Writing Dreams

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

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

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

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

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

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

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

Well let me suggest the opposite as a solution.

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

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

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

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

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

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

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

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

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

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

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.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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


Addendum

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

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

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

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

GDP predictions for Q3 2010

Based upon my study of Real Interest Rates over the past three months (government bond rates minus inflation), I am making a judicious prediction of a number of countries.

Note: GDP measured here is change from the previous quarter in annualised form

Economies that were growing in Q2 and will grow faster in Q3

• Australia: > + 4.9%
• Canada: > +2.0%
• China: Growth (quarterly GDP figures not readily available)
• Euro Zone: > +3.9%
• France: > +2.8%
• Germany: > +9.0%
• Japan: > +1.5%
• South Korea: > +5.2%

Economies that are growing in Q3 at around the same rate as they were in Q2

• Argentina: +12.3% steady
• Britain: +4.7% steady
• Italy: +1.8% steady
• Mexico: +13.5% steady
• New Zealand: 1.5% steady
• Russia: Steady (quarterly GDP figures not readily available)
• Spain: +0.7% steady
• Sweden: +8.0% steady

Economies that were growing in Q2 but will begin to slow down in Q3

• Brazil: < 5.1%
• India: Less growth (quarterly GDP figures not readily available)Poland: Less Growth (quarterly GDP figures not readily available)
• Switzerland: < +3.5%
• Turkey: Less Growth (quarterly GDP figures not readily available)
• USA: < +1.7%

Economies that were contracting in Q2 but will perform better in Q3

• Ireland: > -4.8%

Economies that were contracting in Q2 and will be even worse in Q3

• Greece: < -6.8%
• Iceland: < -11.8%

If these predictions are correct then what we will experience in Q3 will be a broad and strong international recovery, especially in the Euro Zone, while the US grows only slowly.

Common Misperceptions?

Austerity means cutting spending.

No, though this is one way it can be achieved. The other way is through increasing tax revenue by broadening the tax base and/or increasing the tax rate. Any policy which results in smaller fiscal deficits can be termed austerity. Progressives who worry about the US Federal deficit but don't want to cut services only have one option: raise taxes.

Deflation is always bad.

No. Stable prices should be the number one priority of monetary policy (conversely, smoothing out economic peaks and troughs should be the priority of fiscal policy). Yet prices naturally increase or decrease due to changes in supply and demand. The goal of monetary policy should therefore be to ensure price stability over the long term. This has actually been achieved in Japan, where the inflation index has hovered around 100 since 1993, implying that prices have been more or less stable in Japan for the past 17 years.

Which leads me to my next misperception...

Japan has a problem with deflation.

Not so. If stable prices are the goal then the Japanese Central Bank has done admirably. There has been neither inflation nor deflation over the long term in Japan since 1993. Any period of deflation has always been balanced out by a period of inflation. But is this really a good thing? Isn't Japan a basket case of an economy? My next misperception...

Japan's economy is permanently in ruin.

The following graph is from here.

Since 1993, the Japanese economy has grown. Not only has it grown, but GDP per capita has increased during that period. Both measurements indicate that GDP growth and GDP per capita growth can exist during a period of absolute price stability.

Of course the figures in the graph above do show periods of economic contraction. Certainly the 1997-2000 period was difficult, as was 2008 and 2009, but the trend is most obviously upwards.

And measuring GDP per capita is important when you consider that Japan's population has peaked and is at the point of shrinking - I have argued before that shrinking populations don't have to be seen as a bad thing for the economy.

Some predictions using real interest rates

My study of real interest rates has been continuing, though without any publishing on this blog due to data collection. There are some predictions though which I have decided to publish today.

I've broken up nations into four groups.

Group 1 - Plunging real interest rates. These are nations whose monetary conditions have dramatically changed over the previous six weeks to promote inflation. These nations are:

• Britain
• Argentina
• Brazil
• Iceland
• Switzerland
• Mexico
• China
• Russia
• Turkey
  

Now of these nations, the one with the lowest CPI is Switzerland, which means that the inflationary growth will not be as serious, while Turkey and Argentina already have high levels of inflation. High inflation levels are bad for an economy because they act to distort prices which, in turn, leads to more inaccurate "money direction" - the choices money holders have in spending or saving or investing or borrowing currency. This inevitably leads to a "peak" in growth, followed by a trough - inflation usually precedes a deflationary economic downturn.

