney's Kurnell Desalination Plant began operating during the first week of February 2010. At full capacity it produces some 250 megalitres a day of potable water. As I flew from Sydney to Launceston yesterday, I managed to glimpse it through the window as we flew over Kurnell.

It has not been a great time for proponents of desalination plants, at least in Australia. Popular opposition to the plants focuses upon the greenhouse gases produced by the increased energy needed to operate the plant (a problem offset by the co-construction of a wind farm that produces more kW-h over a 12 month period than is consumed by the desalination plant), the added cost it places upon tap water (which is only a problem when water supplies are not low) and the pollution caused by pumping brine back into the sea (a process which causes increased salinity in the affected area but is also a natural part of the water cycle).

Another problem is that the plant has begun operating during a severe La-Nina event which is known to cause high rainfall levels in Australia. The plant was conceived and built during an El-Nino period when Australia was suffering prolonged drought and low rainfall.

Over the past year I have been collating data from the Sydney Catchment Authority which runs a weekly data series on Sydney water storage and supply - specifically the amount of water gained and pumped by Sydney's network of dams. When compared to the previous six years (2004-2009), 2010 stands out as the year the least amount of water was delivered from dams - a direct result of the increased supply of the Kurnell Desalination Plant.

According to the Data I have collated, the average amount of water delivered from the first week of February to the second last week of December is 466,438.91 megalitres. In 2010, the water delivered in this period was 387,674.83 megalitres, which means that the Desalination plant prevented up to 78,764.08 megalitres from being pumped from Sydney's dams.

At the time that this article was published, Sydney Dam levels have risen to 1,863,500 megalitres, mainly as a result of increased rainfall. This represents 72.2% of capacity, the highest since 2002. If we do the math, we prove that, since 78,764.08 megalitres was saved due to the desalination plant, then we can expect the current dam levels to be 3.1% less than what they currently are - 69.1% - if the desalination plant was not operating.

Moreover, simply by crunching the numbers already shown above, we can see that the desalination plant produces around 17% of Sydney's water - at least if we compare 2010's results with the averages of 2004-2009.

The Kurnell plant was built with the understanding that it would be "mothballed" during periods of high dam capacity. It was also decided that the plant would run continuously for two years to iron out any problems before any "mothballing" would occur, so the chances are that the plant will continue to operate throughout 2011 no matter how full the dams get.

The Kurnell plant has been designed to allow for a doubling of capacity if needed - land has been set aside at the site for more buildings and the piping to and from the plant has been designed to allow for a doubling of capacity. If rainfall levels in Australia and Sydney continue to decline (despite the recent wet weather) then increasing the capacity of the plant will be a cost effective solution to any declining dam levels.

Since it would be more efficient to operate the plant for long periods and mothball it for long periods (as opposed to short periods for both), I would suggest some sort of "trigger" mechanism to be put into place:

* 75% Capacity: The plant will be shut down and mothballed once stored water supplies reach 75% capacity.
* 50% Capacity: The plant will begin operating once stored water supplies dip below 50% capacity.
* 25% Capacity: The plant will be doubled in size once stored water supplies dip below 25% capacity, or else another desalination plant built if this has already happened. (This assumes that the plant has been operating continuously since supplies dropped below 50%)

Using the Monetary Base as a Recessionary Indicator

2010-12-18T16:26:00.002+11:00

"The reason why there is inflation is because the money supply is increasing"

I've heard that argument so many times over the years I decided to look at the data. So I began keying in the increase in money supply using the AMBNS data series at the St Louis Fed when I saw this problem:

Yep, the monetary base seems to have gone into overdrive since the Global Financial Crisis hit. The problem was, though, that in a credit crisis banks and financial institutions tend to sit on their money. I then discovered the EXCRESNS data series at the St Louis Fed, which measures excess reserves:

Yes well that graph is certainly frightening and pretty much confirms that the financial crisis we are experiencing is the worst since the great depression. Yet despite the fact that the Fed has been madly pumping money into the economy and increasing the monetary base (M0), "depository institutions" (ie banks, mainly) have sat on a lot of that money. In other words, a lot of the increase in money supply has been countered by a resistance to lend. Yet there is obviously a way to more accurately measure the net amount of money in the monetary base by removing the excess reserves from the monetary base figure. So to come up with the "Net Monetary Base", we get the M0 figure ("AMBNS") and take away the excess reserve figure ("EXCRESNS"). So I punched up the data into my spreadsheet and this is what I have come up with for the past 20 years:

Well there we have it. A line going up. Woo hoo OSO you've done some great work there.

