The events leading up to the coming downturn

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).

The magical GDP Deflator

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.

Bernanke's money printing idea is interesting - but I have a better one

I'm no fan of Federal Reserve chairman Ben Bernanke. Bernanke's response to the 2008 credit crisis was to first state that it wasn't happening and then, when it happened, to say that it wouldn't be too bad. Fail. Moreover he was one of the members of the Federal Reserve Board under previous chairman Allan Greenspan who approved of policy keeping interest rates too low between 2002 and 2005, thus creating the conditions for the property bubble. Epic Fail.

But credit where credit's due - the recent announcement of $600 billion in bond repurchases is a step towards a more effective form of monetary policy, though I do question whether it is needed.

Bernanke has the dubious honour of being labelled "Helicopter Ben" because of some comments he made many years ago about how radical monetary policy could have solved the Great Depression. Given the damaging, persistent deflation during that period, Bernanke surmised that increasing the money supply by seigniorage (money printing) and then handing said money out willy nilly to people and businesses would have wiped out deflation and stimulated the economy to begin growing.

Of course those who ran the world economy in the 1930s did not have the information that we do now, namely that inflation and deflation can be controlled through manipulation of the money supply by central banks. The problem with conventional monetary policy is that it focuses solely upon interest rates to achieve its goal - in the case of the United States, adjusting the Federal Funds Rate is the way interest rates are raised or lowered. Developed countries have similar tools while developing countries tend to increase or decrease the reserve ratio as a way to influence monetary conditions.

Adjusting interest rates affects the money supply: Increasing interest rates will remove money from the money supply while decreasing interest rates will add money to the money supply. If a central bank wants to reduce inflation, it removes money from the money supply by raising interest rates; if a central bank wants to increase inflation (to prevent deflation), it adds money to the money supply by lowering interest rates.

Unfortunately, conventional monetary policy is constrained by the natural limits of interest rates. While there are no upper limits to interest rates, the lowest rate is obviously zero. You cannot have negative official interest rates because depositors will simply withdraw their money from banks - hiding cash under the bed is a better investment than keeping it deposited at the bank. When interest rates reach zero there is nothing conventional monetary policy can do to stimulate domestic demand - Japan is a classic example of this, with interest rates near zero for the last 15-20 years.

The Federal Funds rate is currently 0.20%. It has been below 1% since 2008-10-15, which means that the US has, for the past two years, reached the limit of conventional monetary policy. Enter Ben Bernanke and quantitative easing, and you have a radically new monetary policy tool.

The thinking is rather simple:

• To create more inflation, the money supply needs to be expanded.
• Since conventional monetary policy has reached its limit, no more money can be added to the money supply through the lowering of interest rates.
• Therefore money needs to be added to the money supply through different means.
• Seigniorage (money creation by fiat) is then used to buy back government bonds, thus increasing the money supply.

Seigniorage has been used injudiciously in the past, most notably by Weimer Germany and Mugabe's Zimbabwe, and has created hyperinflation. Yet this is the same process Bernanke is undertaking now. The difference is that the amount being created is limited, which means that the inflationary effect will be similarly limited.

But there are naturally limits to even this level of monetary policy - it is limited by the amount of government bond holders (US treasuries). While the amount of money currently tied up US government debt is huge (over $9 trillion in public debt), in theory this amount may be brought down to zero. This is an important limit for nations like Australia and Norway, whose gross government debt levels are comparatively low (and are actually net negative). Such forms of quantitative easing (as this policy is now known as) do have natural limits that need to be taken into consideration.

So what's my idea then?

Back in March 2009 I wrote an article titled Thoughts on fractional lending and quantitative easing which outlined some ideas I had at the time about unconventional monetary policy. Here it is:

The Central Bank creates money by lending it to Commercial Banks.

This would take the form of a deposit. The central bank creates money by fiat, and then deposits this money in as many banks and financial institutions (institutions that are part of the fractional banking structure) as it can find. This won't be a bond buyback, but a simple deposit. It is not important as to whether the commercial banks pay interest on such a deposit since paying back interest is not important - expanding the money supply is.

Of course, with more money deposited, commercial banks would then have more money to lend out, thus alleviating any credit crisis. There is no money entering the money supply via any bond buybacks or stimulus plans. It's simply money appearing by fiat and being deposited into banks.

But what happens once the economy begins to recover, credit begins to flow again and inflation begins to rise? Well obviously the central bank could then withdraw all or part of its deposit with commercial banks. This would reduce the amount of money commercial banks could lend out and act as a contraction of the money supply.

And then I got thinking again - what if this form of quantitative easing replaced current monetary policy completely? So rather than money being removed or injected into the money supply through bond issues or buybacks - why not simply have the central bank deposit money into commercial banks or withdraw money from its commercial bank accounts? It would still be an open market operation, but one which doesn't require a government bond market to exist or even some form of centrally set level of interest - rates would be completely market controlled and dependent upon how much money the central bank deposits into, or withdraws from, commercial banks.

So, to summarise:

To stimulate growth in the money supply (to battle deflation and thus stimulate economic growth), the central bank creates money by fiat and deposits it into commercial banks.

To restrict growth in the money supply (to battle inflation and thus restrict economic growth), the central bank withdraws money from its commercial bank accounts.

In both cases, the money supply is affected by the ability of the commerical bank to lend up to 100% of its deposits - the more deposits, the more money is lent; the less deposits, the less money is lent.

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Naturally, Paul Krugman and others will point out that increasing the money supply during a solvency crisis does little (the "pushing a string" theory) and I would agree that some level of Keynesian stimulus might be necessary, but one which sources its money from central bank money creation rather than by borrowing from the market.

In this scenario, instead of Bernanke's $600 billion being used to buy back government bonds, it is used (for example) to build wind turbines all over the country. It is monetary policy (money creation) AND fiscal policy (increase in production) acting together, and it is aimed at bettering the environment. Of course the $600 billion could be used to build tanks and machine guns for the army, or it can be used to buy everyone in the US multiple cans of Coca Cola, or it can be used to build mansions for the rich, or it can be used to build houses for the poor - the possibilities are endless, as is the potential for both intelligent or stupid spending.