Group 2 - Real Interest rates dropping moderately. These are nations whose monetary conditions have favoured economic growth over the previous six weeks.

• Japan
• Canada
• Euro Area
• Australia
• Ireland
• Spain
• Germany
• France
• Italy
• Sweden
• India
• New Zealand
  

While inflation may result from these monetary conditions such an increase is not likely to be serious. While these conditions do not guarantee economic growth they do act to either improve growth already occurring or to limit any contraction. Of these nations, Ireland is the only one with a contracting economy experiencing deflation, so it is likely that Ireland will experience only moderate contraction and more stable prices in the coming months. Conditions in the Euro Area are improving, which should affect the PIIGS in a positive way. While India's real interest rates have improved moderately, very high inflation continues to afflict them and there is evidence from my data to suggest that India is likely to have some form of economic contraction (ie either a downturn or lower growth rates) soon. Of the nations on this list, Japan and Germany, with price changes close to zero, are more likely to experience sustained growth.

Group 3 - Real interest rates increasing moderately. These are nations whose monetary conditions have favoured economic contraction over the previous six weeks.

• United States
• South Korea
• Poland
  

Again this is not a prediction of economic decline but a contractionary effect upon growth/decline already being experienced. I have collected more data on US CPI and interest rates than any other nation and the data suggests that conditions in the US are not improving. Growth in GDP for Q1 2010 was 3.2%, following on from 5.6% in Q4 2009, which shows that the Obama stimulus of 2009 has passed its peak and is headed on its way down. Real interest rates in the US declined considerably between July and December 2009. In fact "considerably" is too conservative a word to use - real interest rates declined from 5.7% to 0.62% over that six month period. The US would be in "Group 1" in December last year, which indicates that the US economy is beginning to slow down. Considering the speed of the decline and the growth experienced in Q4 2009 and Q1 2010, I would be very surprised if growth ended up exceeding 1.0% for Q2 2010 (which is now).

Group 4 - Real interest rates increasing substantially. These are nations whose monetary conditions have seriously deteriorated over the previous six weeks.

• Greece

Greece has suffered mainly from the market's fear of a sovereign debt crisis - and such a fear is not unfounded. With increasing austerity measures being put into place, Greece's economy looks set to contract - ie shrink - some time this year. Inflation in Greece is still running a little high (3.9%) but increases in bond rates have more than exceeded this amount. Inflation in Greece is likely to turn into deflation as soon as the economy begins to shrink. Growth in the Euro Area, though, is likely to moderate any Greek downturn (and also help Ireland stop its current economic decline).

And that's Stephan Bibrowski in the picture.

Farm the whales?

Save the Whales! Environmentalists for decades have been closely associated with this particular campaign and are directly responsible for the worldwide ban on commercial whaling in 1986. As a result of this ban, whale numbers around the globe have increased - though they are still a small fraction of the amount that existed in the 19th century and before.

Now, however, there is a proposal to allow Japan to have limited commercial whaling as a way to try to control and regulate the practice. Japan has, of course, been openly flouting international law by continuing to allow whaling for "scientific purposes", though it is clear that such practices are simply a front for commercial whaling - as proved by the presence of whale meat in Japanese restaurants and dinner tables.

Naturally such a proposal will result in an outcry - no! Whales are noble creatures! To use them for food and other commercial reasons is immoral! Allowing commercial whaling will cause the extinction of another of earth's animals! We cannot condone murder!

But the only way for people to adhere to such an argument is for them to be vegetarians, specifically vegetarians who believe that killing animals is murder. The vast majority of us - myself included - are happily omnivorous. Yet it is one thing to eat whale meat - it is another thing to do it and cause the death of a species. Chickens, cows and pigs have all died so that I and millions can enjoy our KFC bucket, our medium rare steak or our bacon and egg breakfast.

