A 20 basis point cut

The Bank of Japan cut its benchmark interest rate to 0.3 percent in a split decision to help stave off a prolonged recession.

Governor Masaaki Shirakawa cast the deciding vote to lower the key overnight lending rate from 0.5 percent after four of the eight board members dissented, the central bank said in Tokyo today. Three wanted to cut the rate to 0.25 percent, and one wanted to leave it unchanged, Shirakawa said.
Heresy! Don't these people know that the only way to change rates is to do it in multiples of 25 basis points? ie 7.75% to 7.50%, 8.00% to 8.25% etc etc.

Actually, to be honest I always wondered what would happen if someone did this. Imagine if the Fed dropped rates by 10 basis points, from 1.0% to 0.9%? Everyone would be sooooo confused.

It would be like the US Treasury issuing 20c coins instead of quarters. Hah! Who would ever do such a thing?

Kubuntu 8.10 now out

I'm downloading it now as I type this.

Kubuntu is a version of the popular Linux operating system Ubuntu. I have been using Linux since 2003 and Kubuntu Linux since 2005.

Armed with an obsolete computer running an increasing buggy and annoying Windows 98, I took the plunge and installed Mandrake Linux into my computer. Because of problems with Mandrake, the growing popularity of Ubuntu and my brother's expertise with Debian (he can help me fix things up when they break or when I break them) I bit the bullet in 2005 and began using Kubuntu.

I have not used Microsoft Windows regularly now for over 5 years. That has not been to my detriment at all for the following reasons:
  1. Kubuntu, like all Linux versions, is free to download, copy and distribute. I therefore have an up to date software package that did not cost me any money to get.
  2. I was prepared to work at my relationship with Linux. I knew it wasn't Microsoft and there were some behaviours I needed to change. It took time, but I am now used to Linux.
  3. I'm not a PC gamer, which means I don't need the latest and greatest hi-performance hardware, which is expensive. You can't really be a hard-core PC gamer without Windows anyway.
  4. I don't need to spend hundreds of dollars buying office software. OpenOffice.org is just as good as Microsoft Word, Excel and the others.
  5. I do not miss Internet Explorer - not after my Firefox experience. I don't miss Outlook Express either - Thunderbird is enough for me.
  6. I don't run any anti-virus programs. Though Linux has a few viruses, I do not have any problems with spyware or malware or virus scanners chewing up processor speed. Simply having a strong root password keeps things secure. Since 2003 I have not had any problem with viruses or security.
  7. The Graphical User Interface is reasonably clean and user-friendly these days. Click here to see a screenshot of my own computer running Kubuntu 8.4.
  8. The people who run Ubuntu/Kubuntu release a new version every six months. Imagine if Microsoft did that! No - Vista users are stuck with their version for years but with Ubuntu you get a totally new version available every six months. This means a few new features, but mostly less buggy and more user friendly software that you were using before. Every six months you get to own and run an operating system that is improving incrementally and effectively.
  9. Adept Manager allows you to download all available free and open source software (and more) from a central software repository. Most Ubuntu/Kubuntu users run Adept (or its equivalent) a few times every month to get software updates. Bugs and security patches get fixed up quickly and easily and don't crash your operating system like Microsoft ones do.
  10. Wine allows an ever increasing amount of Windows software that can be emulated on Linux.
Yes, I am trying to sell you on Linux. It is the future of software. If you doubt the power and ability of open source software, look no further than Firefox, which is software owned by no one and everyone. If you've been using Firefox for two or more years, you would know just how much better it has become over time. Well - that's how it gets with Linux.

My preferred "distro" is Kubuntu. If you choose something else, like Ubuntu or Debian or SuSE or Fedora or Mandriva, you will still be able to enjoy the benefits of Linux.

One last thing - I have always maintained that the popularity of Linux will increase once the recession begins to hit. Read here for why.

Well this is ironic...

Apparently a bunch of my fellow evangelical Christians decided to get together and pray for the economy. Nothing really wrong with that. The problem is that they decided to gather and pray at The Wall Street Bull. Probably because they somehow feel that touching an object while they pray somehow releases some sort of spiritual anointing, a number of pray-ers prayed while touching the bull, as per the photo above. A video of the event shows the crowd singing "God Bless America", though not the Bull-touching bit.

What is ironic, though, is that these fellow believers of mine forgot very disturbingly about a rather important event in biblical history - namely Israel's worshipping of the Golden Calf (Exodus 32) which made these rather fervent believers look like they were involving themselves in idolatry. Furthermore, the irony continues when it was progressive, non Christian blogs and commentators who picked this up (see here and here).

Even more ironic, if that were possible, is Colossians 3.5, which says:
Put to death therefore what is earthly in you: sexual immorality, impurity, passion, evil desire, and covetousness, which is idolatry. (ESV)
The English word covetousness here is the Greek word pleonexia and is roughly translated as "the wish to have more". The NIV translates the last few sentences more roughly as "greed, which is idolatry".

So you have a bunch of Christians praying over a golden calf which looks suspiciously like idolatry. But then when you take it to its next level, they're not really praying to a statue, they're praying for the economy. But by meeting at the Wall Street Bull, they are essentially aligning themselves with the financial industry, which means they're really praying for Wall Street who, through their greed, has ended up causing misery for the entire nation. So in many ways these Christians are praying for an institution which is based on greed - and that, according to Paul in the Colossians, is idoltary.

As someone who knows a little bit about the Bible, this sort of event is shameful to the Christian faith, no matter what the intentions of the participants were (unless there's footage of them cursing the bull as being a representative of greed, then I might think they were okay).


Liveblogging GDP 2008 Q3

Final Update 13.40GMT / 0940EDT

Sharemarkets are up about 3%.

Mrs OSO just visited me a few minutes ago and reminded me that while it is lunchtime in the UK and morning in America, it is past midnight here in Australia. Good night all. I hope someone was reading all this!

Hot day tomorrow in Newcastle, NSW. 36°C ( 96.8°F) predicted.

Update 13.35GMT / 0935GMT

Just did some more reading of the official release. Residential spending (ie the subprime bubble) has been declining rapidly since 2006 Q2. That's 2½ years.

More than that, I've just done some basic maths work on each quarter's decline in residential spending. If we take 2006 Q1 to be an indice of 100, the 2008 Q3 comes out at 15.85. This is based upon figures from table 8 of the official release. This means that residential spending has declined by, what, 84.15% since 2006 Q1. Is that right? Or have I got my sums wrong?

I got my sums wrong. If we take 2005 Q3 to be an indice of 100, 2008 Q3 comes out at 58.27. This means residential spending declined by 41.72% over the last 3 years.

Update 13.16GMT / 0916EDT

Calculated Risk has a post and discussion about this GDP release. CR will post the usual graphs anon. CR points out that consumer spending has declined for the first time since 1991.

Some classic comments:
At least they're not going down the same road as the American consumer did, funding their spending orgy through a massive buildup of new debt ... oh, wait.
- Mook

My goodness, we might be in a recession with another quarter of results like this.
- Blackhat

those numbers will look rosy when we compare them to Q4
- 12th Percentile

Update 13.06GMT / 0906EDT

Market futures are up. The -0.3% figure was better than the entrail readers expected.

Update 13.03GMT/ 0903EDT

Public Debt as percentage of GDP has dropped slightly to 43.31%. My debt watch on Wednesday had it at 43.73%. This is because of an increase in nominal GDP. Don't worry doomers, the number will get higher by and by.

Update 12.59GMT/ 0859EDT

Continuing job losses coupled with declining gains from stocks and other investments have put consumers under severe stress. The GDP report showed that disposable personal income dropped at an 8.7 percent rate in the third quarter - the steepest since quarterly records on this component were started in 1947 -- after rising 11.9 percent in the second quarter when most of economic stimulus payments still were flowing.


Businesses also were clearly wary about the future, cutting investments at a 1 percent rate after boosting them 2.5 percent in the second quarter. It was the first reduction in business investment since the end of 2006. Inventories of unsold goods backed up at a $38.5-billion rate in the third quarter after rising $50.6 billion in the second quarter.

Prices were still rising relatively strongly in the third quarter, with the personal consumption expenditures index up at a 5.4 percent annual rate, the sharpest since early 1990. Even excluding volatile food and energy items, core prices grew at a 2.9 percent rate, up from the second quarter's 2.2 percent rise.

