Solving Australia's House Price Crisis

The Problem

I used to believe that one of the most solid economic laws that can ever be argued for is the notion that "what goes up must come down". In other words, asset price bubbles (such as property or sharemarket over-investment) will naturally fall back to realistic levels. Tulip mania, the 1929 Stock Market crash... all the evidence is there.

But no longer. Asset price growth in property and shares has continued. Even the correction inherent in 2008 Global Financial Crisis has been exceeded in some areas. I am referring especially in this case to Australia's property price bubble.

Current Monetary Policy, which has evened out the business cycle, is probably to blame here. Controlling levels of inflation by adjusting interest rates has been one of the success stories of the world's post-1980 economy. But modern measures of inflation don't take asset price growth into account. A low inflation economy with a growing asset price bubble has been the norm in many western economies for decades.

One Solution: Higher Interest Rates?

One solution would be to factor in asset price bubbles into inflation measurements. As an indicator, this is fine. But what should be the central bank's response to this changed rate of inflation? Would it be wise to increase interest rates to push down a growing asset price bubble when the rest of the economy probably won't handle such a change? After all, if, say, the Reserve Bank of Australia (RBA) increases interest rates to deal with the growing property bubble, would the effects on the non-property sector of the economy result in a bad recession? Would the cure be worse than the disease?

Of course the real problem here is that interest rates have a very broad effect on the economy. This is inherent to current monetary policy and it can't be avoided. This doesn't mean that adjusting interest rates are somehow a bad thing - there are obviously times when a broad adjustment is going to be required.

But in the case of asset price bubbles, especially in the case of Australia's property market, a different approach is needed. One in which specific monetary goals in that particular market need to have external adjustment. A micro-prudential policy, probably with a dash of micro-monetary policy as well.

A Better Solution: Keep Property Prices Stable

In the case of Australia's overvalued (and now deflating) property market, it is important to neither keep prices rising nor to let prices fall. Property should retain its value over the long term, adjusted for inflation.

For this, an inflation-adjusted property price index should be created, with regular monthly updates. With the index starting at 100, the goal should be a long term price index that has peaks and troughs, but remains at 100 on average.

The advantage of stable property prices is threefold.

Firstly, it means that those who invest in housing will be investing in something that retains its value. All forms of investment exist because people with money wish to gain more. If property prices retain their real value over the long term, people will feel safe investing in them. Obviously such investment needs to be compared to other forms of investment, and the risk/rewards that such investments have, in order for the market to respond appropriately.

Secondly, it creates a disincentive for speculation. Any form of asset price growth leads to speculators who are not so much concerned with actual assets, but whether they can profit from the process of buying low and selling high. Speculation has its place in an economy, but asset price growth in shares or property turns investors into speculators. This results in profits derived from the process rather than the utility of the asset being invested in, and creates a parasitic sort of investment class. This has been one of the great problems in the world's post-1980 economy, with huge asset price bubbles in both shares and property coexisting with lower levels of GDP growth. But if an asset is neither growing nor shrinking in real value over the long term, there is less incentive for speculation.

Thirdly, assuming wages keep rising, it makes for more affordable property prices over the long term. If an economy has rising wages but property prices remain stable, then, by definition, property prices become more affordable. My belief is that property prices are too high, and there are plenty of stories and statistics out there which show how difficult it is for younger people to afford to buy their own accommodation. A long term increase in housing affordability is the best solution here.

So how would this be achieved?

The real property price index would, like the inflation index, be used by a central bank to determine whether to remove or inject liquidity into that specific market. Currently, the adjustment of interest rates is the only current solution, and as I have pointed out above, its usefulness is in its broad effect, not in its narrow effect, making its use problematic in the case of stabilising property prices.

The solution would require a central bank to use two policy tools to keep prices stable. Micro-prudential policy tools would be used to stabilse the peaks and troughs of a typical business cycle, while micro-monetary tools would be used during a serious drop in prices.

Micro-prudential tools

If the index is showing a substantial change in house prices, then the Central Bank would adjust prudential rules that govern mortgages, by increasing or decreasing the minimum deposit required for mortgage holders. This would be based on lending laws that would apply across the entire property market, ensuring that people applying for a mortgage would have to increase or decrease the initial deposit.