But it's not the actual amount of money we're interested in so much as the annual increase. So here's the year on year increase in Net M0, with recession bars thrown in:

Now THAT looks more interesting doesn't it? In fact the most obvious question I had when I first made this graph was "What is that spike in the money supply in the middle of the graph?" According to the Federal Reserve Bank of New York:A variety of factors continue to complicate the relationship between money supply growth and U.S. macroeconomic performance. For example, the amount of currency in circulation rose rapidly in late 1999, as fears of Y2K-related problems led people to build up their holdings of the most liquid form of money...
Interesting stuff. Yet there also seems to be another factor at play here, namely the fact that recessions seem to be associated with monetary bases that are only growing slowly. Let's look at the same graph for 1970-1990:

Oh well so much for that theory I suppose. Look those four recessions in the 1970s and early 1980s - obviously the money supply was increasing before and after these recessions. If we connect the above graph with the 1990-2010 one we'll even see that while the increase in the money supply drops in the late 1980s, it is still increasing when the early 1990s recession hits. So it appears as though the experience of a contracting money supply causing a recession is only applicable to the last two recessions. Or is it?

We need to remember that inflation is something which needs to be factored in here. While inflation can be caused by an increase in the monetary base, it can also result from an increase in money velocity as well as supply constraints. In theory, if the money supply is increasing (or decreasing) at a faster rate than inflation (or deflation), then it means that goods and services are getting "cheaper" in relation to the total money supply; conversely, if the money supply is increasing (or decreasing) at a slower rate than inflation (or deflation), then it means that goods and services are getting more "expensive" in relation to the total money supply.

So let's put that in some graphs - the spread between annual growth in the net money supply and annual inflation, for 1960-1970, 1970-1990 and 1990-2010:

Bingo! Suddenly it all makes sense. Recessions occur whenever the spread between the Net Monetary Base and Inflation is negative. A negative result implies that inflation is greater than the increase in the money supply, which means that a real deterioration in purchasing power occurs. It is thus a reliable recessionary indicator going back to at least 1960.

Of course one of the characteristics of this indicator is that while negative results imply a recession, the actual recession may or may not be directly associated with that period:

The 1973-74 recession starts almost immediately the spread goes negative (it was the direct result of the 1973 oil crisis, which was a supply shock).
By contrast, the 1980 and 1982 recessions start after a long negative spread period.
The early 90s recession is also different in that it started after the spread returns to positive.
The GFC recession started after multiple dips into negative territory and continued for some time even when the positive spread exceeded 1000 basis points.

Obviously if we keep a close eye on this spread, we can determine whether the economy is in danger of recession. At the present time (using data from November 2010), the spread is 426.61, which is healthily in positive territory. In fact, here's a graph of the last 36 months:

This shows that it was touch and go in the first half of 2010 as the spread neared zero but remained positive, but that things have improved somewhat since then.

To create this graph yourself you can download the following data from the St Louis Fed and use it in a spreadsheet:

AMBNS (The Monetary Base)
EXCRESNS (Excess Reserves)
CPIAUCSL (Inflation Index)
NBER recession cycles

The equation is simple:

AMBNS minus EXCRESNS = Net Monetary Base
Place the results of the Net Monetary Base and CPIAUCSL side by side in the spreadsheet
Use the spreadsheet to determine the year on year percentage growth of both the Net Monetary Base and CPIAUCSL
Take the year on year result for the Net Monetary Base and minus the year on year inflation result to discover the spread
Add recession bars from NBER data

Here is how the page in my spreadsheet looks with this data.

Update: 2011-01-08
Graphs showing each decade can be found here.

Iceland vs Ireland: Which is worse?

2010-12-03T19:36:00.001+11:00

Much has been said recently about the contrasting fortunes of Ireland and Iceland. In 2008, both nations were seriously affected by the global financial crisis with both economies declining substantially. Recent commentators, most notably Paul Krugman, have argued that Iceland's response to the crisis has had a better outcome than Ireland's. Iceland, with its own currency, allowed the Krona to depreciate substantially - a process which caused an inflationary bout. Ireland, on the other hand, is part of the Eurozone and while capital flight has been felt in the Irish bond market, the Irish economy has not undergone a currency depreciation - a process which has caused a bout of deflation.

So in order to discover which nation has had a worse economic experience, I have mined some data at official sites. For Irish GDP data, I downloaded the latest Quarterly National Accounts; for Icelandic GDP, I looked up data at Statistics Iceland. In order to ensure harmony between the two datasets (and thus ensure apples are being compared to apples) I cross checked the data with the latest Eurostat GDP release. Then, via a spreadsheet, I have created an Index comparing the economies of the two nations. Here is that index:

As you can see the current situation is hardly good for either nation. According to this index, Ireland's economy has shrunk by 13.4% since 2007 Q4, while Iceland's has shrunk by 11.7%. The advantage that Iceland has over Ireland in terms of GDP is quite small. Moreover, Ireland's economy has been in trouble longer than Iceland's - it wasn't until 2008 Q4 that Iceland's troubles really began while Ireland's had begun 12 months previously.