Update 12.55GMT/ 0855EDT

The economy suffered its biggest decline since 2001 in the third quarter, ushering in what may be worst recession in a quarter century and boosting the chances of Barack Obama and his fellow Democrats in next week's elections.

Gross domestic product contracted at a 0.3 percent annual pace, less than forecast, a Commerce Department report showed today in Washington. The last major economic data before the election also showed that a record two-decade consumer spending boom ended last quarter as the credit crunch deepened.

``The crisis really kicked up in late September,'' Ethan Harris, co-head of U.S. economic research at Barclays Capital Inc. in New York, said in a Bloomberg Television interview. ``We're going to be looking at a very unfriendly GDP number in the fourth quarter, with a drop of 2 to 4 percent.''


The 6.4 percent rate of decline in spending on non-durable goods, like clothing and food, was the biggest since 1950.

Cutbacks in investments in business equipment and less spending on residential construction projects also contributed to last quarter's contraction.

A narrower trade deficit and a smaller decline in inventories prevented a deeper contraction. Excluding those two categories, the economy would have contracted at a 1.8 percent pace, the most since 1991.

Update 1244GMT/ 0844EDT
And the magic number is:


  • Q2 unchanged at +2.8%
  • -14.1% change in durable goods
  • Exports down. Q2 driven exports were only temporary.
  • Big increase in government spending.
  • Federal Spending increased 3.9% in Q2, 5.8% in Q4. 
  • Defense Spending increased 6.6% in Q2, 18.1% in Q3. I guess someone decided to spend lots of defense dollars to stimulate the economy.
  • State and Local government spending increased 2.5% in Q2, but only 1.4% in Q3.
  • Disposable personal income increased 11.9% in Q2 but  -8.7% in Q3. Looks like the stimulus checks were spent pretty much straight away.
  • Actual figure for GDP is $14.4292 trillion.
  • Implicit price deflator is 4.1.


As Doc Neeson said, "This is it folks, over the top!"

For all lovers of doom and destruction, today's economic release is of major, major, historical importance - the all important 2008 Quarter 3 GDP figures.

As my little poll has shown, most readers like turtles, but some of you are convinced that today's figures will bring a little bit more doom and gloom into our lives, giving us that wonderful feeling of "Oh no, not ANOTHER day" when we wake up.

At 12.30GMT/0830EDT today, the BEA will release GDP figures for the quarter in question. You can wait on the page here. A link to the actual pdf download will follow as soon as I can manage it.

Bloomberg's poll of entrail readers has a median of a -0.5% contraction and an average of -0.6% contraction. What is interesting is that the highest forecast is +1.2% (RBS Greenwich Capital) while the lowest is -1.9% (ClearView Economics). Not being terribly experienced in the hagiography of studying how economic forecasters forecast, I would hazard a guess and say that the chances of an accurate forecast have somewhat diminished, given the wide spread of results.

Being the doomer I am, I would expect a 75% chance of between -0.5% and -1.0%. A 12.4% chance of between zero and -0.5%. A 12.4% chance of between -1.0% and -1.5%. And a 0.2% chance of anything else.

Did any of that make sense? I'm writing so many percentages that your browser might interpret them as commas.

Anyway, I'll be live blogging the GDP release because it's so darn exciting. I'll be also linking to Bloomberg and news reports as they arrive through the series of tubes that is the internet.

Please join me here in 50 minutes (it is 11.40GMT/07.40EDT) and we can chat in the comments about what is going on.

Message from a Butterfly

Love Will Tear Us Apart

This new BBC music video of Joy Division playing Love Will Tear Us Apart is a real winner:

I'm also a big fan of Anton Corbijn's film Control (a biopic about Ian Curtis, lead singer of Joy Division):

I have to admit that I have cried - twice - watching the end of the film. Curtis was a brilliant man. A brilliant, stupid, creative and destructive man.

A Deflationless Depression?

Logic can be a bad weapon when the equation isn't finished.

Think back to the Great Depression. Long lines of unemployment, years of economic contraction, suffering, etc.

One big thing that happened during that period was deflation - a continual falling of prices. Goods and services dropped in value on a daily basis.

The problem was chronic, and policy makers at the time either didn't know how to cure it, or didn't really see it as an important issue. In hindsight it was. Keynes rightfully argued that a good response would've been for the government to expand its operations and run a deficit, thus increasing economic growth and reinflating. Monetarists rightfully argued that interest rates at the time were too high and that increasing the money supply by lowering rates would've been a good solution. Ben Bernanke, in his study of the Depression, declared that there was always the option of merely creating money ex nihilo and throwing it around until deflation disappeared (and thus was born his nickname "Helicopter Ben").

So... here we are on the cusp of yet another potential depression. Ben is doing his best to keep deflation at bay - interest rates have dropped again, a process which acts to stimulate money growth. If the problem gets any worse Ben may have to warm up his helicopter and begin money bombing.

But will this solve the problem? Will the simple process of creating more money - which is balanced out by the market's deflationary money hoarding - do the trick? Is it simply a matter of monetary policy?

The answer to that, of course, is no. It will certainly help prevent exacerbating the problem, but we need to remember that the Great Depression was not simply a failure to keep prices stable.

At present, I would argue that our current set of policy tools and economic understanding is quite capable of coping with an economic upheaval similar to that which caused the Great Depression. Yet I would also argue that the upheaval we are experiencing now is twice as worse as the share price bubble bursting in 1929.

The basis for this argument is the below graph, which I mentioned back in July and which was instrumental in changing me from an "optimistic financial doomer" into a "pessimistic financial doomer":

The graph is sourced from this article at Naked Capitalism.

There is always something terribly frightening about any graph showing exponential growth as it plots something in the real world. "What goes up must go down" is the rule - and the current market crash seems to be following this principle.

I still cannot believe that total credit market debt is equivalent to around 350% of GDP. If that isn't frightening enough, look back the great depression years - the "spike" on the left hand side of the graph. This may, of course, be simply a Propter Hoc scenario - two bits of information that appear to be linked but aren't - but I honestly doubt it since we are comparing stats from the same area of study.

(Note: an example of a Propter Hoc fallacy would be to say that the decline in popularity of Spirographs has occurred while childhood literacy has dropped - thus creating the impression that declining literacy rates could be stopped by buying more Spirographs. The two areas of study - developmental psychology and sales figures - need more to link them than just sheer coincidence. In the case of the graph above and the instance of economic downturns, the information is linked in the area of financial statistics, thus making the correlation between the two more reliable).

If the graph is correct (and I trust Yves), then we are facing a financial situation many times worse than that which hit in 1929. Debt-based asset price bubbles (such as property or shares), when they go bust, leave a trail of deflationary and expanding debt.

It is important to look at the above graph and compare the Depression years with the years since 1980. The depression years saw debt increase to around 170% of GDP before the crash. The increase of the debt to 260% of GDP occurred after the crash and is most likely due to the deflationary spiral that the world economy went into (debt levels remained the same while GDP contracted sharply, thus increasing the share of debt to GDP).

What we have seen since 1980, however, has been a build-up of credit market debt to a level representing 350% of GDP. That is around twice the comparable amount of debt that was present before the 1929 crash. This means that we have further to go.

Think of it like this: The economy is a car ("automobile" for you yanks). In 1929 the car hit the wall at 100kph and crashed. Unfortunately no one knew how to fix the car properly after the crash, which meant that the problem got worse. Moreover, it took years of research and study to determine the best methods of fixing the car properly. Now that the car has hit the wall again, it is tempting to say "well we know how to fix it now" - except this time the car has hit the wall at 200kph.

And that goes back to the title of this article - a deflationless depression. I am absolutely certain that we have learned from the policy mistakes of the 1930s and we are able to prevent the world from going into a 1930s-type deflationary spiral. But we must also remember that our economy has hit the wall harder and faster than in 1929. We cannot assume that this will be of no consequence.

Monetary policy is, of course, an essential tool for running an economy properly. But monetary policy is best used as a preventative rather than a cure. The most effective form of monetary policy occurs when interest rates are raised or lowered in response to price signals while the economy is running along relatively smoothly. Emergencies like deflationary spirals or stagflation do require monetary intervention - but they still remain emergencies. It is obvious that central banks like the Federal Reserve need to step in and provide emergency assistance to an economy that has hit the wall - but the work that monetary policy does in those cases is not a cure, but merely a bandaging of wounds and a setting of broken bones. At some point the market ends up having to cure itself with bed rest.