What makes standard Keynesian fiscal policy work is twofold: firstly, money is injected into the economy, and, secondly, goods and services are produced, leading to a multiplier effect. Modified forms of Keynesian stimulus - such as Bush's tax cuts in the early 2000s - have only a single effect, namely money is injected into the economy. Monetary policy, even of the unconventional (quantitative easing) or radical (my March 2009 proposal) variety, has a similar effect: money is increased, but its demand (money velocity) is not. What the market does with the money after it has been gained depends upon how the market is acting, which is why monetary and/or fiscal stimuli do lead to some level of economic growth, but not as much as that enjoyed by a true Keynesian injection.

So the question comes down to this: what will the markets do with the $600 billion that Bernanke injects into the economy through "QE2" (as many have called it)? That, of course, is the issue. Will the markets use that money to invest back into the US economy or will they do something else? The markets have already reacted to the announcement by dumping some of their US dollar holdings, so it may be that QE2 just leads to a dollar devaluation, with the fiat money instead being directed towards Japan, Europe and other major economies. Here in Australia the dollar has breached parity and made buying CDs and books from Amazon.com that much cheaper. Thanks for stimulating the Australian economy, Ben.

But then all this goes back to whether the money supply should be increased. While US inflation is low (currently 1.14%, year on year) deflation is hardly a problem just yet. Deflation hit the US economy very hard in late 2008 when the credit crisis hit, but since then prices have stabilised somewhat. Paul Krugman and others would argue that the US should actually target 4% inflation as a goal rather than as a limit, in which case Bernanke's policy is heading in the right direction. Interest rates have certainly bottomed out, but where is the deflation that can't be influenced by conventional monetary policy?

And this therefore calls to question the reason for quantitative easing. Is Bernanke aiming to stimulate the US economy or is he simply trying to maintain price stability? If it were the latter, then Bernanke is crazy since the US doesn't have a problem with price stability at the moment (unless you adhere to absolute price stability like I do, of course, but that's another topic!), which means that QE2, as an inflationary policy, is being implemented when prices are not in danger of deflating. This can only mean that Bernanke is aiming to stimulate the US economy, and this is problematic.

Who in government should be responsible for direct actions to stimulate the economy? In most nations this responsibility is undertaken by politicians - in other words, elected officials. The Federal Reserve Bank is not run by elected officials but by public servants. Most central banks the world over see price stability as their major, if not sole, concern. Stimulating economic growth should not be the role of a central bank, though central banks should be open to being co-opted by governments to produce outcomes aimed at stimulating growth (an example being my proposal of Bernanke's $600 billion being used to build wind farms above). But if any policies are pursued to stimulate economic growth, they must originate from, and be ultimately controlled by, congress or parliament or diet or duma.

The problem with having a dual role - as the Federal Reserve obviously has - is that it is more open to corruptive influences. "Stimulating the economy" may mean dumping $600 billion into the accounts of troubled financial giants whose incompetency is what drove them to the verge of bankruptcy; it's not a coincidence that these financial giants just happen to own a considerable number of US treasuries that they can sell to the Federal Reserve Bank for the $600 billion being offered. If the Fed was only concerned with price stability they could simply ignore these troubled corporations and only respond to price signals from the Consumer Price Index.

Nevertheless QE2 does open the doors to monetary experimentation, which should be welcomed by those who have been concerned with the limits of interest-rate-based monetary policy.

Update 00:15:00 UTC

If $600 billion were used to build wind farms, the result would be huge. The Cape Wind project will produce 454MW for $2.5 billion. Using simple maths, $600 billion could buy 253.34 GW of nameplate electricity generation. Since the US has around 1075 GW of nameplate electricity generation, you're looking here at 25% of the US electricity market. Obviously these are hard and fast facts and there are certainly limitations to this form of extrapolation, but the sheer amount of money involved here needs to be subject to opportunity cost: would $600 billion of fiat money be better spent constructing wind turbines or injected into the US bond market?

Krugman's inflation suggestion: not a good idea

Paul Krugman is good man. He's brilliant too, and deserves that Nobel Prize he got. Moreover he and I both warned of the coming economic crash. So I respect him.

But since 2008 our paths have diverged. Krugman and Joseph Stiglitz, brilliant though they are, are arguing that a dose of inflation is needed to recover the economy. In the other corner lies OSO, Kenneth Rogoff and those who run the European Central Bank, who argue that price stability must be maintained whatever the circumstances, and that efforts must be made to reduce sovereign debt levels.

One of Krugman's arguments of late is that increasing the money base won't help the economy to recover and points to the experience of Japan, who increased their monetary base back in the 90s without seeing an commensurate increase in inflation (at least not enough to reduce deflation). Money printing will not work during a solvency crisis he argues.

Maybe I'm a little too monetarist to agree with Krugman here. My response to the idea that money printing won't lead to inflation is to naturally point at Mugabe's Zimbabwe and Weimar Germany. Certainly these two examples are extreme but they do provide an extreme example of what can happen if governments resort to seigniorage to fund government spending. You can be assured that if the US government organised a similar scheme with the Fed the result will almost certainly be the same. Moreover, had Japan in the 1990s followed the same policy (Mugabe Zimbabwe/Weimar Germany money printing) the result would've been the same.

So how do I explain the facts around early 90s Japan that Krugman uses as evidence? It's simple: Japan didn't increase the monetary base enough. Erring on the side of caution and concerned that they didn't want hyperinflate, Japan's increase of the monetary base was simply too small to make any impact on M2. Since a central bank can theoretically create an infinite amount of money, nothing really prevented Japan from increasing the monetary base beyond what is shown on Krugman's graph.

This is important to realise because I believe that a new system of monetary policy needs to be created, using some of the more radical monetarist ideas of years past. Moreover, unlike Krugman and Stiglitz, I would argue that the inflation target should not be "high" (Krugman argues for 4% inflation) but should be even tighter than what was practised over the past 30 years. Absolute price stability (whereby there is neither inflation nor deflation over the long term) should be the new goal, and it is something that I have been presenting as a solution for some years now. Certainly at the outset of the financial crisis I asked the question of whether the current system needed to be changed. It seems that the thinking of progressive economists has been "yes", but in the opposite direction to what I would argue.