Nevertheless, one important indicator shows a huge difference between the two: unemployment. The latest figures from The Economist show that Ireland's unemployment is currently 13.6%, while Iceland's unemployment is 7.5%. Another important indicator is the budget balance. The Economist tells us that Ireland's budget balance is -37% of GDP, while Iceland's is only -7.7%. While both nations have serious problems, these figures seem to show that Ireland's is far worse.

Of course one of the reasons why Iceland and Ireland are so different in their experience of the economic crisis is the one that Krugman likes to champion: devaluation. Iceland has allowed the Krona to devalue while the Irish are "stuck" with the Euro. Yet this argument assumes that exchange rate variations don't really matter - at least over the medium to long term. It is obvious, though, that Iceland's GDP has reduced in value in comparison to the Eurozone simply because of the Krona's devaluation. When we factor in the devaluation of the Krona when comparing the two nations, the difference is much starker:

The data for the Krona's performance against the Euro can be found here. I averaged out the monthly mid-range figures for each quarter. For example the Euro-Krona exchange rate for 2007 Q4 was 88.7466926667 while for 2008 Q1 it was 101.325026. I then assigned an index of 100 for the 2007 Q4 and used the math in the spreadsheet to multiply each quarter's decline in currency to the GDP figures.

According to this graph, Iceland's GDP, as measured in Euro, has declined by a whopping 52.1% since 2007 Q4, which is due to a combination of economic decline and currency devaluation. While Iceland's unemployment rate may be lower than Ireland's, holders of the Krona (ie the citizens, businesses and government of Iceland) have had their wealth taken away... not by taxes, not by spending cuts, not by austerity measures, but by the foreign exchange market.

Ireland has a number of choices, none of them good. One choice is to default on debt. Another choice is to take money away from households and businesses in the form of spending cuts and/or tax increases. Iceland, by contrast, has had these choices forced upon them by the currency devaluation. If Ireland had the choice of default, Iceland has already done this as international creditors have lost out on their investment. If Ireland has the choice to take money away from households and businesses, Iceland has already had this done as the purchasing power of the Krona has been essentially halved.

The Iceland/Ireland battle is an interesting one because it lines up different views of economics: Iceland is favoured by Krugman and those who believe in using inflation as a means to reduce real debt; Ireland is favoured by Europhiles and those who believe that currency devaluations and inflation damage economies; Iceland is favoured by those who are not too concerned about sovereign debt default; Ireland is favoured by those who believe that debt should be paid back, especially sovereign debt; Iceland is favoured by those who believe that the Eurozone and its "one size fits all" monetary policy is doomed to failure; Ireland is favoured by those who see inherent advantages in having a common currency and monetary policy which ensures that the currency retains its value; Iceland is favoured by those who believe that monetary policy should be used by central banks to help grow the economy when needed; Ireland is favoured by those who believe that price stability should be a central bank's sole concern, and that fiscal policy should be used by governments to grow the economy when needed.

My bet, of course, is with Ireland - the Eurozone recovery, led by Germany, will create a demand for Irish goods and services, grow the Irish economy and reduce Irish unemployment. Nevertheless it will be fascinating to see how these two nations perform as years go by.

Random thoughts on the basics of economics

2010-11-21T09:22:00.001+11:00

At its basic level, economic growth involves an increase in the production of goods and services. Real growth - that is, economic growth adjusted by population - is thus a function of efficiency: an increase in the production of goods and services per head of population. This implies an increasing efficiency in production. In a market system, efficiency is measured by profits and price. In any system (market or otherwise), efficiency is measured by total cost.

Profit: When goods and services are cheaper to produce, private companies make higher amounts of profit.
Price: When goods and services are cheaper to produce, consumers pay less.
Total Cost: When goods and services are cheaper to produce, the total cost of production and consumption to the economy is lowered.

The economy suffers when:

The total cost of purchasing these goods and services goes up - total cost being price plus total cost of ownership plus total cost of production. Cost involves more than price.
The measurement of price and cost becomes opaque due to changes in the value of money, which acts as a unit of measurement. (Money is simply the means by which society orders the economy around. Money acts as a unit of exchange, a unit of measurement and an asset that is subject to the laws of supply and demand.)
Investment bubbles occur within a market system. A bubble is inherently unproductive.
An economy produces and consumes goods and services that it does not need (eg, most Western nations can survive on half the food they consume without any real negative effects to the economy)

If there is no increase in the efficiency of production, the economy moves into a steady state, neither growing nor declining (the model proposed by Robert Solow).

An increase in the efficiency of production usually results from technological change (also pointed out by Solow)

While the market system is the most widely used economic system, government forays into an economy have proven to sometimes work and sometimes not. The only pragmatic reason for a government to inject itself into an economy (ie by producing goods and services itself) is if it is able to be more efficient than the market in the area being affected (there are other reasons than being pragmatic though).