It is entirely possible to have a deflationless downturn - just as the 1970s showed us that it is possible to have an economic contraction and high inflation at the same time. Whatever the Fed or the US government will do in response to the current crisis will never be enough to cure it but hopefully will be enough to limit the damage. After all, the last thing we need is for policy mistakes to make the situation worse.


Indulge me for a second

Update: Noni said this in the comments:

If everyone in my city sold their home and bought an identical one this year, their net benefit (in housing, not in dollars) would be zero, but the market's benefit would be huge. Something wrong, there.

Money spins around, profits grow, GDP increases, but nothing actually changes. A very perceptive remark Noni.


Let's say I started as a stockbroker in 1990. And let's say that I was a lazy stockbroker. And let's say that every day I put a buy order in on a bunch of stocks and a sell order in on the same bunch of stocks at the end of the day.

So. 2 orders. One is buy in the morning. Two is sell at the end of the trading day. A boring job (as per the photo).

You know, considering the leap in the value of shares from 1990 until, well, about a year ago, my lazy stockbroking activity would have been quite profitable. Given the peaks and troughs of the sharemarket, a simple buy in the morning and sell at the end of the day would have gained me a net profit over my 17 year trading history.

Of course we all know it's more than just what I outlined. There's candlesticks and lines of resistance and Fibonacci sequences and goat's entrails that tend to help brokers make their decisions.

But, in the end, if a guy can make a profit from about half an hour's work and a disciplined adherence to his system, then surely financial markets are a simple way to make money?

The sad thing is, however, that the current blurggh that the market is going through sort of destroys his monetarius modus operandi - unless, of course, the market goes into permanent stasis or, in the case of Japan, perpetual decline (which, of course, favours the stockbroker who shorts in the morning and buys in the afternoon).

Whatever financial skills are needed, it is surely not the same as brain surgery. Let's hope that all the brilliant minds of the next generation don't choose a career that rewards laziness.

PS I said "indulge me". I know that there are skills involved in being a successful stockbroker. I'm just joining in the "financial people are dumb" meme.

PPS Yes I knew monetarius is not latin.

OSO's debt watch

Public Debt on 2008-10-27 was $6.25 Trillion

US GDP in 2008 Q2 was $14.29 Trillion

Debt/GDP Ratio: 43.73%
( [Debt / GDP] x 100)

Public Debt/Person: $21,378.59
(Public Debt / US Population)
(September 2008 resident population + armed forces overseas = 305,449,862 source)

In one week, the Debt/GDP ratio went from 43.32% to 43.73%, an increase of 0.41%.

In one week, public debt per person went from $20,264.04 to $21,378.59, an increase of $1114.55.


Vote GDP Poll

To the left is a voting booth for a GDP poll.

The consensus among the "experts" is a contraction of -0.5%.

GDP figures will be out on Thursday, 8.30am EDT (12.30GMT)

Meanwhile, here's a little boy who likes turtles:


Collapse - temporary, permanent or...?

Is society going to collapse? Dave leant me a book titled "Collapse of complex societies" which was quite interesting.

But it is unlikely. Why? Because even if the current economic crisis is the worst on record, history shows that we have recovered from them. The 19th century is replete with economic collapses. In fact, part of our knowledge of how/why economic collapses occur is due, in part, to the 19th century experiences we have had. Heck, we even survived the great depression... though not unscathed for the generation that endured it.

Yet complex societies have collapsed in the past. The fact that this has happened in the past means that it can certainly happen again. I'm not talking here about Rome either, which took centuries to fall apart (Rome wasn't destroyed in a day). There is plenty of evidence from the past that complex societies simply... stopped.

But even if we collapse and turn into Mad Max Waterworld The Postman, the evidence suggests that we will eventually reform again and complex societies evolve again (the "Dark Ages" were not permanent).

So... be happy. Even if we go Mad Max, the world will eventually rebalance itself again. It might take 1000 or more years to do this though...

See Wikipedia: Societal Collapse.


From the ABC:
The Australian dollar is trading near Friday's closing price of 61.7 US cents this morning after suffering its biggest sell-off since it was floated in 1983 over the weekend.

On Friday the currency hit a five-year low against the greenback of just over 60.5 US cents.

CommSec analyst Juliana Roadley says the dollar could fall below 60 US cents.

"Here at CBA we are looking that it might move below 60 but moving into the new year, we feel it will stabilise around these levels at the moment," she said.

"There is a lot more water to go under the bridge before we possibly see stability coming back into the markets.

Ms Roadley says the dollar is being sold off as investors turn to stronger currencies.
The last time the Australian currency was this cheap was during the tech boom years of the late 1990s. International investors threw money into the Dow Jones and the Nasdaq because of America's healthy economy.

Now America's economy is anything but healthy - yet here we are with investors throwing money at the US Dollar. What gives?

The problem at the moment continues to be volatility. As this economic crisis has spread from the US to all developed countries and then to emerging economies, a set of dominoes is falling. Because a lot of these economies are smaller entities, investors are pulling out in fear and putting their money into something they can feel safe with for the moment - which is the US Dollar.

But I don't think that this is a long term thing. The amazing and unprecedented rise in the US Dollar is not an expression of the strength of the US Economy. Instead, it is simply what people are throwing their money into until things begin to calm down.

Moreover, the medium term chance of capital flight and a crashing US Dollar continues to be an increasing risk. The Yen and the Euro (despite the latter's devaluation) will be the beneficiaries of this process.

Remember - this crisis started in the US and resulted from poor US policies and US market failures. That such actions would eventually lead to a rush to BUY the Dollar was certainly not foreseen by me - but I still maintain that a drop in the US Dollar is a much more likely outcome than for its price to remain as is.

In terms of specific predictions, the US Dollar is very unlikely to go beyond 70 on the US Dollar Index once the crash occurs.


Down on the upside

A few random thoughts have been appearing in my head recently (probably due to all the painkillers I've been taking for the tonsillitis that has laid me low for the past few days). Some have turned into articles.

But here's a short one.

The economy is currently on a downslope, to put it mildly. America is going down, and so is the rest of the world. It's tempting at this point to view the frailties of non-American economies as they downward go.

But that's not where strength lies. In an open economy, strength will be shown on how the nations recover from this crash.

I'm pretty impressed with the Eurozone. They didn't create this crash - America did. But the Eurozone is getting sucked down into the whirlpool as well. Surely that shows how much Europe, well, sucked?

Not really. We'll see how much non-US economies don't suck not by their ability to be sucked into the whirlpool but by their ability to regain balance after the whirlpool stops. Methinks that the US will remain covered with silt while Europe and Australia and Japan begin to float on the surface.

Any more metaphors you want me to use?

Here's the reason for the picture.

Cliff Diving and its results

Calculated Risk has published this article:

Cliff Diving: Volvo Sales Plunge 99.7%

Talk about some serious cliff diving - from Thisismoney.co.uk: Volvo truck sales plunge 99.7% (hat tip Jonathan)

The depth of the recession was revealed today as truckmaker Volvo admitted demand across the Continent has crashed by 99.7% as it took orders for just 115 new lorries in the last three months.

That compares to orders totalling 41,970 in the third quarter of 2007.

It was Calculated Risk that invented the "Cliff Diving" meme in relation to plunging financial result sheets. At some point, though, a "cliff dive" ends with the diver splattering all over the ground (apologies to those whose constitutions are 8 or below). I'm pretty sure that a 99.7% drop in sales is more than a cliff dive. It's a splatter.

And we all thought that "Cliff Diving" was such a funny name. A pity that all that "cliff diving" is now leading to financial splatter.

Jobs gone. People poorer. We told you so didn't we?

Make sure you verify your sources

How domestic interest rates influence trade and production

Okay, here's some theory for you. Let's pretend things are going along fine - there's no second great depression heading our way and the markets are humming along the way they were over the last 10 years or so.

Now let's pretend that, for no reason whatsoever, that the Federal Reserve Chairman and the FOMC decide to raise interest rates from, say 4.5% to 8.5%.