I had assumed that the question of whether inflation was good or bad was solved once and for all by Paul Volcker, who ended the stagflation of the 70s by raising US interest rates and killing off inflation - a process which put the US into a deep recession but which resulted in a low inflation recovery. Moreover I also remember the post-war commitment to Ordoliberalism in West Germany, which created the Wirtschaftswunder - and the importance of low inflation in creating an effective post-war nation.

My argument is this: the closer an economy gets to price stability, the more scope there is for sustainable growth. Conversely, the further away an economy gets from price stability (and that includes persistent inflation as well as persistent deflation), the more scope there is for something to go wrong.

Of course money isn't the real issue. The real issue is the production of goods and services and, according to Robert Solow, the ability to make them more efficiently over time (the cheaper production of goods and services over the long term leads to real economic growth). Money is important - it is essential - but how an economy produces & consumes and invests & borrows depends upon whether price signals are accurate or not. Of course no economy is perfect and people with money will not make rational decisions - but when money retains value over the long term, people are less likely to use their money for irrational purchases or investments.

As I have pointed out years ago, there are three things to remember about money:

1. It is used as a unit of exchange to purchase goods and services.
2. It is subject to the laws of supply and demand.
3. It is used to measure relative worth.
   

The problem arises when the effects of 2) interfere with the need for 3). If the value of money changes - either through the process of inflation or of deflation - then it no longer functions effectively as a way to measure relative worth.

As an example of this problem I remember reading the biography of Allan Border in which he purchased a car in the early 1970s for around $300, and then sold it in 1978 for the same amount. Of course in the intervening years the level of inflation was quite high, which meant that while he may have felt he had done well in not losing any money in selling it, the reality was that the depreciation of the value of his car matched the depreciation of the value of the currency he used to buy it in the first place.

Of course these arguments seem to be axiomatic - logical presentations without the influence of hard data - and I admit that this is a failing except in two areas: The effect of low inflation in post-war Germany to help create the Wirtschaftswunder; and the need for Paul Volcker to destroy inflation in the early 1980s to bring about a more sustainable economy.

Aiming for higher inflation, as Paul Krugman argues, is exactly the wrong thing to do. It may result in some level of growth but over the long term it will erode America's economy even further. Price stability must be maintained no matter how good or bad an economy is running. It is non negotiable. Economic problems can't be fixed by abandoning price stability, even though many economic problems may remain while price stability is maintained. Other solutions must be found, which puts the onus squarely upon governments to adjust their spending and tax rates (either by expanding or contracting their spending, depending upon how much in debt they are). In many cases it may simply be a matter of waiting until the market sorts itself out.

Other articles of a similar tone:

2008-10-11 Economic Crises still need price stability
2008-10-13 Random thoughts on money (explains some of my thinking in more detail)
2009-01-28 I still believe in inflation targeting

A response to John Quiggan's "Zombie Economics"

John Quiggan, an economist, political commentator and fellow Australian, wrote an article recently for foreignpolicy.com entitled "Five Zombie Economic Ideas That Refuse To Die". His article fits into the same tone that Richard Werner wrote in "New Paradigm in Macroeconomics" in 2005, namely that neo-classical economic ideology (called neo-liberalism here in Australia) has failed to deliver what was promised.

Before I begin my critique of Quiggan's article, I need to first point out that I regularly enjoy reading Quiggan's blog. I find his point of view interesting and his arguments compelling. Like Quiggan I have a lot of sympathy towards Social Democracy and its tenets, as well as some of the wars he has engaged in (namely an informed disdain for News Limited and defending the science of global warming). I also need to point out that much of my critique of Quiggan's article is not based upon a defence of neo-classical economics but upon policy that I believe is simply the best choice.

Let me start with Quiggan's first point, that of "The Great Moderation". Quiggan says:

More importantly, central banks and policymakers are planning a return to business as usual as soon as the crisis is past. Here, "business as usual" means the policy package of central bank independence, inflation targeting, and reliance on interest rate adjustments that have failed so spectacularly in the crisis.

Quiggan then goes on to quote Jean Claude Trichet's comments about inflation, namely the importance of maintaining price stability in good times and bad. Quiggan points out that this attitude is "startlingly complacent".

My argument is that Central Bank independence should be maintained and that monetary policy should be geared towards keeping inflation down. Unlike many who argue that an "inflation target" should be set, it is my point of view that absolute price stability be the goal of monetary policy, whereby money neither increases nor decreases in value over the long term. Now while neo-classical and neo-liberal economic ideology argues for strict price stability, my reasons for holding this position do not come from either of these movements but from a much older idelogy - Ordoliberalism. This economic school was developed in Germany in the post war years and was responsible for Germany not just recovering from the devastation of World War Two, but becoming the economic powerhouse of Western Europe.

Let me just do a quick history lesson here. Please be patient.

After the hyperinflation of the Weimar Republic years and the disaster of the Hitler years, West Germany suffered under some very vengeful and short-sighted policy by occupying US forces. Joint Chiefs of Staff Directive 1067, signed by President Truman in 1945, attempted to de-industrialise Germany. Even though Germany did gain some relief from the Marshall Plan, the amount of money they were forced to pay in war reparations was greater than anything they received from the US. In short, West Germany, wrecked from the war, faced the prospect of paying the allies (net) war reparations while being forced to de-industrialise and turn into an agrarian economy. The result was disaster for Germany: poverty went hand in hand with growing inflation. In the years following the end of World War II, poverty in Germany grew worse and worse.

JCS 1067 was eventually overturned and the West Germans were granted the responsibility to look after their own economy. The philosophy that guided them was Ordoliberalism - the idea that the state should regulate the free market in order to allocate resources effectively. It was neither the Democratic Socialism that was embraced by the UK and France in the 1950s nor the Laissez-faire model of the US. One of the tenets of this philosophy was low inflation: Price Stability. The Deutschmark replaced the Reichsmark under this change, and stable prices formed the basis of Germany's growth during the years now known as the Wirtschaftswunder.