With Sovereign Bankruptcy must come a change in Sovereignty

2010-11-19T19:44:00.001+11:00

It appears as though Ireland will accept a bailout from the IMF. Without this, and without help from its European partners, the Irish government is likely to default on its debts. While Ireland's sovereign debt level is not as bad as some, a budget deficit of 38.5% of GDP has passed the point of ridiculousness. Even though the economy is improving, it has not improved enough to make an impact on the nation's finances.

Ireland, like Iceland and Greece, has been the creator of its own problems. In normal times, political and economic stupidity and profligacy can be forgiven and eventually papered over. Not this time. The Global Financial Crisis has led to social and economic misery around the globe. Like a cyclone or hurricane it caused major damages to whichever country it hits, but especially upon those who were unprepared and whose financial and economic systems were already dangerously unbalanced.

Ireland's biggest advantage is that it is part of the European Union and that it is part of the Eurozone. This means that it was not tempted to destroy its people's wealth through a currency devaluation - the error that Iceland has made and one which the United States is likely to make. Whatever can be said about architects of Ireland's demise, at least those who saved responsibly have retained their savings and their purchasing power. This will help in Ireland's recovery.

But just as bankruptcy leads to the closure of a business, so should a sovereign default result in a change of sovereignty. This is not to say that Ireland should cease to exist as a political entity - far from it. What needs to change is the nation's constitution and its political system. And this is not code for a new election and some constitutional amendments - rather it is the creation of a completely new nation with a new constitution and a newer way of doing things.

The modern Republic of Ireland came into being during the 20th century. Independence from the United Kingdom resulted from a bloody but thankfully short-lived war. The nation was proclaimed a republic in 1949, completely seceding from the commonwealth of nations and setting up an Irish presidency to replace the British crown as the nation's executive.

Of course none of these political achievements of sovereignty need to be repealed. Nor should the efforts of individuals in gaining such sovereignty be ignored or forgotten. Yet the Republic of Ireland has had its day. A new nation needs to be created from the ashes of the old.

France is in its Fifth Republic. The current political entity of France came into being in 1958. Of course France existed long before 1958, even longer than the four republics and other institutions that governed since 1789. Yet despite the idea that France is an "older" country than Ireland, the current iteration of France is actually nine years younger. Countries have dissolved themselves in the past and reformed themselves into newer entities.

What is needed is an Irish Second Republic.

Some time in the near future (1-2 years), the people of Ireland need to vote in a new constitution. Specifics of the electoral system will be voted on. Moreover, the political parties currently involved in the government will be dissolved - their assets stripped and sold off and the money given to the treasury of the new government. No politician who served in the first republic will be eligible to serve in the second republic. The new political parties will have to go back to the drawing board in garnering popular support. Once the constitution has been approved by the people, the second Republic will be "born" and a new country will result.

Naturally you might ask the question why? Why should sovereign bankruptcy lead to a change in sovereignty?

Part of my reasoning on this is that nations, like individuals, need to suffer the consequences of their actions. Since Ireland as a nation is responsible for its current plight, then Ireland as a nation should cease to exist and be replaced by a new entity. Just as a bankrupt business needs to close permanently, so should a country shut itself down permanently. Yet a nation is not like a business in that it consists of people, and people exist no matter what happens to a business - so the only reasonable solution is that when the nation is "shut down" it undergoes a new birth into a new national identity. So should the current Irish republic shut down and a new one replace it.

Moreover there is the idea that Ireland's plight is not just due to the stupid decisions made by those in power, but by the political system that brought such people into power into the first place. As a result, the political system itself needs to change. From a business perspective, it isn't just sacking the board and electing a new one that will solve the problem - it is the entire system of how the board was voted in, and how the business runs itself, that needs to be changed.

Some may find my business/nation analogies here to be simplistic or offensive. They're not meant to be. Yet just as a company board acts on behalf of shareholders, so too do elected officials act on behalf of the people who make up the nation. Since Ireland's current political system led the nation into bankruptcy, it only stands to reason that a new political system be set up. Wipe the slate clean. Start again as a new country.

Of course, one alternative solution would be for the Irish to simply take the money and keeps things running the same way. Not only does this not punish those who failed, but it leaves in place a clearly defective political system that may just fail again in the future.

Another solution might be to subsume Ireland into the territory of another nation. A nearby friendly nation could, in theory, offer to pay off all of Ireland's debts if Ireland become part of their... kingdom. Naturally such a suggestion is ridiculous.

For Firefly Fans

2010-11-17T10:56:00.001+11:00

2010-11-17T09:36:00.001+11:00

When banks refuse to lend, the government should create banks that do

2010-11-13T06:00:00.000+11:00

One of the more distasteful occurrences over the past few years has been the sight of banks and financial institutions wallowing in the mess they created. Yet this has not been as distasteful as the sight of these same banks and financial institutions being propped up by the US Federal Government, either in the form of bailouts or in increasingly radical monetary policy.