And let's also assume that there is no inflation problem on the horizon. And let's also assume that congress won't fire the board and the chairman. And let's also assume that no political pressure is placed upon the Federal Reserve. In other words, the hike in interest rates stays.

So what will happen?

Well the first thing that would happen is that international investors will see the US Dollar as more attractive to invest in. A rise in the US Dollar is a given. But at some point, the rise will stabilise at an upper level. The rise won't create an ever-rising dollar, but will create a higher point of value.

The reason why the dollar is more attractive to invest in is twofold. The first is that raising interest rates to such a high level automatically causes dollar investments (like treasuries) to compete more effectively with other international investments. The second is that raising interest rates will have a restrict the growth in the money supply or even reduce it. Since money has value, the effect of reducing its supply will be to increase its demand and thus its price. In the international world, this would end up increasing its value.

The other thing to happen, of course, would be that the US Dollar could buy more imports while simultaneously restricting exports. Buying overseas goods would be a lot easier and exporting goods overseas would be harder if the US Dollar was set up so high.

But unfortunately this is where a lot of experts have ended their analysis. It goes like this:

High Dollar = More Imports = Less Exports = Current Account Deficit

and since:
High Interest Rates = High Dollar

High Interest Rates = Current Account Deficit

(Sorry about my Austrian aversion to mathematical formulas but I'm better at thinking axiomatically)

Let me just point out that whenever anyone examines an economic model, the best way to do it is to examine it dynamically. In other words, movements in equations need to occur.

Let me add a spanner in the works:

High Interest Rates = Drop in Aggregate Demand

and since:
Drop in aggregate demand = Less Imports = Trade Surplus

High Interest Rates = Trade Surplus

So rather than High Interest Rates leading to a higher current account deficit, such rates could actually result in the opposite - a current account balance or surplus.

At issue is this equation:

High Dollar = less expensive imports

but since:
High Interest Rates = Drop in aggregate demand

Net result = ??

And that's the question. If a nation increases interest rates - a process that reduces demand while making imports less expensive - then what will the net result be? Will it increase the demand for imports or decrease the demand for imports?

In the end, the price of the currency depends more upon the economy as a whole rather than just the interest rate paid on risk free securities. While higher interest rates would most certainly result in an short-term inflow of investment, it would also reduce aggregate demand, thus making other areas of the economy less likely to be invested in. So while risk-free securities might benefit (such as government bonds) other areas might be harmed (such as the sharemarket, property and corporate bonds). The result would have to be a net drop in overall demand, and thus a drop in demand for imports as well.

The way to determine this is to go overboard with interest rates. Let's say that, instead of raising rates to 8.5%, the Fed raised rates to 850%. This would essentially destroy all demand in the economy. For a short while, the currency would explode upwards but, as the interest rates murder demand, people would be investing out of the economy almost immediately. Eventually the currency would drop despite the high interest rates being offered.

Keep this in mind and then think about what would happen if rates were raised more realistically. There wouldn't be a shock death of the economy, but the effect would be contractionary. There wouldn't be capital flight, but some investors would see better opportunities offshore. Moreover, as time went by the price of the dollar would devalue somewhat to take into account the more attractive offshore investments.

I know this is all axiomatic and there's no equations being put forward here. But I will say this as a conclusion:

Higher Interest Rates = Movement towards Current Account Surplus

and thus

Lower Interest Rates = Movement towards Current Account Deficit

Thus if an economy has a current account deficit, raising interest rates will result in the current account swinging into balance. And if an economy has a current account surplus, lowering interest rates will result in the current account swinging into balance.

In practical terms, had the US had higher interest rates in the last 10 years, and if Japan had lower interest rates over the same period, the current accounts of these two nations would be more in balance, rather than being in deficit (US) or surplus (Japan).

(And it goes without saying that the Bank of Japan didn't help the situation by buying US treasuries over the past 15-20 years)



Yes, currencies around the world are dropping against the US Dollar... all except the Yen. This graph from INO shows how the US Dollar has dropped against the Yen since the latest market collapses. Japan is the largest foreign holder of US treasuries (source).

It is actually good in the long term for the Yen to go up in relation to the Dollar. Japan runs large current account surpluses while the US runs large current account deficits. A rebalancing of this situation will occur if the Yen appreciates over the long term.

In the short term, however, it is one possible avenue for capital flight. The market might just run away from the US and invest in the Yen.


Futures indicate around a 5-6% drop in the Share Market today. The market may even "trip" (cease trading for the day) because of the loss.

Wasted resources

For a classic example of wasted resources, look here.

Imagine if all that money had been used to create wind farms or solar farms or even to create biochar based forests from the desert.


I gotta say, the current state of the world economy is one of complete confusion. No one really knows what is going to happen and no one really knows when things will become less confusing.

I have written in the past about the danger that America faces in terms of Capital Flight. Yet now I see that emerging markets are going crazy and people are cashing out and... putting their faith in the US Dollar.

I still believe that capital flight is a danger - especially with a consensus emerging that the Federal Government should run deficits for a while to stimulate growth. As I have mentioned before, US government debt is one of the more alarming areas of the current crisis because it has yet to really bite.

But bite it will - that much I am certain of. What I am not certain of is its timing. It may be that (barring any miraculous fiscal turnarounds) the world may lose its love of the US dollar a few more years into the future.

By the way, I'm not trying to reinterpret my own predictions of doom and gloom in the face of mounting evidence against them. I'm happy to admit that the emerging markets crisis hitting now was something I did not foresee and which has added yet another missing piece of the final equation. Yes, I was thinking that the US Dollar might collapse within the next 6 months and I now severely doubt that prediction.

But I'm not through with predicting a US Dollar crash yet - not by a long way. The fact is that all the signs are there that the US Dollar doesn't deserve its current value. These include an economy in recession, low interest rates and mounting government debt.

So while I'm happy to say that I'm wrong about the timing, I'm happy to keep with the broad reality that a dollar crash must occur.

It's just that I didn't factor in some dominoes that are falling now. Moreover, the chances are that there are plenty of hidden dominoes out there waiting to fall.


Radiohead vs The Smiths

About 20 years too late, The Smiths have become one of my favourite bands. Here's Radiohead playing a version of The Headmaster Ritual. Highlights include Thom Yorke's bobble-head, Jonny Greenwood's pink shirt and lack of head, and Phil Selway's rather unique drumming style (and bald head).

Knock-on effects

This is not good:
Emerging market banking systems by contrast often need dollar financing not to support their portfolios of US assets but to support their domestic dollar lending.

And it is now clear that a broad range of emerging economies do need access to the international banking system to continue the kind of breakneck growth that they have experienced recently — and have been caught up in the recent “deleveraging” of the global financial system. The FT’s Garnham again:

Analysts said emerging market currencies were being hit as foreign investors pulled money out of developing regions, driven by liquidity pressures from the credit crisis. “There seems little now that the authorities can do to reverse the process of deleveraging that is taking place with financial institutions all contracting their balance sheets at the same time,” said Derek Halpenny, at Bank of Tokyo-Mitsubishi.

Hungary is scrambling for euros.

Ukraine’s government is scrambling for dollars and euros – both to back its currency and to cover the maturing foreign currency borrowing of its banks.

Pakistan’s government needs dollars.

Korean banks are scrambling for dollars.

As are Russian banks. And Kazakh banks. And Emirati banks.

In many of the oil exporters, the government was building up foreign currency assets (reserves, sovereign wealth funds) while the private sector (including many firms with close ties to the government) were big borrowers from the international banking system. In the Emirates there is an added complication: Abu Dhabi was the emirate building up its external assets, while Dubai was the emirate doing the most borrowing.

But across the emerging world, external bank loans have dried up – creating a scramble for foreign currency liquidity.
If America sneezes and the world catches a cold, what happens when America comes down with a dangerous case of the 'flu?

Another emerging market collapse seems to be underway (the first was the Asian economic crisis in the mid-late 1990s). My goodness, everything seems to be built on houses of cards.

OSO's debt watch

Here's something I might do on a regular basis - reporting US government debt.

Unlike the "Debt Clock" in New York, I'll be making a more judicious measurement.