The problem is, though, that mainstream society is not vegetarian and is not likely to become vegetarian by choice. Poorer people around the world are vegetarian not by choice but by circumstance - but for us in rich, industrialised countries, we are happy to eat meat. The problem is that the environmental movement contains more than its fair share of vegetarians who morally oppose eating animals so that, if they get their way, no one would eat them. For carnivorous greenies like myself, that is a problem.

I've written previously about our coming vegetarian future, yet this situation will come about simply by necessity rather than choice: the limited space available for farmers to meet future demand will be dedicated to grains and legumes rather than livestock as the food energy output of the former is greater than the latter. Cows, pigs, sheep and chickens will still be used for food in the future - but they will be much more expensive than they are today.

Whales, of course, are no different to any other animal when it comes to consumption. If we can happily eat cows and pigs and fish, we can also happily eat whale. The difference, though, is that whales are endangered while cows and pigs are not. From this we can come to some sort of ethical conclusion which allows mankind to consume animals so long as we do not cause them inordinate suffering or wipe them out completely.

Such a conclusion is not outside the bounds of Christian teaching either. Christian blogger Byron Smith pointed out that Reformation hero John Calvin could be classed as a "greenie" for this teaching:

The earth was given to man, with this condition, that he should occupy himself in its cultivation... The custody of the garden was given in charge to Adam, to show that we possess the things which God has committed to our hands, on the condition that, being content with the frugal and moderate use of them, we should take care of what shall remain. Let him who possesses a field, so partake of its yearly fruits, that he may not suffer the ground to be injured by his negligence, but let him endeavor to hand it down to posterity as he received it, or even better cultivated. Let him so feed on its fruits, that he neither dissipates it by luxury, nor permits it to be marred or ruined by neglect. Moreover, that this economy, and this diligence, with respect to those good things which God has given us to enjoy, may flourish among us; let everyone regard himself as the steward of God in all things which he possesses. Then he will neither conduct himself dissolutely, nor corrupt by abuse those things which God requires to be preserved.

So the idea is then that even carnivores like yours truly (and you too most likely) have a responsibility to care for the earth that God has provided so that we can live, and that those who degrade the earth and make it worse for future generations are committing a very serious sin.

But let's get back to whales. For centuries mankind has sent fleets of ships into the oceans to hunt and kill whales to provide consumers with food and whale oil. Of course there's nothing wrong with utilising these resources - but what happened ended up bringing whales to the brink of extinction. Thanks to the 1986 ban (and to Star Trek IV), commercial whaling has been outlawed - excepting the Japanese and a few others - and whale numbers have begun to grow again. One notable example of this is the Blue Whale, which had dropped to maybe 650 individuals during the 1960s, but has increased to over 5000 today after a whaling ban in the 1960s (though still a fraction of the 275,000 Blue Whales estimated to have been alive before commercial whaling began). Population increases among other whale species has also been noted.

So with all this good news, why consider going back to whaling? The logic behind such a return is similar to that employed by advocates of drug legalisation - harm minimisation is more effective than criminalisation. In the case of whaling, the argument is that a heavily regulated return to commercial whaling is more likely to preserve whale numbers than the current ban. This is because the ban has created a demand for illegal whaling. Allowing a return to commercial whaling - which would be heavily limited by quotas - would reduce this demand and legitimise it. Moreover, quotas could increase as whale numbers increase, or decrease if numbers decrease, so long as the amount of whales killed by commercial whaling is much lower than the amount of whales that are born - preferably by a large percentage (eg 1 whale killed by commercial whaling for every 10 whales born). Linking quotas with whale population will ensure that commercial whaling companies have a financial interest in increasing the amount of whales in the ocean, thus giving them incentive to not hunt illegally (lest a complete ban be reinstated) and self-regulate.

The question is, though, have whale numbers increased to the point where even commercial whaling can be reinstated? While the 1986 ban has led to growing whale numbers, whale populations worldwide will still take centuries to recover from mankind's plunder. Depending upon the species of whale, a return to whaling - even heavily regulated by quotas - may still be unsustainable. While I certainly support a careful return to commercial whaling, my support is heavily qualified.