On the one hand I heartily approve of the "creative destruction" that oftentimes besets capitalism, namely that companies and corporations should suffer the consequence of their actions. To watch a stupid company wallow in the mess that it has created is a sober reminder of the perils of too much risky behaviour, especially if such behaviour is endemic. Schadenfreude aside, one of the major advantages of this "creative destruction" occurs when new entrepreneurs with different ideas begin to take control. Recessions and economic downturns are excellent ways of restructuring and improving the system that failed.

But on the other hand, banks and financial institutions are not just like any other company or corporation. Lending money for the purposes of profit is one of the most important practices of a market economy. The collapse of financial institutions can be far more damaging to an economy because, without them, it becomes harder for investors to invest, and harder for borrowers to borrow. This is called a Credit Crisis, and it is what caused both the Great Depression of the 1930s and the Global Financical Crisis that we are experiencing today.

Many economists have pointed out since 2008 that the United States economy is not in a liquidity crisis, but a solvency crisis. This doesn't just mean that it is harder and harder to borrow and lend (as per a liquidity crisis), but that the very financial institutions themselves have become insolvent and close to bankruptcy. This means that money "pumped into" the economy through monetary policy is unlikely to have much effect, since it takes time for bad debts to disappear from the books of these financial institutions (a process that could take years). This in turn leads to "Zombie Banks", whereby the net worth of these institutions is less than zero.

So what we have now is a series of zombie banks and other financial institutions. We're trying to resuscitate them in the hope that they will come alive again, and the process by which we are resuscitating them involves conventional monetary policy (raising and lowering interest rates) and unconventional monetary policy (quantitative easing).

Yet I think that there is an alternative to the current situation. If banks and other financial institutions have encountered a solvency crisis and have been "zombified", then perhaps it would be better to simply put them out of their misery, while simultaneously creating "new life" - creating new banks and financial institutions that do not have the same limitations of the undead ones.

The process would be rather simple. A bank is brought into existence by way of congressional legislation and capitalised with quite a few billion dollars of tax payer's money. A board of directors is set up, also by congressional fiat. This board should consist not of industry insiders but experienced businessmen and women who are not just cognizant of the circumstances that led to the recent financial collapse but also willing to avoid the mistakes that were made by the industry leading up to it. The bank will thus become a profit making government enterprise, governed by the congressionally appointed board, and will begin setting up offices throughout the United States to begin operations. As time goes by - say a few years - the bank will be privatized and an IPO will be made on the share market. The money raised in the sale will then be deducted against the tax-payer's money invested in the first place, with the debt remaining becoming a corporate bond owed to the government that will eventually be repaid over time. Moreover, laws would exist to prevent the bank from being merged or acquired by single entities wich would keep the bank owned by a plurality of shareholders for at least the first 10 years of its privatised life (or however many years congress decides upon).

If all goes well, the new bank will generate enough income and profit from its activities to not just pay back money owed to taxpayers, but paid back with interest. This would not just be revenue neutral but revenue positive, allowing a net reduction of government debt over the lifetime of the operation (from creation and capitalisation to IPO and then debt retirement).

And what happens to the Zombie banks while this new bank is created? Hopefully as the new bank grows and develops, so will the zombie banks shrink and eventually disappear.

It needs to be pointed out that the best solution would not be the creation of a single bank, but of multiple ones. Instead of one bank being created and capitalised with tax payer's money, a whole number of banks can be created. This whole process of bank creation could also span many years, with multiple banks being created annually. The process would only stop once congress decides that enough is enough and that the market no longer needs any direct government support.

The creation of multiple banks will help prevent any unsavoury relationships between the banks and the government that created them - once privatized, the government will treat the bank the same as any other, without fear nor favour. Moreover, the creation of multiple banks is essential for a more competitive banking environment.

The advantage that these new banks will have is that they will be solvent, which means that they will be able to respond more effectively to conventional or unconventional monetary policy without being burdened by debts. These banks will also be governed and run by wiser individuals than those who created the crisis, leading to a change of thinking within the credit market hierarchy - a process that is less likely to occur if zombie banks with their flawed management keep being propped up. It also allows "creative destruction" by allowing failing banks to (eventually) go under without compromising the credit market as a whole.

Of course Minarchists would point out that the creation of such financial entities would result in the government intruding into an important part of the marketplace and should not be undertaken, considering, you know, that the government will abuse its position and yada yada yada Nazi tyranny founding fathers blah blah blah. But for those who take stock of what the Founding Fathers of the United States said and did should not be too concerned since congress often created public companies by legislation. In fact the First Bank of the United States was created by the 1st congress which, despite functioning as a proto-central bank, was also partially privatized for the purposes of open market, profit making operations. In short, the government creating a bank by legislation to function in the open market is not just something the Founding Fathers would approve of, but is something they actually did.