For starters, while it is true that US Federal Government Debt is now nearly $10.5 Trillion, a substantial part of that debt is deemed as "intergovernmental holdings". I'm not absolutely certain how to describe what intergovernmental holdings are, but I am certain of one thing - it is government debt held by the government itself. This means that when intergovernmental holdings are paid off, the money simply goes back to the government. So when we look at the debt level, you can pretty much "write off" that section of debt.

As of today, however, US Federal Government debt held by the public is $6,189,647,424,005.11. That is approximately $6.19 Trillion. Debt held by the public is debt that the government has to pay out to those outside of government. It is thus a true measure of just how indebted the government is.

But numbers can mean anything. $6.19 Trillion sounds like a lot, but if GDP was $500 Trillion then this debt would be quite small. Moreover, GDP changes as the economy runs along, which means that an expanding GDP could actually make debt levels proportionally lower despite increasing in size. That's not been happening however. 2008 Q3 GDP is due to be released next week and should show a contraction.

Public Debt on 2008-10-20 was $6.19 Trillion

US GDP in 2008 Q2 was $14.29 Trillion

Debt/GDP Ratio: 43.32%
( [Debt / GDP] x 100)

Public Debt/Person: $20,264.04
(Public Debt / US Population)
(September 2008 resident population + armed forces overseas = 305,449,862 source)


America has no room for fiscal deficits

It says:
Wall Street rose more than 4 per cent overnight after US Federal Reserve chairman Ben Bernanke supported the implementation of another US Government stimulus package.

Dr Bernanke told a US Congressional committee that it should consider measures to help improve access to credit by consumers, businesses, and other borrowers, as the North American economy faces a protracted slowdown.
This is precisely the area that I differ with in regards to other econ-bloggers. A month ago I argued that the time had come to follow The Washington Consensus. This called for nations that in economic trouble to enact "fiscal policy discipline".

It's not as though I reject Keynesian policy at this point - in fact, I think the idea of running a deficit during hard economic times is an essential activity, all things being equal. The problem with this in America's case is that things are not equal.

It is popular for many econ-bloggers to remind us all of Hoover's mistake. Faced with the biggest economic collapse in history, Hoover exacerbated the situation by insisting on tax rises and spending cuts to ensure that the US government ran a balanced budget. At the same time, the Federal Reserve kept interest rates too high, making the situation even worse.

Thus, the logic goes, insisting on fiscal discipline during a recession is deadly. Paul Krugman thinks so, as does Ben Bernanke.

Well, allow me to disagree with the Nobel Laureate and the Reserve Chairman.

The situation the US finds itself in now is not completely analogous to the situation in 1930 onwards. For starters, the US in 1930 did not depend upon the actions of foreign investors as much as it does now. In 1930 (as far as I know) US treasuries were not being bought and sold by sovereign investors like the Bank of Japan or the Bank of England. Around $2.7 Trillion in US treasuries were owned by foreign investors - a number which represents approximately 20% of GDP.

The second problem that faces the US now is that public debt is already way too high. $6.06 Trillion in federal government debt is owed to the public - around 44% of GDP (and likely to get higher as the bailout, reduced tax revenue and contraction in GDP will increase that percentage).

Again, let me say that I am not against running deficits during recessions in ordinary circumstances. Hoover's decision to balance the budget was a wrong one, to be sure, as was ultra-tight monetary policy from the Fed in the 1930s as well.

But what I am saying is that the circumstances that the US is in today - namely already huge levels of public debt and a dependence upon foreign investors - makes the current economic crisis even worse. The fact that the US government already has unsustainable amounts of debt (due to a combination of Reagan and GW Bush) allows little, if any, room to move.

I have pointed out in earlier posts the danger of capital flight - when foreign investors flee from a country and, in the process, crash the currency. This happened to Russia and many Asian countries in the mid-late 1990s and the result for them was horrible. I vaguely remember the Russian central bank lifting rates to 100%.

If the US should increase its level of net government debt, the danger of capital flight will be increased markedly. There is every reason to believe that foreign investors' love affair with the US dollar might come to a sticky and bloody end if the US continues to borrow money to boost consumption.

Many might argue, however, that the US Dollar is too big to fall. The US Dollar is, after all, the world's reserve currency. All I can say to that is to look at the example of Enron or Lehman Brothers or Washington Mutual - huge companies that were in the top 30 biggest companies in the US. If these big companies can go bankrupt and collapse, then it stands to reason that international investors may eventually raise the level of risk associated with investing in the US, causing the Dollar to drop in response.

I have to say that too many American economists have been blinded by their Americocentricity - they have lived and studied so long within the US "bubble" that they are unable and/or unwilling to step outside of it and see the bigger picture. This is why Krugman and Bernanke - amongst others - are arguing so vociferously for more stimulus programs and bigger deficits. The fact is that they can't see how public debt levels are already unsustainable and the danger this poses both in terms of future fiscal restraint and US dollar values.

If capital flight does occur and the US dollar does crash, the result will be disastrous - what I often refer to as "financial armageddon". If you think the problems of the present are bad enough, they will be made 100% worse if the US dollar crashes.

Let me finish off here with a market example.

Let's say that Widgets Banking Corp, a nondescript but medium-sized efficient US bank, decides to purge itself of its debts, lay off half of its staff and cut costs. What would this do to its share price? Investors, seeing that the company has taken steps to minimise its losses, would reward this effort with higher share prices.

In the same way, if the US government made steps to purge itself of debts by slashing costs and increasing its revenue stream, international investors in the US Dollar would react by valuing the currency even more.

You see, the problem is that traditional Keynesian thinking has the government acting within a closed economic system. The problem is that the system is open. If the US government goes ahead with Bernanke's advice and runs even bigger deficits to boost consumption, the result is likely to be capital flight.

Frying pans and fire come to mind here.



I'm not a huge fan of American Football, but this article in The New York Times shows a fascinating development of how the game can be played.

From what I understand, the "standard" situation of two lines of big blokes facing off at one another and then having a group hug while someone else throws a ball backwards is being challenged by this new structure. The picture above (which is from the NYT article) shows the potential of the A-11 formation.

Basically put, the A-11 formation allows any player to become the Quarterback. This sort of formation, according to the NYT, allows 16,632 different scenarios of play, compared with 36 scenarios if done the "traditional" way.

The A-11 formation seems to also create a new breed of player - quick and fit as opposed to huge and inertial. This will also breed a new type of play, which will increase the speed at which the game travels.

As an outsider from Australia, I can't help but see this development as being comparable to Rugby Union and Rugby League. Both games, popular and profitable here in Australian and in other nations, reward teams that are quick and creative.

I personally think that this will bring about a sea change in American Football, so long as the rules don't end up being changed to prevent it.



Confused? Read about Lucky Ducky here.


Bush finally gets it right

From America's Finest News Source:
In a nationally televised address to the American people Wednesday night, President Bush called upon every man, woman, and child to spiral uncontrollably downward into complete and utter panic.

Speaking from the Oval Office, Bush assured citizens that in these times of great uncertainty, the best and only course of action is to come under the throes of a sudden, overwhelming fear marked by hysterical or irrational behavior.

"My fellow Americans, the time for running aimlessly through streets while shrieking and waving our arms above our heads is now," Bush said. "I understand that many of you are worried about your economic future and our situation overseas, and you have every right to be. Yet there is only one thing we as a nation can do in times like these: give up all hope and devolve into a lawless, post-apocalyptic, every-man-for-himself society."

"For those of you who have remained resolute in your belief that things will turn around eventually, I urge you to close your eyes, take shallow rapid breaths, and begin freaking out immediately," Bush added. "At this point, anyone who isn't scared to death needs to wake the fuck up—because we're screwed here."

Reducing Risk

Think back oh, I don't know, fifteen years. It's 1993. The world has just recovered from a recession and economic growth is finally on the up. But unemployment remains too high for comfort and people talk about a "jobless recovery" while a young(er) Bill Clinton begins to contemplate strategies for reducing public debt.

And Nirvana, of course, releases In Utero.

It was definitely a strange time. In Utero was released after the success of Nevermind catapulted Nirvana from alt-rock trendiness to mainstream success. Overnight a struggling band had become millionaires and the music world was changed forever. But... In Utero? What went on there? It wasn't as though the album wasn't a success - it was (it reached no. 1). Nevertheless there was a sense of disappointment that many new Nirvana fans felt. Gone were the Gen-X anger anthems, replaced by a depressed sense of self loathing that made the band more British than American.