What we have learned from economic history is that any major swing towards inflation or deflation leads inevitably to hardship. Deflation beset the world during the Great Depression; Inflation beset the world during the 1970s and hyperinflation has led to ruin in numerous nations, including Ancient Rome, Weimar Germany and Zimbabwe today.

So what level of inflation does Quiggan want? Is 5% inflation too high? is 7%? Is 50%?

Ah, Quiggan might respond, what about the US over the last ten years? They had low inflation and that didn't stop the financial crash did it? To which I would respond by pointing out two things: Firstly that interest rate policy alone will not prevent a crisis from occurring, but is one important part of a whole host of things that should prevent a crisis. If a driver gets injured because another car rammed into him, it would be disingenuous of him to blame it on his tyres.

Secondly, that while inflation was historically low in the US for the past ten years, real interest rates were negative between 2002 and 2005. Many economists have pointed out that the US Federal Reserve kept interest rates too low during this period which, in turn, created the property bubble which burst and helped create the current financial crisis. The Washington Consensus, a neo-classical and neo-liberal text that has guided IMF policy for many years, specifically highlights the need for real interest rates to be positive. Had the US actually kept in lockstep with neo-classical ideas, this period of negative interest rates would never have been allowed. The crisis thus did not stem from a complete adherence to neo-classical ideology but from a deliberate rejection of what I consider to be good policy. If we go back to the car analogy, a driver who has injured himself by driving irresponsibly shouldn't blame the laws that he neglected to follow.

It also needs to be pointed out that the Federal Reserve Bank, unlike the ECB and Australia's Reserve Bank, did not have an inflation target to aim for, but kept markets guessing. The Fed certainly had a goal for price stability, but it was amorphous and opaque. This of course shifts the issue to whether a Central Bank should be independent. The original reason for making a Central Bank independent was to insulate it from political pressure in order to enact monetary policy that would be governed by price stability and not political interference. While I still believe in this, I am also willing to admit that Central Banks are not necessarily immune from market influence. The Federal Reserve, for example, has an unusual amount of employees working for it who once worked for Goldman Sachs. The fact that the market has been able to influence central bank policy does not therefore mean that they should come back under government influence, but that steps be taken to insulate it from all forms of undue influence. In other words, I am advocating a Central Bank that is not just independent, but also transparent and accountable.

To summarise my position on central banks and the current economic crisis: Central Banks should focus upon price stability as their main goal and set realistic low inflation targets (and again let me advocate absolute price stability instead of low inflation targets). Central Banks should be independent of government and market influence, while remaining transparent and accountable for their actions. Jean Claude Trichet, head of the ECB, was quoted by Quiggan as saying this, which I heartily affirm (and which Quiggan criticises):

Keeping inflation expectations anchored remains of paramount importance, under exceptional circumstances even more than in normal times.

There is nothing "neo-classical" or ignorant about this policy. In fact one could argue that had this policy been abandoned during the current crisis, we would be suffering even more.

One last thing before I move on: shouldn't central banks have a wider focus of reducing unemployment and fostering economic growth and not just price stability? To me that question is moot. Worrying about economic growth and the unemployed should be the focus of the government, not the central bank. "Pump priming" the economy through Keynesian stimuli should not be ignored as a policy, and nor should increasing the size of government to bring about a better economy over the long term. These I advocate, which plainly shows just how different I am from the neo-classical mould of "keep government small and let the market do everything", though I would point out that the government needs to control the level of debt throughout this process.

Quiggan's points on modern day monetary policy and the so called "Great Moderation" were my main problem. Now let me move on to Quiggan's other points.

The second point Quiggan critiques is the "Efficient markets Hypothesis". While Quiggan and I agree that letting the market do everything is a silly and dangerous policy, so to would be the idea that the government do everything. Quiggan is not a communist who advocates a planned economy, but his article is light on what he thinks should replace the current crazy "markets are always wonderful" idea. My argument has been that there are sectors of the economy that the government is better suited to controlling and sectors which the market is better at controlling, and that there are even areas where a combination of government and market result in the best outcome. Health Care, for example, has been shown to work best when a government run universal health care system operates alongside a smaller market system aimed at those who wish to pay more for their health. It is this combination of majority government and minority market which works so well in Western European Social Democracies and in countries like Canada, Australia and New Zealand. The US system, in which government healthcare is limited and which the market is dominated by health care companies, has been shown to be less efficient and less effective than the one employed by social democracies.

So while I agree with Quiggan that the "efficient markets hypothesis" is bunk, I would also argue that some markets are efficient while others are not - and those that are not should have some level of government intervention, which ranges from a stricter regulative environment at one end to complete government control at the other end. This again shows my belief in Ordoliberalism.

Thirdly Quiggan points out the stupidity behind Dynamic Stochastic General Equilibrium. I'm certainly in complete agreement with him on this one, as with his fourth point, that of the complete failure of "trickle down economics" to trickle anything down to lower income earners. Median wages in the US have certainly stagnated in the last ten years, and were affected most by Reaganomics, which cut taxes for the rich. While I admit that income and wealth disparity will (and should) always exist, there is a point at which it becomes ridiculous. Aiming for a GINI coefficient of under 30 should be a policy goal for any nation who wishes to intelligently reduce poverty levels.

Quiggan's final point concerns privatization: the selling off of government assets and economic sectors and their replacement by private companies. Again this is one area that I am in partial agreement. There are some government entities that definitely needed to be privatised. In the case of Australia, Qantas, the Commonwealth Bank and Telstra were progressively privatised over many years and I have no problem with these changes. Why should the government compete in the airline industry if private industries can do it better? Nevertheless the privatization debate is grounded on the efficient markets hypothesis, which I have written briefly about above. Privatization might lead to better economic and social outcomes, but then again so might nationalization of some industries. The guiding principle here should be pragmatism and social and economic harmony.