Moreover, the creation of new, solvent banks is a better alternative than trying to resuscitate the zombies through increased inflationary policy. Increasing inflation deliberately (which appears to be Krugman's solution) would naturally reduce the debt burden of the zombies and may even result in a more solvent environment. Nevertheless, this would be at the cost of debasing the currency, which may create a pre-2008 environment of negative real interest rates and another bubble economy developing. Additionally, this would ensure that the same financial hierarchy who created the crisis in the first place would retain their power without suffering the consequences of their actions.

The current crop of banks and financial institutions killed the credit industry and helped create the current economic crisis - it stands to reason that they deserve to die and suffer the consequences of their actions. Instead, we have chosen to keep them on life support, feeding them money via bailouts and loose monetary policy in the hope that they will live again, and in the hope that they won't make the same mistakes again. We should abandon this strategy. Instead, we should create new banks capitalised with tax payers money - new banks who will eventually take over the market and allow the zombie banks to die off peacefully.

US Dollar history since 1980 - and how it affects GDP

2010-11-12T14:24:00.001+11:00

The USDX is the indice that measures the relative worth of the US Dollar to the rest of the world. Here is a graph showing how the US Dollar has performed since 1980:

As you can see, there was a huge increase in the mid 1980s. The Plaza Accord wiped out the value in the second half of the 80s, while the late 90s saw a resurgence in the US dollar, partly as a result of panic induced by the Asian Economic Crisis, and partly by the Dot-Com Bubble. The large swing upwards in 2008 was due to panic induced by the 2008 Credit Crisis, when investors dumped shares and fled to the safety of treasuries, which naturally drove the US dollar up.

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Now if we add Real GDP to the mix, we can see just how well the United States as an economy has performed against the rest of the world. The idea here is that we look at Q1 1980 as the baseline (100), and then adjust each quarter's GDP performance by the 12 month USDX average. I chose to average out the USDX over twelve months rather than three months because otherwise the graph would look a bit too shaky. Here it is:

What is notable here is that the US economy grew rapidly in the early 80s and then busted as a result of the Plaza Accord. this meant the US GDP relative to the rest of the world did not recover until the 90s. The indicie on my spreadsheet shows that GDP per capita peaked at 193.86 in Q3 1985, reached a trough of 133.49 in Q1 1991, and then reached 195.29 in Q2 1998. In other words, it took 13 years for the 1985 peak to be reached again.

GDP then peaked at 259.93 in Q1 2002, which is interesting since this was after the early 2000s recession had peaked. Obviously the drop in GDP was more than made up for in the rise of the US Dollar. Since 2002, the US has been in a protracted fall in real GDP measured against the value of the US Dollar, the trough being 192.54 in Q3 2008 (just when the credit crisis was hitting the most). Since then there has been a small rise, but not by much. The Q3 2010 indice was 207.38 (awaiting GDP revisions), which means that the US economy has barely doubled in size since 1980.

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Now we look at Real GDP per capita. This is an important measurement because it examines economic performance per head of population rather than just output. Measuring Real GDP per capita is probably the broadest way to measure whether an economy is growing or is in recession. If we adjust it according to the USDX, we get this:

This, of course, looks worse than Real GDP. In fact the latest indice on my spreadsheet for Q3 2010 is 151.48, which means that economic growth per person is only 50% better than what it was in 1980. Peaks and troughs are pretty much the same as Real GDP.

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The last thing I want to look at is the performance of public companies in the US. The Russell 3000 Index measures market capitalisation and has been running as an indice since September 1987. If we adjust the indice by the USDX (monthly values for both) we get the following graph:

Again you can see here the massive impact of the Dot-Com bubble in the late 1990s. The index peaked at 532.12 in August 2000, with a trough of 266.82 in February 2003, a smaller peak of 417.43 in May 2007, a deep trough of 209.98 in February 2009 (a few months after the credit crisis started), and a recent peak of 326.03 in April 2010. The October 2010 indice is 309.75.

In many ways you can see just how damaging the Dot-Com bubble was - each successive peak appears to be lower than the previous one. And remember that this takes into account the relative value of the US Dollar, which means that while Market Caps (and the Russell 3000) might be increasing, the US Dollar might be lowering in value - so what we're seeing is US Market Capitalisation in the context of the entire global economy.

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NOTE: The use of Real GDP figures as opposed to current dollar GDP figures here may be problematic. When I measure public debt I only ever use current dollar GDP. If there are any problems with this then let me know, since re-doing these graphs according to current dollar GDP will be fairly easy (the numbers are already in my spreadsheet).

If anyone wants the raw data on my spreadsheet, contact me and I'll send a copy to you. Having my data and conclusions verified by others is a pleasure (even if it means that I have been proved wrong).