In retrospect, however, In Utero is Nirvana's most critically acclaimed work. It has stood the test of time and is deservedly viewed by fans as the band's creative and musical peak. At the time, though, it was a risk.

Risk and reward are two very obvious and very common concepts that our society uses. Most of the time it is an unconscious decision. In the financial and economic world, however, risk is a quantifiable condition that governs how much should be lent out and at what terms.

And fifteen years ago, risk aversion certainly affected the economic world as it climbed out of a recession and into a jobless recovery. The early 90s downturn was not as vast or as damaging as the early 80s one, but it did serve as a reminder that even the best efforts of exuberant Reaganomics could meet natural limits.

But between then and now, something happened. First a tech bubble popped, leaving the US in recession in 2001, and then the subprime bubble popped in 2006, leading to a credit crisis in 2007 and then the proto-depression that we are going through now. At some point between 1993 and 2001, the market's ability to accurately measure risk disappeared. Yet no one seemed to learn and risk analysis went off the rails yet again as the housing bubble promised heaven on earth and delivered hell on earth instead.

You've seen people who get into destructive relationships and then, after a period of healing, enter into another destructive one? Well, that's pretty much what has happened in the last ten years with risk analysis.

I was interested to read at Mark Thoma's site today the story of Nassim Nicholas Taleb. Taleb said that Bankers “are not conservative at all; just phenomenally skilled at self-deception by burying the possibility of a large, devastating, loss under the rug”.

Taleb sounds, of course, like an angry Austrian - he doesn't use mathematical equations and Gaussian somethings - instead he uses what appear to be unprovable axioms and, from those, basically states that these people are idiots (more or less). Pre-2007 and Taleb was written off. Post-2008 and people are noticing.

One problem with modern understandings of how risk works is that often it is predicated upon historical performance. Take periods of economic growth and recession - the so called "peaks and troughs" that typify modern economic evidence. It is very easy to see these events in a closed system and as a cycle - which they are. What we may not be able to see, though, is the bigger picture. We don't factor in variables enough, resulting in a "Salient Oversight" that ends up like a sabot in an industrial machine, causing a sudden, damaging halt in the process. Taleb, along with many others, could see that the financial and economic machine was going to shut down painfully because the designers and maintenance workers of the machine - banks and financial institutions with complex risk-management equations - were blissfully unaware of their impending doom. The level of risk, therefore, was a lot higher than it appeared to be.

What do we do? If we're going to learn from the smoking, screeching machine that this economy has become, what policy goals, if any, need to be implemented?

The first area that needs to be worked on is the most obvious, and yet it is probably the least important - regulation. It was obvious from the outset that the entire financial industry became lazy during the late 1990s. Risk wasn't important while share prices soared. Instead of basic questions like profitability and p/e ratios and long term goals, the focus instead was upon candlesticks and lines of resistance and Fibonacci sequences. In other words, the focus of finance was upon the practice of finance, rather than the companies that needed finance.

Which is why the US economy then began to be mainly a "financial" economy - high share prices created paper profits which created higher share prices until a very impressive house of cards was built. Better regulation would certainly have helped the focus stay upon real-world measures of wealth and may have helped reduce the pain that many are suffering now.

But it is the second area that I want to focus upon here - the importance of interest rates in determining risk.

Whenever interest rates increase - and by this I am talking about the Federal Funds rate (or foreign equivalent) - the entire market for lending moves towards a more risk-averse environment. This is because, by increasing rates, the Federal Reserve is essentially increasing the competition for the investor dollar. Since US government bonds are (rightly) seen as a risk-free security, any increase in bond rates will make other forms of investment more riskier by comparison.

Conversely, whenever interest rates decrease, the environment becomes more risk-friendly. By lowering rates on government bonds, other forms of investment become more attractive.

So, in summary:
  • Increasing rates = less riskier investing.
  • Decreasing rates = more riskier investing.
I'm not one of these people who somehow sees debt and risk as being bad things - they're good things, but only when balanced with savings and safety. Just as over-borrowing and investment in high risk ventures can result in economic carnage, so can over-saving and investment in low risk ventures result in a low-speed, sluggish economy.

The issue here, though, is balance. The market should be allowed to invest in riskier ventures if it sees it as being profitable while also being given allowances to be conservative.

The problem, though, is when interest rates remain too high or too low. I have argued that since 2002, the Federal funds rate was too low. This resulted in negative real interest rates and the creation of the subprime bubble.

And because interest rates were too low, the market responded by investing in an area that seemed reasonable and profitable at the time, but was eventually proven to be too high a risk - the property market. Had interest rates been higher, and had real interest rates been positive from 2002 onwards, the chances are that the subprime bubble would have popped earlier or maybe not even formed at all. In fact, the higher the interest rate was, the less chance a bubble would've been formed in the first place.

All this goes back to what I have been arguing about the importance of maintaining value in a currency. As I said before, currency is unique in that it is both a unit of measurement and a commodity that is bought and sold. When money changes in market value, its usefulness as a unit of measurement is ruined. In practice, inflation forces the market to over-invest in high-risk ventures. By contrast, deflation forces the market to under-invest in ventures that are not very risky at all.

In order for the market to make more rational decisions, money must remain a stable and predictable unit of measurement while still being bought and sold as a commodity. To find the balance between risk-friendly and risk-averse, interest rates must act as a compensator to prevent the market from going too far in either direction. Absolute Price Stability (neither inflation nor deflation over the long term) should therefore be seriously considered as the means by which central banks run monetary policy.

Risk will always be a part of modern financial investment and behaviour. As I have said before, risk is not wrong - but too much of it is. Neither is conservative investment wrong - but too much of it is.


Looks like this:

I'm no financial/market maven. I think candlesticks are useful when there's no electricity, lines of resistance are guerilla tactics and Fibonacci is an Italian fashion designer.

But I would hazard a guess that, at present, no one knows what the heck is going on.

And it's also very interesting - like being a gawker at a recent traffic accident.



That's where I'm taking my sister today for a drive. I'm sure you can all stand not to read anything serious and economic from me today surely?


Berserk Market Behaviour

U.S. stocks staged the biggest rally in seven decades on a government plan to buy stakes in banks and a Federal Reserve-led push to flood the global financial system with dollars.

The Standard & Poor's 500 Index rebounded from its worst week in 75 years with an 11.6 percent advance, its steepest since 1939, and the Dow Jones Industrial Average climbed more than 936 points. Morgan Stanley soared 87 percent after sealing a $9 billion investment from Japan's Mitsubishi UFJ Financial Group Inc. Alcoa Inc., Johnson & Johnson, Chevron Corp. and Prudential Financial Inc. posted their biggest gains since Bloomberg began tracking the data. Europe's benchmark index climbed 10 percent, its best jump ever, and Asia's added 3.1 percent.

``The worst of the immediate danger is past,'' said Bruce McCain, chief investment strategist at Key Private Bank in Cleveland, which manages $30 billion. ``It's always easier when you've got markets going up and you're not having to talk clients back in off the ledge.''
I don't know who this Bruce McCain is but his words might just come back and bite him so hard on the bum that he won't be able to sit down on his financial seat.

Volatility is the key here. This incredible market rally is a result not of certainty, but uncertainty. I would prefer a week where the market advanced or contracted not more than 0.5% per day. That sort of behaviour would indicate a return to normalcy, not a financial roller coaster ride.

The reality is that the US economy is still contracting, unemployment will continue to grow and houses will continue to foreclose. Today's rally does not presage a return to normalcy, nor does it indicate that the worst is over.