Like many post-crash commentators, Quiggan's points are a mix of good and bad. There is no doubt that the previous policy regime needs to be challenged but there is a point at which the proverbial baby is thrown out with the bath water. Marxism and Communism made the mistake of treating capitalism as an enemy that should be destroyed, while modern-day market advocates treat government as a similar enemy. Different ideologies, same blindness. Neo-classical / neo-liberal economics has certainly failed, but in developing alternatives we cannot ignore some of the truths hidden within its failure: Not all markets are efficient, but some are; Not all government programs are efficient, but some are; Price stability won't solve everything, but it does solve some things.

OSO's pontifications at Reddit

I've realised that some of these are worthy of posting here:

In response to the GOP's "Pledge" about controlling the US budget:

I'm actually a person who has looked at the stats. I know how much the US budget deficit is. I know how much US public debt is. I know the proportions of spending by various government agencies.

So let me summarise from here what the biggest things in the budget are, in order of amount:

1. Department of Health and Human services. (Medicare and Medicaid).
2. Social Security.
3. Department of Defense.
4. Interest paid on money owed

So there are only these four places for the Federal Government to cut into. Everything else represents a very small proportion of government spending. Even if you completely cut funding to NASA, Homeland Security, the FBI, or Department of Education, the result will be negligible.

So what Americans need to ask the GOP is "What are you going to cut spending on to bring the budget back into balance?".

1. Is the GOP going to gut Health and Human services? This means less money for Medicare and Medicaid. Old people especially will be hit by this.
2. Is the GOP going to gut Social Security? Less money for retirees.
3. Is the GOP going to gut Defense? Yeah right I see that happening.
4. Is the GOP going to stop paying debt off? That would mean defaulting on treasuries.

In the end the only real solution is to increase tax revenue, which means increasing taxes. The GOP won't do that. In fact they'll probably cut taxes for the rich again, convinced that maybe this time it might work.

Which means that the GOP will simply put the Federal government further and further into debt. That's what they've been doing since 1981, so we can assume that they'll go with tradition on that one.

In response to predictions of the "end of the world" and the fact that so many have failed:

The thing is that history is replete with instances of societal collapse and population downturns. War, famine and disease have taken away huge proportions of human population.

The "end" is never the "end", unless you're talking about Jesus returning or a massive impact event. The Roman empire ended - slowly and painfully. But people still lived in Rome. Other empires came along and replaced them.

We have around 6 billion people living in the world at the moment. If global warming takes a turn for the worse and agricultural production drops by 95%, it will probably mean the deaths of billions. But it won't be the end. People will still survive. Countries will disappear, governments collapse, borders moved, but there will still be stable governments and healthy people for a minority of the people on earth. And it will be that minority that will eventually flourish to replace the collapse.

So it's not the end of the world, but an end of a chapter.

In response to a Conservative Redditor who is very concerned about radicals taking over the Republican Party:

As a Liberal/Progressive, I like you.

We disagree over spending: I'm happy to increase spending and increase taxes; you're happy to decrease spending and decrease taxes. Both of us, however, oppose the stupidity of continually running deficits.

Even though I'm a lefty I have, like most people, a foot in both camps. I may believe in increasing welfare but I also believe in personal responsibility; I may believe in wealth distribution but I also believe that the talented and the hard working should be rewarded; I may oppose corporate corruption and tyranny but I also oppose government corruption and tyranny.

What saddens me is that conservatives in the US have degenerated into anti-intellectualism, blind ideological adherence and an inability to think critically. Popular conservative commentators reflect this belief.

Conservatism as a set of political beliefs has a lot to offer - seriously it does. But conservatives in the US pose a net threat to America's safety and prosperity.

If the GOP and the Tea Party do not do as well as they hope during the 2010 mid terms (ie control one or both houses of congress) I can see violence resulting.

A further comment on the same thread:

I don't even know who the "extreme radical left" are in the United States. There are certainly a few unreconstructed Marxists out there who still preach class warfare and the need for a people's revolution but they have, as far as I know, almost no influence upon the Democratic Party. Even Bernie Sanders is too right wing for these old Marxists.

There's a few anarcho-primitivists in the environmental movement, but they are too small.

I visit Daily Kos often - it's probably a good place to start in finding out the thoughts and beliefs of the young mainstream left in the United States. Although they support an expansion in government spending to fund universal health care, better public schools and better environmental policies, they are hardly trying to create a communist America. The policies of the Kossacks and those like them in the Democratic party is to move the US into more of a Western European social democracy. They may find the free market problematic and in need of change, but they are not preaching a complete government takeover of private businesses, wealth and property. By all means of measurement, the left in the US is moderate compared to historical progressive policy.

By contrast, the right wing in the US has no real precedent in history. The US right want the government to be turned into Minarchism while maintaining a series of very conservative social laws (eg against homosexuality & abortion, more censorship, etc). The America that the US right wing want is one in which the federal government runs the armed forces, state governments run law enforcement and the legal system is covered by both. Apart from that, the government should do nothing. Education will be run either as a private business or home schooling. The poor will receive no welfare except from the charitable giving of the wealthy. Health care will be provided entirely by private business and insurance agencies, with those who cannot afford it left uninsured or begging for charitable handouts. Social security should be eliminated and people should provide for their own retirement. These policies are a complete repudiation of all that has been learned in the last 150-200 years of Western Civilization. Thus the right wing in the US is historically very radical in its views and not moderate by any way of measuring political and economic beliefs.

And the more radical a belief is, the more likely that violence is to erupt. It erupted on the "left" when communism swept into Russia and China. It is likely to erupt on the "right" in the US due to the Tea Party.

And I finish by promoting Absolute Price Stability on a thread discussing the gold standard:

Fiat currencies are as inherently failure-prone as a car is - it depends upon the driver.

Car drivers can be stupid, they can be smart. If a car crashes it is oftentimes the fault of the driver.

When it comes to fiat currencies, it is up to central banks to control supply to ensure that it matches demand. When the demand for money increases so should its supply. When the demand for money decreases, so should its supply.

Money demand is called Money Velocity.