In a market of increasing property prices, these micro-prudential rules would have the effect of denying liquidity to the property market, resulting in less money available to invest, and thus cause a drop in prices.

The same micro-prudential policy can be used when prices begin to fall. By decreasing deposit ratios, more liquidity from investors would enter into the market, causing prices to rise.

Micro-monetary tools

In the case of a substantial drop in prices, however, direct monetary policy would be required. Even if micro-prudential deposit rates were dropped to zero, economic conditions might still be so bad that prices keep dropping. When this occurs, the central bank could invest directly in the market itself. This would involve the central bank creating money by fiat, and then using it to purchase property. This is similar to Ben Bernanke's "money by helicopter" theory, except that instead of giving free money out to everyone, fiat money is used by a central bank to directly enter a market. Once prices have begun to stabilise at the 100 index level, the central bank can then begin gradually selling off this property, with any money it gains from the process being "de-fiated" into nonexistence.

Of course such a targeted policy would impact the wider economy, and inflation rates will be impacted by the specific policy tools that the central bank would use to stabilise prices. But these broader effects would best be served by broader policy tools - ie, interest rates.

Summary

To summarise, the current property price bubble in Australia can be solved through the following means:

1. Set up an index which measures property prices adjusted for inflation and update it monthly. This would require work on behalf of the Australian Bureau of Statistics and funds to create it.

2. Grant the Reserve Bank of Australia the power to determine mortgage deposit rates, requiring all registered mortgage lenders to set a minimum rate of deposit. If the rate is set at, say, 20%, this would mean that someone wanting a $1 million mortgage would have to have saved a $200k deposit.

3. Grant the RBA the power to change mortgage deposit rates.

4. Give the RBA the directive that mortgage deposit rates should be adjusted in order to keep real property prices stable over the long term. Specifically, this would be an index number of 100 averaged out over the long term.

5. Grant the RBA the power to purchase property with money created by fiat as another way to keep real property prices stable.

6. Property so purchased by the RBA will be maintained and managed by a separate government body until such time as the RBA sells the property.

7. Property directly purchased by the RBA will be sold once prices have stabilised.

8. Money generated by the RBA's selling of properties is "de-fiated" into nonexistence, and is not part of general government revenue.

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).

A Recession indicator has been triggered

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

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

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

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

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

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

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

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

As a tl;dr, remember this:

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

House price stability via direct government intervention

A comment I made here about the Australian housing bubble:

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

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

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

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

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

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

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

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

US Inflation for February will be big

Here's a screencap of my spreadsheet.

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

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

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

On the surface, annual inflation is still benign:

• November 1.1%
• December 1.4%
• January 1.7%

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

• November 1.5%
• December 5.2%
• January 4.8%

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

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

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.

More on using the Monetary Base as a recessionary indicator

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

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

Using the Monetary Base as a Recessionary Indicator

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

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

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

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

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

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

Now THAT looks more interesting doesn't it? In fact the most obvious question I had when I first made this graph was "What is that spike in the money supply in the middle of the graph?" According to the Federal Reserve Bank of New York:

A variety of factors continue to complicate the relationship between money supply growth and U.S. macroeconomic performance. For example, the amount of currency in circulation rose rapidly in late 1999, as fears of Y2K-related problems led people to build up their holdings of the most liquid form of money...

Interesting stuff. Yet there also seems to be another factor at play here, namely the fact that recessions seem to be associated with monetary bases that are only growing slowly. Let's look at the same graph for 1970-1990:

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

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

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

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

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

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

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

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

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

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

The equation is simple:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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.

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

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.

US CPI September 2010

Download here.

The Index increased from 218.150 to 218.372. This implies a month on month inflation rate of 0.1% which, when annualized, is 1.22%.

The Index in September 2009 was 215.911, which means that annual inflation is 1.14%.

Note that the current index is still lower than September 2008, which was 218.846. The effects of deflation in 2008 and 2009 have not yet been exceeded by the current recovery.

Real Interest Rates have remained stable at 1.51%:

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.