More thoughts on money

These thoughts and axioms arrived in the shower a few minutes ago:

  • Money is unique because it is both a unit of measurement and a commodity that is bought and sold.
  • Paradoxically, its role as a commodity ensures that it is an unreliable unit of measurement because its value is determined by the marketplace.
  • When the market devalues the price of money, it is experienced as inflation. While inflation has many causes, all forms of inflation involve money devaluation.
  • When the market revalues the price of money, it is experienced as deflation. While deflation has many causes, all forms of deflation involve money revaluation.
  • When there is neither inflation or deflation, the supply of money matches demand.
  • A central bank has a monopoly in money creation - no other organisation has the ability to supply money to the marketplace (commercial banks are merely one means by which the central bank supplies money to the marketplace)
  • While the market can determine the demand for money, central banks can ultimately determine supply.
  • Unlike most goods and services, money is infinitely fungible.
  • Central banks have the theoretical power to create an infinite amount of money if required.
  • Central banks also have the theoretical power to remove all money from the money supply.
  • It is theoretically possible for central banks to supply as much money, or as little money, as the market demands.
  • It is theoretically possible for the value of money to remain constant, given the power of central banks to increase or decrease supply in response to market demand.
  • The only time money can succeed as both a unit or measurement and a commodity that is bought and sold is if its value remains constant.
  • Absolute Price Stability (neither inflation nor deflation over the course of the business cycle - money remaining at a constant value) should therefore be the only reasonable monetary goal of central banks.
  • An economy running Absolute Price Stability should prevent endogenous economic shocks from occurring.
  • An open economy running Absolute Price Stability is still exposed to exogenous economic shocks.
  • A single unit of currency whose value remains constant should provide superior net economic results than a series of different and competing currencies whose values do not remain constant.
  • A single international currency and international central bank committed to Absolute Price Stability will be the first step in me conquering the world and making a one world government! mwa ha ha!! would be, um, good.


Join together?

The phrase "The bigger they are, the harder they fall" may ring true often, but it depends upon how "big" is defined. If "big" means tall, then certainly a taller structure with more mass than a shorter structure is likely to crash harder. But if "big" means broad, then a wider structure with more mass than a smaller structure of the same height is more likely to survive.

A good, but sad, example of this is to compare the World Trade Center with the Pentagon. The World Trade Center had around 800,000 m2 of floor space while the Pentagon has about 616,000m2 of floor space. That's not entirely comparable, but the fact was that two airliners were able to completely demolish the WTC while one airliner was never able to demolish more than a small percentage of the Pentagon. The reason? The WTC was tall, while the Pentagon is wide.

So when it comes to examining the current economic crisis, what will happen? Is the US economy "tall" and thus prone to a systemic collapse, or is it "broad", and thus able to resist the current crisis more or less intact?

Yet the answers to those questions can quite often ignore other important facts - namely that the "small" structures will get hurt, no matter how comparatively tall or broad they are - and I am referring here to the world's smaller entities. Like poor Iceland for example, whose economy has collapsed and suffered capital flight despite the fact that the country was merely an innocent bystander.

The genesis of the Euro was, in part, to the effects of Black Wednesday in 1992, when the European Exchange Rate Mechanism was unable to withstand market pressure. While the Euro had been proposed for a long time, the effects of Black Wednesday spurred mainland Europe on towards the adoption of a single currency (while the opposite effect occurred in the UK). Since its complete adoption in 2002 by many European nations (now called the "Eurozone") the Euro is one of the three most important currencies on the planet with the US Dollar and the Japanese Yen. Moreover, the Eurozone itself has a higher GDP than the US, which means that the Euro is associated with a larger economic area than either the US Dollar or the Yen.

The creation of the Euro and the Eurozone is an example of smaller nations banding together to create a single economic unit. This obviously has advantages and disadvantages, but one advantage it does have is a better ability to withstand economic shocks. If the Euro and the Eurozone did not exist, and if European nations still used Francs, Lira, Marks and Punts then the current crisis would've hit Europe harder. As it is, the crisis Spain is in now is being distributed throughout the entire Eurozone rather than just hitting the Spanish. Conversely, the crisis Iceland is in now would have been avoided had icelanders adopted the Euro. Accession to the Eurozone and the adoption of the Euro is now very much on the Icelandic agenda, despite the horse having already bolted.

This joining together of national interests for the common good is an example of making the economy broader rather than taller. Spain's crisis is a crisis for the whole EU, but, because the crisis is smaller in comparison to the rest of the Eurozone, the crisis is far more manageable. Since Spanish households, individuals and businesses have got Euro bank accounts, their deposits and savings are safer than if they had remained as Lira. This has been to the detriment of other members of the Eurozone, of course, but the overall net result of a common currency is greater than if these countries retained their national currencies.

The current crisis will certainly cause many nations to reconsider their financial independence. Since international trade is so important to all economies of the world (with the exception of places like North Korea or Pitcairn Island), the importance of maintaining economic balance should eventually outstrip any desire to keep national currencies.

What is not debatable at the moment, nor once the crisis is over, is whether the supranational Eurozone is superior to America's US Dollar. Even though the crisis started in the US, the subsequent economic performance of the Eurozone or the US will not settle any questions over which one is superior. The reason is that the US does have a "broad" economy that will eventually recover, even though it is a single national entity.

One thing that will be proposed once the crisis is over is the adoption of a single international currency. While this may scare some Americans who would begin to babble about conspiracies and The United Nations and UFOs, the idea certainly has merit - the broader an economy gets, the more likely it is that economic shocks can be contained or prevented. In reality, though, such an event is unlikely to happen during my own lifetime, let alone during the 21st century - national identity is still going to be important to many people, and that includes financial sovereignty. The crisis will probably help spur some Eastern European nations, Iceland, Switzerland, Sweden, Norway, Denmark and maybe even the UK, Turkey or even some North African nations to join the Euro but that would be the extent of any supranational economic reactions to the current crisis.

What will occur in light of the current crisis will be a series of international economic agreements - especially ones that set up common policy requirements for how central banks operate. If the US Federal Reserve, the European Central Bank and the Bank of Japan (US Dollar, Euro, Yen) all had common policies (ie common inflation targets and common responses to monetary conditions) then the international marketplace would be a much safer and more predictable place to invest money. If other nations joined this agreement, then conditions would become safer still - and that is what the world really, really wants at the moment doesn't it?


A solution to our problems

Scared yet?

From here.

Capital Flight is now being discussed

My statement in the previous article that "the only reasonable conclusion is deflation" is taking a hammering now that I'm looking at other blogs.

Krugman quotes from another blogger:
"Is this the beginning of the end for the dollar and the Treasury market? Is this the first sign of the bursting of the bubble in Treasury securities? That market, in a sense, represents the ultimate bubble as it exists at the whim and caprice of foreign investors, who have as participants in a Faustian bargain, financed our war(s) and our lifestyle so generously over the last decade. Maybe even that bizarre construct is crashing about us as we speak."
And responds:
Maybe I should be drinking something a bit more … calming .. than coffee right now.
This afternoon I co-led a forum on the financial crisis with my Evergreen colleague Peter Bohmer. I had a flash as I was preparing: at some future point we could be in for a reverse tsunami.

Here’s the idea: A real tsunami begins with an outward flow of water. If you’re standing on the beach and suddenly the water line retreats 10 or 20 meters, it’s time to race for higher ground. Now consider the opposite phenomenon. The massive Fed/Treasury spending spree to hold the crisis at bay, thus far unsuccessful, is being financed by a massive capital inflow. Some of this comes from foreign CB’s eager to do their part, but a big part is the result of global capital flight to the supposedly least risky currency. Suppose we get out of this alive and calm returns to the markets. Most of those people are going to want to bring their money back—that’s the reverse tsunami. How do we finance that? The Fed’s balance sheet will be wall-to-wall junk.

Housing Doom also points out
that foreign central have swapped agencies into treasuries. Apart from abandoning things like Freddie and Fannie bonds (which deserved to be abandoned), the stage is now set for any foreign central bank to pull out of America. All they need to do is sell the bonds and buy Yen or Euro or whatever.

If Krugman's worried - so should we be. Maybe now is a good time to panic.

Economic Crises still need price stability

I admit it - I'm not an inflation hawk, I'm an Inflation Mushroom Cloud Layin' (insert crass Oedipal phrase), (insert crass Oedipal phrase)!

I have spent the last few years arguing on this blog of the necessity of controlling inflation over and above what many policy makers would think is reasonable. On my own I developed the theory of Absolute Price Stability, which is the #1 Google search for the phrase, even though others had actually invented the idea long before I did.