Random Thoughts on Government as Business

2010-11-12T09:38:00.001+11:00

One way to look at the place of government in an economy is to view it is as just another business. This is because:

It produces goods and services
It has customers
It has shareholders

Of course there is a limit to which government can be identified as a business:

It cannot go bankrupt (debt can be defaulted)
Monopoly: It has little to no competition in an economy
If it is a national government, It can declare war against foreign national governments
It writes and enforces law to govern both society and itself
It has the means of creating money and enforcing its use

The way I always look at government is that it is a mutualized monopoly - while it has no competitors (and is thus a monopoly), its customers are its shareholders. At least in a Democratic country, the government's customers are the people, who are equal shareholders in the national government.

Tax, therefore, should be seen as the price the customers pay for the goods and services that the government provides. The fact that a "user pays" system is not set up does not mean that the system is flawed, since "user pays" itself can be a flawed way of pricing, depending upon the goods or services produced (selling food over the counter is a good user pays system, having toll booths every few kilometres to pay for road building and maintenance is not a good user pays system).

World trade needs to be rebalanced - here's my suggestion

2010-11-08T13:26:00.001+11:00

International trade has been around for centuries and has been the creator of both good and bad world economic conditions. What has evolved now, though, is a trade and capital imbalance that is one of the causes of the current economic crisis. If a new economic order is to be created out of this mess, world trade and capital flows need to change.

In the bad old days, mercantilism ruled the waves and nations would compete against each other to gain the best export advantages. This was a self destructive process, since it resulted in trade tariffs and quotas. Mercantilism was part of a broader scheme called "economic nationalism" which saw international trade as a win/lose battle against other nations. Instead of fighting against another nation with armies, countries would fight each other economically. Fortunately economists appeared whose arguments proved beyond reasonable doubt that international trade was actually a win/win - though with a number of caveats.

Sadly, mercantilism is still around. It is practised most notably by China and Japan, with a number of smaller nations (eg Singapore) jumping in. When one nation has a mercantilist trade policy in world trade, the result is a large trade surplus. This trade surplus generates large amounts of foreign currency, which the countries then use to reinvest back into their trade partners. So in Japan and China's case, their trade surplus with the United States leads to large US dollar profits which, rather than being converted into Yen, are reinvested back into the United States. It is a circular process which creates a "virtuous cycle" - US demand for Japanese & Chinese goods leads to US Dollar profits for Japan & China, which leads to reinvestment of these profits back into the United States, which results increased domestic US demand, which results in increased demand for Japanese & Chinese goods. The problem is that this "virtuous cycle" has been exposed as just another bubble that is in the process of bursting.

Theoretically, mercantilism has been abolished. The Word Trade Organisation and its members take a very dim view of member countries setting up trade barriers or quotas. Japan and China get around it however, thanks to the actions of their Central banks. Instead of creating trade barriers, the Central banks of Japan and China sell their own currency and purchase US government bonds (treasuries). This keeps the Yen and the Yuan/Renmimbi cheaper while simultaneously making the US dollar more expensive. With cheap domestic currencies and a customer country with an expensive currency, Japan and China naturally end up having a trade surplus with the United States. Having a cheap currency allows the development of cheap labour thus undercutting any competition from US based companies.

This situation is reflected in a fairly basic economic indicator called the Current account. Nations which have a Current account surplus are nations who receive large amounts of foreign currency for goods and services they sell, as well as from investments that they have in foreign nations. Nations which have a current account deficit are nations who borrow lots of money from nations with current account surpluses.

It is best to look at the current account as an accounting measurement. If our world economy consists of two countries, and country one has a $1 billion current account surplus, then the other country will have a $1 billion current account deficit. You can't have these two nations in this model both running current account deficits or both running current account surpluses. When we take this model to the wider world we realise that one nation's current account deficit is another nation's current account surplus.

So which is better? It might sound better to have a current account surplus, but this is actually mercantilist thinking. In reality they are just as good or just as bad as each other. If we think that the US current account deficit is bad, then we must conclude that the Japanese current account surplus is bad too.

The problem with running large, long term current account imbalances is that, over time, the economy becomes "geared". In the case of the United States, the economy has been "geared" towards the importation of goods and services, it has become "geared" towards borrowing money from overseas - in short, it is an economy that is geared towards consumption and borrowing. By contrast, China and Japan have been "geared" to complement the United States - they are geared towards producing goods and services, and they are geared towards saving. In short, Japan and China are geared towards production and saving.

The figures for these three countries are stark. The United States is running a current account deficit of 3.3% of GDP; Japan is running a current account surplus of 3.3% of GDP; China is running a current account surplus of 4.9% of GDP. Smaller economies have even more notable imbalances (eg Singapore with a current account surplus of 18.4% of GDP, Turkey with a current account deficit of 5.4% of GDP)

Now of course China and Japan DO purchase goods and services from the United States, and people in China and Japan DO borrow money from the United States, and the United States DOES manufacture goods that it exports to China and Japan, and the United States DOES save money. But what we're talking about here is the net result. Just because the United States gets most of its manufactured goods from China and Japan doesn't mean that the United States doesn't manufacture anything. What I'm trying to point out here is that in the back and forth of buying and selling and borrowing and investing that makes up international trade, that current accounts reflect an overall, net position. This means that various industries within these countries stand to gain from any changes in the exchange rate, whichever way it goes.