Basically it goes like this: Money velocity is sped up or slowed down according to the actions of the market and the government; Money supply is increased or decreased by the actions of the market and government when they respond to interest rates set by the central bank.

It is quite possible for a fiat currency to exist without any form of long term inflation. Japan since the early 1990s has had enough bouts of deflation and inflation to ensure that the Yen has neither gained nor fallen in value.

Of course Japan's economy during that period has not been the best, but what it does show is that an economy can function, GDP and GDP per capita can be raised and prices can remain stable even when a fiat currency is being used.

The key here is absolute price stability: ensuring that money neither rises nor falls in value over the long term.

Of course, by this argument, even low inflation targets are too high. The ECB, for example, tries to keep inflation under 2%. They should be keeping it just above or just below zero so that the average over the long term is zero.

As for gold... the problem with a gold standard is that for it to act as a currency it would need to not just retain its value but neither increase nor decrease in value, otherwise inflation or deflation would result. To increase gold supply would require more gold to be extracted from the ground (which would make mining companies de facto central banks) and, once it has been extracted, it cannot be "unextracted". By contrast a fiat currency can be created or "decreated" instantly by the actions of a central bank.

Optimum Sovereign Debt Levels

Over at Angry Bear, Bruce Webb asks the question "What is the optimal level of US Public Debt?". I felt compelled to reply to this, even though it will be seen as heterodox.

But first, some history. Back in the late 1990s when I was working out my economic understanding, I came to the mistaken conclusion that government deficits were bad and government surpluses were good. This was, in part, due to the influence of then Australian treasurer Peter Costello, who, with PM John Howard, made deep budget cuts after the 1996 Federal election. These budget cuts were made because the previous government, the ALP under Paul Keating, had run budget deficits and increased debt to around 20% of GDP. At the time I thought such debt levels were terrible but in hindsight they are very small compared to the gigantic levels of government debt experienced by the US and Europe. Chalk that one up to successful Liberal party propaganda.

So, armed with a dangerous amount of a little knowledge, I began to play around with the idea of governments running huge surpluses. Never being burdened with Randian anti-government attitudes helped me through this process. I began to understand that any government with huge amounts of savings had the luxury of increasing spending or lowering taxes as time went by. After all, with the money in these surpluses being ploughed back into the economy in the form of buying shares or depositing with banks, the interest and earnings of these investments would act as a secondary source of income to taxation. Taxes could therefore be cut, and spending could be increased, without having the problem of running deficits and increasing debt. Taken to its logical extreme, taxes could be cut altogether as revenue from investments covered the entire budget. Nevertheless I still believed that running a surplus over the course of the business cycle was the best thing to do.

Of course this is an interesting idea, but after a while I began to understand the balance between the government and rest of the economy - if government went into debt, the rest of the economy saved; if the government saved, the economy went into debt. You can't have both the government AND the rest of the economy saving at the same time (at least if you ignore external forces coming into play). If the government saved, and saving was good, then the rest of the economy borrowed, and borrowing was "bad" apparently. But of course I knew that not all debt was bad, so my thinking began to change.

Since then my view has been that the optimal, long term, debt level should be zero. And by that I do wish to stress the importance of the phrase long term - I have no problem with governments getting into debt or having net savings. This is where I'm happy to be a Keynesian, whereby governments respond to economic downturns by running deficits (as a result of less tax revenue and increased spending due to automatic stabilisers such as unemployment benefits) and to economic expansions by running surpluses (as a result of increased tax revenue and decreased spending on such things as automatic stabilisers). Yet over the course of the business cycle - that is, when expansions and contractions balance each other out over many years - net government debt should be zero, and budgets should be balanced.

Unfortunately I can only offer axiomatic and logical arguments for this point of view. Most advanced nations have erred on the side of deficits and debt. Australia, by contrast, is perhaps the only nation around at the moment whose level of government debt is nearest to zero. Norway, by contrast, has been running massive surpluses for years now and has government savings of around 119% of GDP. While my younger self would congratulate Norway on this, my current view is that Norway's fiscal situation is just as bad as Greece or Italy. The aim should be zero net debt, not large net debt, nor large net savings.

The axiomatic argument that I have is that, in a perfect economic model, borrowing matches savings and money owed matches money lent. Moreover, sectors like the government, business and households do not actually exist but all are one. Since the government represents a huge percentage of national GDP (15-25% in the case of the US, more so in European social democracies), how a government operates naturally affects the rest of the economy. My argument therefore is that balance is best: a government that is neither a net saver nor net lender allows the non-government sector to operate in balance as well. One argument that I have heard from fiscal doves is that government deficits increases non-government sector saving, and that is a good thing isn't it? Well no it's not. The reason is that the non-government sector should be allowed to function as close to a theoretical "perfect economic model" as possible. As soon as a government runs a massive long term deficit, the non-government sector naturally gears itself towards savings. Similarly, if a government runs massive long term surpluses, the non-government sector gears itself towards deficits.

It's the "gearing" here which is important - and by "gearing" I mean that the economy begins to focus upon that which will make the most profit. A government that borrows too much will create a non-government sector that saves and invests too much since it is more profitable to do that than to borrow. Similarly a government that saves too much will create a non-government sector that borrows and spends too much, since that will be the most profitable thing for the non-government sector to do. If you have a long-term balance, whereby the government neither borrows nor saves too much, you will have a non-government sector that is in balance as well.

Of course my argument for this issue is axiomatic and not dependent upon hard evidence. This is because international trade and investments gets in the way. The presence of massive current account deficits in the US and massive current account surpluses in Japan and China affect my whole argument and render hard evidence impossible to gain. Yet my attitude towards current account imbalances is the same: over the course of the business cycle, a nation's current account should be balanced. In short, the US should not be running huge current account deficits and Japan and China should not be running huge current account surpluses: massive deficits are just as bad as massive surpluses. In the case of the US, massive deficits have created an economy that is geared towards borrowing and consumption, while massive surpluses in Japan and China (a hangover of mercantilism) have created economies that are geared towards saving and production. For the world economy to function better, nations need to ensure that their current accounts remain balanced over the course of the business cycle (ie long term).