But all of this may be irrelevant anyway - experts are, after all, predicting an ocean die off once global warming goes too far. Maybe all I'm supporting is simply rearranging deck chairs on the Titanic. Time will tell.

Random thoughts on population decline, economics and the Islamic hordes

One of the greatest errors made in modern studies of demography and economics is the assumption that population decline and an ageing population is somehow disastrous.

Behind this assumption are two further assumptions - that taxes are somehow bad and that a decline in GDP is bad.

It is true that many western nations will have a declining population by 2050. Many of these nations have old age pension systems funded by tax revenue, so the retired and aged people living in these countries will be supported by these taxes.

But of course the assumption is that increasing these taxes are bad. They're not. And the reason is that when a population declines, a country is spending less money in the following areas:

• Property: Less people means less demand for property.
• Infrastructure: Less people means less need for new water, electricity and telecommunications infrastructure to be built.
• Education: Less people at the younger age spectrum means smaller schools and colleges.

So for all the doctors and nurses and administration staff that is needed to support an ageing population, there will be a drop in demand for constructions workers and teachers to compensate for it. In other words, an increase in welfare spending on the aged is matched by spending decreases in other areas of the economy.

Ah, I hear you say, but constructions workers and teachers are essential for economic growth whereas nurses and doctors looking after retired people are a drain on the economy. Not necessarily - they are all producing goods and services. What you're worried about is GDP.

An increase in GDP is not necessary for good economic conditions. Economist Robert Solow's exogenous growth model proves that the natural state of an economy without any growth inputs is one of stabilisation. In other words, it is quite possible to have a stable state economy that provides workers with full employment.

Of course, when a population declines the effect upon the economy is negative. Yet that is not necessarily a bad thing. If an economy is in decline as a result of a population decline, the trick is not to aim for growth, but to focus on GDP per capita. In other words, so long as GDP per capita increases, total GDP can continue to fall. Another way of looking at it is to ensure that GDP decline is slower than population decline: If GDP declines by 0.5% in a year while population declines by 1% over the same period, then you have a good thing happening.

There is one final problem with people worried about population decline - they do not seem to understand basic demographics. "Populate or Perish" is one catch cry that sums it up - we must increase our population or else our nations will die out.

That's rubbish.

Take the USA. In 2009, the USA had just over 309 million people. If the population in the US begins to decline such that there would be 209 million people by 2109, is that such a bad thing? Population decline won't wipe a country off the map - no one is going to "perish". Unless, of course, people somehow think that Moslems will continue to have lots and lots of babies and take over the world - a common semi-racist belief amongst many. It is racist because it is based mainly upon ethnic assumptions and because it assumes that such ethnicity will not change. The reality is that many Moslem nations have exhibited a substantial drop in fertility rate over the last ten years.

Demographers have pointed out that when you take into account things like infant mortality rates, accidents and other conditions, the average woman must have 2.1 children in order for the population to remain stable (ie 10 women producing a total of 21 babies). If the average woman has less than 2.1 children there will be (eventual) population decline, while if they exceed 2.1 there will be (eventual) population growth. Of course, many western nations have fertility rates of 2 and below, which indicates population decline. But here is a list of nations with predominately Moslem people who are near or below 2.1:

• Bahrain: 2.29
• Lebanon: 2.21
• Kuwait: 2.18
• Indonesia: 2.18
• Turkey: 2.14
• Iran: 2.04
• Tunisia: 1.93

And all of those nations have declined from higher fertility rates in the past. This proves that there are Moslem nations that are not breeding children to take over the world, which means that Moslem nations which are having lots of children can also drop down to low birth rates.

In summary, population decline is not an economic problem, it will not cause economic and social chaos and it will not allow a horde of Moslems to take over the world.

A 20 basis point cut

Bumblurg:

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

Governor Masaaki Shirakawa cast the deciding vote to lower the key overnight lending rate from 0.5 percent after four of the eight board members dissented, the central bank said in Tokyo today. Three wanted to cut the rate to 0.25 percent, and one wanted to leave it unchanged, Shirakawa said.

Heresy! Don't these people know that the only way to change rates is to do it in multiples of 25 basis points? ie 7.75% to 7.50%, 8.00% to 8.25% etc etc.