But the problem with gearing is that any changes in the exchange rate will impact both consumer-friendly nations and producer-friendly nations. Just as investment bubbles will inflate, burst and destroy wealth in the form of stock market busts or property busts, so too can it happen on an international scale. The US, for example, has been running as a consumer-friendly nation for a long time and, as a result, the bubble is about to burst. The United States is naturally the world's financial capital, yet debt has ballooned out of control over the years. The GFC is the beginning of the end of the consumer-friendly United States. Steps need to be taken to gear the United States into a more producer-friendly economy. This doesn't mean becoming mercantilist and running a current account surplus, but it does mean policies to ensure a balanced current account.

The current accounts of Japan and China should therefore no longer be running at a surplus, but should become balanced (ie neither surplus nor deficit) over the long term. This means that the current account of the United States should no longer be running at a deficit, but should become balanced as well. Put simply, the United States needs to produce more and consume less, and save more and borrow less. On the other side of the coin, this means that China and Japan needs to consume more and produce less, and borrow more and save less.

Retooling the United States to become a more producer friendly economy will be painful and it will take time (ie years) to bear fruit. Similarly, retooling Japan and China to become more consumer friendly will be painful too, and will take a similar amount of time to bear fruit.

One solution to the problem of international trade and current account imbalances is to have a common currency. That is what Europe has done with the creation of the Euro. Within the Eurozone, current account differences do occur: Germany has a current account surplus, Spain has a current account deficit. But that doesn't really matter since comparative advantages are very real in international trade, while internal current account issues within the Eurozone will be dealt with by the market without having problems caused by differing currencies. What does matter is the Eurozone's current account overall (presently a current account deficit of 0.4%, which is close to being balanced)

But since the chances of Japan, China or the United States joining the Eurozone (and all that such a joining would entail) is virtually none, another solution must be found.

The solution I have is for the creation of a new international trading agreement that ensures all member nations have balanced current accounts. This would involve the creation of national currency boards in each member nation whose role will be the maintenance of a balanced current account (as opposed to the traditional role of a currency board to maintain a fixed exchange rate). If a nation has a current account deficit, as the United States does, then the currency board (acting with various government bodies like the central bank and/or treasury) will sell off its local currency and purchase foreign currencies on the foreign exchange market, most obviously the currencies of nations who run current account surpluses. Of course these currency boards will have a reciprocal arrangement with the currency boards of the nations they are dealing with. So in the case of the United States and Japan, the US currency board would sell off US dollars and purchase Yen, while the Japanese currency board would sell off US dollar and purchase Yen as well - with the eventual aim of ensuring a balanced current account between the US and Japan.

This system still allows floating currencies but the forex market will be initially dominated by the actions of national currency boards buying and selling currencies in order to create balanced current accounts throughout. This would be better than instituting fixed exchange rates or returning to a gold standard. Since the currency boards will be operating with their respective central banks, money creation by fiat followed by the selling of this currency will be one way to devalue a currency. These currency boards would then only act to ensure a balanced current account. So long as a balanced current account is maintained for their nation or currency zone, they will stay out of the forex markets. Long term current account maintenance will, however, result in regular forays into the forex market - but each foray being only as large as it needs to be to maintain a balanced current account.

Moreover, the more nations which join this agreement, the more natural comparative advantages between nations can be maintained. Rather than ensuring that each nation has a balanced current account with every other nation, the agreement will simply ensure that member nations have a balanced current account overall. For example, in an international economy of three nations, nation A might have a $500 billion current account deficit with country B, country B might have a $500 billion current account deficit with country C, while country C has a $500 billion current account deficit with country A. In this situation, each nation has an unbalanced current account with individual nations, but the overall result is a balanced current account for each of the three nations.

Once this situation is imposed, international trade and capital flows will be easier for the market to handle, since the market will act in the knowledge that currency values will only move within a certain band - and that band will be determined by the currency board and only acted upon according to the status of the current account. There will be less market speculation and more real trade being achieved. This should also result in more predictable, more sustainable economic growth for all nations involved. The win/lose attitude of mercantilism should be replaced by the win/win of balanced international trade.

Addendum

Of course the theory I am working with here is that balance ensures better economic conditions for all. Ensuring that nations (or more correctly, currency zones) run balanced current accounts is one "pillar" of the new economic order that I see should emerge over the next few decades. These three pillars are:

Each currency zone has a balanced current account - neither current account surplus nor current account deficit over the long term.
Each currency zone has governments that run balanced budgets over the long term - neither budget surplus nor budget deficit over the long term
Each currency zone maintains absolute price stability - neither inflation nor deflation over the long term.

I believe that if these three pillars are set up and maintained, the chances of devastating economic downturns (eg great depression / GFC) will be minimised.