But then it is also obvious that some nations need more investment than others, while some patently need less investment. In this situation, imbalances can exist so long as a common currency is used. And this is also one reason why I am pro-Euro and pro-internationalist and see an eventual one-world government and one-world currency as a good idea in the end.

But there's one more thing to add: inflation and deflation. Since inflation represents a devaluing of currency it is therefore a period when the economy gears itself towards consumption and borrowing. Deflation represents a devaluing of goods and services and is thus a period when the economy gears itself towards saving and production. In a perfect economic model, prices are stable over the long term as the force of saving and spending, of production and consumption, balance each other out. Unlike most economists, I see no room for a little inflation over the long term. If an inflation index is 100 today, it should be 100 in 25 years time, with brief deflationary forays below 98 and brief inflationary forays above 102.

So, in short, this is my position:

1. Governments (no matter how large or small) should have zero net debt and run balanced budgets over the long term.
2. Currency areas should have balanced current accounts over the long term.
3. Prices should be stable, neither inflating nor deflating, over the long term (absolute price stability)
   

Balance is the key. Do we dare to aim for an economy in which the government sector has zero net debt, in which the nation or currency area runs a balanced current account, and in which prices are neither allowed to rise too much or fall too much but remain stable?

Australia needs to slow down

Australia has weathered the global financial crisis better than most. GDP figures out today show a 0.9% increase in 2009 Q4. Couple this with 5.3% unemployment and you have a remarkable set of figures. Most western nations - including the US - would find Australia's situation far more preferable than their own.

Australia's success has to do with a combination of good policy and luck. Good policy includes a strict adherence to Washington Consensus policies for the past 25 years - privatization of selected government owned industries (Commonwealth Bank, Qantas, Telstra), an intelligent regulatory framework for the financial industry, fiscally prudent government spending, a broad-based tax system - as well as the recent Keynesian stimulus package undertaken by current PM Kevin Rudd. Luck includes a high demand for Australian minerals and ore, which has come mainly from China: their recent stimulus package, alongside renewed consumer demand from the US, has created both an internal and external demand for raw materials that Australia can provide.

Australia: Bloody beautiful mate.
Let's throw another Western economy on the barbie.

So Australia is riding high, but there are nevertheless economic imbalances that need to be addressed, lest Australia fall. One example of this is Ireland, whose economy performed well for over a decade before it crashed so badly during the current financial crisis, exposing its fragile economic underbelly.

For Australia to avoid a future imbalance, steps must be taken to reduce domestic demand - to slow down.

Go slower when conditions are poor.
This applies to road conditions and economic conditions

The two indicators of Australia's economic problems are, firstly, the property market and, secondly, the current account.

One of the triggers of the global financial crisis were overvalued property prices in America and other parts of the world. Once property prices collapsed, households and financial institutions were lumped with bad debts which, in turn, led to a credit crisis - an absence of lending and borrowing (an essential pillar of a market economy). Eventually these economies fell like the proverbial house of cards. Yet despite Australia's own property bubble being popped, there are signs that it has begun to inflate again. Home loan affordability in Australia has improved drastically since June 2008, but recent signs indicate an injudicious addiction on behalf of the financial industry towards property. Government policies such as the First Home Owners Grant and Negative Gearing, which were instituted under the Howard Government and continued unchanged under the Rudd government, have created the conditions for overheating. I would argue that prices still have far to drop in relation to average income before property prices reach a more sustainable level. Steps therefore need to be taken to prevent this growing bubble.

Do we really want to fuel house prices?

The second problem with the Australian economy is the current account - which has been in deficit for over 25 years. The current account basically measures Australia's debt with the rest of the world. Last quarter, Australia's current account deficit was $18.48 billion, which is 4.2% of Australia's GDP. Moreover, net foreign debt levels (that is, how much Australia owes the world in total, minus what the world owes us, as a percentage of Gross Domestic Product) are 51.8% of GDP, which is better than the 56.3% figure 12 months previously. Certainly Australia's debt position to the rest of the world has improved slightly in the last year, and that can be seen in the household savings rate - the more Australian households have saved, the more money was paid off external debt. It is imperative for Australians to maintain a high savings rate if net external debt is to be reduced to zero.

People get very annoyed when debts get too high

Let me explain this further: In a currency area it is essential that a balance of savings and borrowings be maintained.^† If one currency area has an overbalance in borrowing, which is indicated by a large current account deficit, or if it has an overbalance in saving, which is indicated by a large current account surplus, then that currency area has a structural problem. In a currency area that borrows too much there will be an increase in consumption alongside an accumulation of debt; in a currency area that saves too much there will be an increase in production alongside an increase in the savings rate. Both of these are bad, since one currency area's deficit is another currency area's surplus. Each currency area should have a balance for it to remain strong. In Australia's case, high levels of external demand for raw materials has not resulted in a current account surplus. For Australia to have a more balanced economy there needs to be less domestic spending and borrowing in relation to external demand. This can be achieved either by an increase in exports (eg China demanding even more raw materials and prices going through the roof) or by a decrease in domestic demand. Since Australia cannot rely upon China (and thus the US) to make commodity prices rise even higher than they are now, it is up to the Australian Government to step in and reduce domestic demand.

Just say no to buying and borrowing.
It's the noble thing to do

Reducing domestic demand can be achieved both through fiscal policy (government spending) and monetary policy (interest rates set by the Reserve bank). In the former case, there seems little need for any sort of further fiscal stimulus on behalf of the Rudd government. Rudd's fiscal stimulus has undoubtedly contributed to Australia's economic stability, but now is not the time to increase it. Furthermore, in order to prevent any potential property bubble from inflating, policies such as the First Homeowners Grant and Negative Gearing (both of which involve government money being funnelled into the property market) should be stopped. While I would not rule out any increase in government spending on welfare, health care or education, I would argue that such increases in government spending would be a systemic increase rather than a temporary Keynesian stimulus and would thus require an increase in taxes to cover.

It's all a matter of balance.
And that's a fair cop.