To quickly summarise what I have said (in case you haven't been turned off yet by my recent goings-on about it), I believe in the following axioms:

  • The value of money is solely due to its ability to determine the cost of goods and services and to be used as a way of exchange. It is a way of measuring the worth of economic activity in a quantifiable manner.
  • Over-investment and under-investment bring about economic harm to a society.
  • Investment in the wrong place and the failure to invest in the right place also bring economic harm to a society.
  • When the value of money changes, the market (as households, businesses, individuals and government) will inevitably make poor decisions in regards to what to buy and sell, and what to invest in and borrow for.
  • While the market will always be prone to errors in judgement, ensuring that the value of money remains constant will help minimise this risk.
  • In order for the value of money to remain constant, monetary policy should now be focused upon Absolute Price Stability - whereby the value of money is affected neither by inflation nor by deflation.
  • In practice, Absolute Price Stability is not about price fixing, but inflation fixing. Monetary policy should always ensure that neither inflation nor deflation permanently affect the value of money over the long term. Short term experiences of inflation and deflation are to be expected, but over the long term, monetary policy should ensure that money's average value remains constant.
At present the economic world is suffering a massive credit crunch. In the past I have argued that inflation will continue to bedevil the world even though a recession takes place. I was wrong. I was predicting a different recession to the one now being experienced. Moreover, the one being experienced now is far more dangerous because it now seems to be an unwinding of the entire financial system that the world has been operating for decades. In this sense, the recession was always going to arrive. Moreover, two of the conditions of the recession that I was predicting (fiscal irresponsibility by the US government and the effects of Peak Oil - see here) are still major threats that need to be taken into consideration.

Absolute Price Stability, however, doesn't just mean no inflation. It also means no deflation. Financial conditions have deteriorated so badly in the last month that the only real result will be deflation.1 While the stupidity of the Fed between 2002-2005 and the fiscal ineptitude of the White House and Congress between 2001-2008 has allowed inflation to grow, we are now seeing the results of those decisions - essentially what goes up (inflation) must come down (deflation).

If the Consumer Price Index begins to show increased deflation (as I think it will - the September figures are due soon) then the only real solution is for the Fed to begin seigniorage - money creation. This is the emergency solution that Ben Bernanke has written about previously, from which he derives his nickname "Helicopter Ben" - the idea being that deflation can be solved by simply throwing money everywhere.

In theory, a central bank can create and control an infinite amount of money. Bernanke and others in the Fed could, if they choose, create $100 Quadrillion dollars out of thin air. The idea that deflation can't be solved is incorrect.

And this is where Absolute Price Stability comes in. If this sort of policy is introduced, the Fed (and other central banks) could quite easily control deflation by creating money and buying back bonds. This would not be done randomly or stupidly - the last thing we need is a Weimar America - but certainly the sterilizing effect of deflation can be balanced through judicious seigniorage. In fact, some of this money creation could be used in the form of stimulus checks or given to the unemployed - it doesn't have to go towards corporations or financial firms.

I'm saying all this not just to push my idea of Absolute Price Stability (which I think will help solve the current crisis and prevent many from occurring ever again) but also to point out that while I have described myself as the "Inflation Mushroom cloud laying (insert crass Oedipal phrase), (insert crass Oedipal phrase)!", the reality is that I am just as opposed to deflation as inflation. I am not advocating some form of permanent deflation - that would be crazy - but instead the belief that money itself is best used when it retains its value.

Moreover, I believe that such a policy is best practised universally. There is only one country which practices Absolute Price Stability and that is Japan (Mark Thoma confirmed that with me once on a comments thread at Economist's View) - yet Japan is sliding into recession too. The reason is that Japan, despite practising Absolute Price Stability, is strongly connected to the world market - which means that a problem in the world market will also affect Japan. But if all countries practised Absolute Price Stability - and made it into an international treaty - then the world would be far less likely to suffer the sort of upheavals that we are experiencing now.
1 - Unless the US Dollar crashes of course (see Krugman!). But let's ignore that for a moment.


Title of post


Dow 3600.00?

Well it's certainly been a fun day on Wall Street today. All sorts of records are being broken... but none of the good ones. Yet there is a sort of Hubris going on.

Take the book Dow 36,000, released in 1999 during the tech boom. That book examined the economy at the time and pretty much came to the conclusion that the good times will never end and a Dow Jones Industrial Average (DJIA) of 36,000 was entirely possible within a few years.

Well, the DJIA never did reach that mark... and today it fell 678.91 points (-7.3%)  to 8579.19.

Dow 36,000? More like Dow 3600.00!


Crisis prevention in hindsight

I'm in dot point mode today. Let me start with this one.

  • If interest rates were higher in the past, the current crisis would not be so dangerous.
  • If interest rates had been higher for the past 2-3 decades, this crisis would have been averted entirely.

Now, why do I say this? Well, let me just point out one important fact:

  • Higher interest rates lead to higher rates savings because money becomes more valuable in relation to the goods and services it is exchanged for.

That, of course, is a point I argued in yesterday's post. Now one of the great ironies of economics is that problems are often solutions, and solutions are often problems. Sometimes in order to prevent something from occurring, you need to encourage it to occur. Now that might seem strange, but let me point out another important fact:

  • The current crisis is occurring because the market has now decided to start saving.

Yes, that's right. The US economy has decided that it has had enough with spending and it has now decided to start saving. It has decided that it has had enough of borrowing.

But hang on! If I've been arguing that higher interest rates and thus increased savings rates would have prevented the crisis, am I now saying that the current crisis is due to increased saving? Well, yes - the solution is often the problem.

But let me explain this further. Imagine if the current crisis could be diluted somehow - so rather than one enormous credit crunch and market crash hitting now, that somehow this pain and misery could have been stretched out and diluted. If we give a 20 year time line, for example, imagine if this economic crisis was broken up into 20 pieces and then issued to each year of the past 20 years.

Keep that thought in mind - and that is what higher interest rates would have done.

Look at the following graph. This graph shows the effective federal funds rate (interest rates) in blue, while inflation is in red:

Now let's imagine that interest rates were higher since 1980. This would result in a negative relationship with inflation, with interest rates going up and inflation going down. In terms of the graph the blue line would be higher and the red line would be lower.

But I would argue that had monetary policy been more stricter, and inflation been lower, since the end of the 1980s recession, the result would have been, at the very least, mild recessions in the early 1990s, early 2000s and the one occurring now. In fact, those three recessions might well have never occurred.

And that is why I am an inflation hawk. A recession is always a period in economic history when, for whatever reason, the market rushes back to save money. If interest rates were higher and inflation rates lower, the market would never have needed a recessionary correction in the first place. The price to pay for this would be lower GDP growth but, in hindsight, that is a good thing. So here's another dot point:
  • Higher interest rates = lower inflation = lower GDP growth = less chance of a recession.
Over the years many central banks have instituted inflation targets. While the Federal Reserve did not have one, in practice the Fed did raise rates when inflation approached 4% or more.

But if we assume that recessions could have been reduced in severity or even completely negated if interest rates were higher and inflation rates lower, then the usefulness of inflation targets needs to be reassessed. In hindsight, it now seems clear that these inflation targets were actually too accommodating.

And that leads to my last dot point for today:
  • Absolute Price Stability - an inflation rate that averages zero over the course of the business cycle - should be the ultimate goal of monetary policy.
For regular readers, you saw that coming didn't you?

This morning as I lay in bed I was listening to comments made by some person from The Daily Telegraph, one of Rupert Murdoch's tabloids here in Australia. In the past year or two, the Tele has been waging a war against the Reserve Bank. The person on the radio this morning spoke disparagingly about the usefulness of monetary policy, saying that it was a crude tool like a hammer. He also said that monetary policy was relied upon too much in the past and is no longer working.

In the current crisis, monetary policy has only limited usefulness - that much I agree with. But I would argue strongly that the age of monetary policy is not over yet. Monetary policy is not intended to "solve" any crises, but to prevent them from occurring in the first place. Moreover, the current crisis was not due to an inherent failure in monetary policy, but a failure to use monetary policy wisely.

To use an analogy - the car has crashed and people are lying dead and injured. People like me who support monetary policy would blame the driver. Others who disparage monetary policy blame the design of the car.

In the midst of the current crisis I am absolutely certain that no government or central bank has the ability to stop the market stampede. Steps can be made to reduce the pain, but this crisis cannot be solved. What we can do is learn from it to ensure that no similar crisis occurs again.

Absolute Price Stability is a way to ensure that such a crisis never repeats. If this monetary policy was implemented worldwide, the result would be a stronger and more sustainable international economy.