In the latter case, the Reserve bank must be instrumental in promoting Australian frugality by increasing interest rates. This it has managed to do just yesterday, increasing rates to four percent. More increases are needed for me to feel settled. Increasing interest rates will stimulate household savings which will, in turn, act to reduce external debt and, by decreasing demand, act to bring the current account into balance or into surplus (the latter being the preferred way of paying off levels of external debt Australia currently has). Such an activity will, of course, slow the economy down but that is actually a good thing in the long term, as it will ensure that Australia relies more on external demand and exports than upon internal demand - which of course is needed as Australia's economy is geared more towards consumption and borrowing than upon production and saving.

Australia's answer too.

Of course if the Reserve Bank took my advice and raised interest rates further (I would feel happier with rates at 5% currently) then it would need to justify its actions as it would be acting outside of its stated objective of keeping inflation between 2 and 3% (see here for an example of this). My response to this is simple - the inflation target is too loose and needs to be tighter. Inflation needs to be kept below even 2%.

Which is, of course, just another way of me arguing that Absolute Price Stability (prices neither increasing or decreasing over the course of the business cycle) should be the sole monetary goal of Western nations.

† This does not apply to individual countries within an optimum currency area such as the Eurozone. My argument is that nations within the Eurozone can have many current account differences, with the only important factor being the current account of the entire Eurozone itself. Individual nations within the Eurozone function the same way as individual economic zones do within a nation using a common currency (eg states and counties in the USA) . Since the Eurozone current account has been running at less than ±1% for the past decade, I do not believe that the Eurozone has a current account problem. It has plenty of other problems (huge levels of government debt for a start), but external debt and the current account are not among them.

Zeroflation: the US achieves price stability

The latest CPI has come out (here pdf 98.1kb) and it shows a monthly increase in inflation of just 0.3%.

The year on year inflation figure is 0%.

Of course, the reason why inflation has suddenly dropped from high to zero is because the economy has contracted and loads of people are out of work.

Nevertheless, I would argue that keeping the price of money stable is essential for any sort of recovery to occur. John Maynard Keynes says this in A Tract on Monetary Reform:

[The economy] cannot work properly if the money... assume[d] as a stable measuring rod, is undependable. Unemployment, the precarious life of the worker, the disappointment of expectation, the sudden loss of savings, the excessive windfalls to individuals, the speculator, the profiteer--all proceed, in large measure, from the instability of the standard of value.

It is often supposed that the costs of production are threefold... labor, enterprise, and accumulation. But there is a fourth cost, namely, risk; and the reward of risk-bearing is one of the heaviest, and perhaps the most avoidable, burden on production....[T]he adoption by this country and the world at large of sound monetary principles, would diminish the wastes of Risk, which consume at present too much of our estate.

In other words, when the price of money is stable, the "wastes of risk" are lowered.

Remember, money functions in the following way:

1. As a way of measuring the worth of goods and services.
2. As a means of exchange for these goods and services.
3. As a commodity that is bought and sold.

In order for 1. to work effectively, the value of money must remain the same. In order for 3. to work alongside 1., the money supply must be expanded or contracted according to demand. If the demand for money drops, so should supply. If the demand for money increases, so should supply.

Normally, 1. is not utilised properly. Markets will naturally use money as a way to determine worth, but if the value of money keeps changing (either through inflation or deflation) the market is more likely to make mistakes in investing, borrowing, producing and consuming.

Now that "zeroflation" has been achieved, it is important for the Federal Reserve to adjust interest rates upwards in case of inflation, or to inject more money into the economy in case of deflation. So long as the long term inflation rate is zero (and neither negative or positive), the occasional monthly foray into deflation or inflation can be sustained.

Will the Fed do this? Highly unlikely.

I still believe in inflation targeting

The current economic crisis - which has now lasted so long it should eventually require a name change - has naturally called into question deeply held assumptions and rigid ideologies. And that's a good thing.

One thing which has been questioned is the wisdom of "inflation targeting". The argument is that since inflation targeting was designed to flatten out economic growth and prevent booms and busts, then it is obviously a failure.

I still think that inflation targeting is needed for the following reasons:

• While the crisis is international, it began in the US. The Federal Reserve Bank certainly adjusted interest rates according to inflation, but there was no "inflation target" that was used.
• One of the basic rules behind inflation targeting is to ensure that real interest rates (interest rate minus the inflation rate) are positive. Under Greenspan between 2003-2005, real interest rates in the US were negative. Not only did the Fed not have an explicit inflation target, it did not even follow judicious monetary guidelines to ensure that real interest rates remained positive.
  
• The European Central Bank (ECB) was not consistent in its application of its own inflation target in regards to the Euro. For most of the ECB's life, inflation exceeded its 2% inflation target.
• Despite these problems, inflation in many Western countries in the past decade was low. Yet even low inflation rates did not avert the crisis from developing.
• The solution is not to abandon inflation targeting, but to actually practice and enforce it.
  

I am very well aware that one of the louder voices in this economic crisis is the one which says "capitalism has not failed because capitalism was never tried". Arguing that inflation targeting is still necessary makes me feel like one of these ideologues. Nevertheless I believe the clear evidence is that both the Fed and (to a lesser extent) the ECB were not involved in inflation targeting per se, either explicitly (by keeping inflation below an arbitrary level) or implicitly (by ensuring real interest rates remained positive). If "inflation targeting" is to be defined as the Fed's and the ECB's actions over the past decade then it must certainly be abandoned and replaced by a harsher, stricter inflation killing regime.

Let me rehash one of my typical arguments about Absolute Price Stability. Had inflation targeting been far stricter in the last ten years and aimed at neither inflation nor deflation, but rather a zero net change in consumer prices, then this crisis would never have occurred in the first place. Higher interest rates would have prevented a subprime bubble, it would have dampened economic activity enough to prevent ultra-high oil prices, it would have provided a reasonable alternative to investing in the share market and it would have prevented excessive lending and over-leveraging.

So the reason why I believe in inflation targeting is because, if it was actually tried and if Absolute Price Stability was its goal, the current crisis and mess would never have occurred in the first place.

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.

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.