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

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

Myths of the Marshall Plan

Just checked the Marshall Plan at Wikipedia. Some interesting facts are:

1) The country with the most money given for reconstruction was Great Britain ($3297 million).
2) The next highest amount was given to France ($2296 million).
3) The third highest amount was given to Germany ($1448 million)
4) No money was given to Japan. Not one cent.

I always thought that the Marshall plan was responsible for the economic giants that both Germany and Japan have become. In reality, Germany and Japan pretty much became economic giants through sheer hard work and good economic policy. The fact that Britain got the bulk of the money but lagged behind both France and Germany up until the 1980s indicates some pretty poor policies being put into place.

Japan was, of course, reliant upon the US for its national defence and its post war constitution, so we need to acknowledge them for that.

AAAAAAAAA

A blog post with every single category marked (I'm doing this for scribefire)

Unemployment, Recessions and Monetary Policy

Okay, first look at this graph:

This is another FRED graph, courtesy of the St Louis Fed. The blue line represents the unemployment rate while the red line represents year-on-year GDP growth. As you can see there are some interesting relationships.

It doesn't take an (economic) Einstein to tell you that unemployment rises whenever GDP drops - it is one of the most obvious relationships in economic history and one that is borne out quite clearly in the graph above. Moreover, as I pointed out in a previous posting, unemployment in recessions rises quite suddenly and then tapers off slowly as the economy recovers.

Let me put it another way: Downturns lead to very sudden spikes in unemployment; recoveries lead to a slow and steady decrease in unemployment.

This is an important piece of economic data, because it teaches us that, while a definite relationship between GDP and employment exists, the relationship does not have an equal result. During the recession and recovery period, GDP drops then recovers again, and may even exceed GDP levels prior to the recession - yet this occurs while unemployment levels remain higher than what they were prior to the recession.

This graph, again from the St Louis Fed, shows what I am talking about:

Because of the way the graph is designed, the unemployment data appears different to the first graph but is exactly the same. What is different is that the GDP figures are now measured in chained 2000 dollars (which takes inflation into account) rather than the year-on-year GDP growth of the first graph.

Look at the 1979 and early 1980s "double dip" recession. What do we see here? The first thing to note is that US GDP at the beginning of the 1979 recession was lower than at the end of the early 1980s recession. In other words, the US economy had a net expansion - albeit a small one - that spanned these two recessions. Yet unemployment, which was 6% at the beginning of the 1979 recession, reached 10.8% when the second recession was over.

So. We have a situation in which there was net economic growth alongside a considerable increase in unemployment. Why?

The issue is not the fact that there was net GDP growth - the issue is that GDP growth during this period (1979-1982) underwent a series of contractions (whereby GDP actually declined). It is these contractions which have the effect of causing large spikes in unemployment.

I would argue, therefore, that the best conditions for creating steady employment over a long period is not to increase GDP growth, but to prevent economic contractions. The longer the period between contractions, the more stable the labour market is and the less unemployed people there will be.

Of course, this is not to say that GDP growth isn't important - it is. Moreover, preventing an economic contraction logically assumes that GDP should grow.

What I am suggesting, though, is that GDP should never be allowed to grow too fast. Growth must be sacrificed in the short term in order to allow growth over the long term. Moreover, short term growth must be sacrificed in order to prevent a contraction later.

For those whose study of economics takes into account the importance of social justice, economic growth must not become an end it itself. In other words, increasing output, while important, should not be the sole outcome. Any form of economic growth must result in higher standards of living for the people who live in the economy - including those whose contributions are not as great as others.

From a macroeconomic perspective, therefore, progressive economists should embrace any system or policy that will prevent contractions while allowing room for slower-paced economic growth.

Here's one: Absolute Price Stability.

Yes you were probably waiting for my solution, probably even waiting for that one.

Absolute Price Stability (APS) is an alternative form of monetary policy to the inflation targeting practised by most central banks. Rather than trying to keep inflation under 3% (which is the policy of the Reserve Bank of Australia), APS involves the central bank keeping prices completely stable over the course of the business cycle. In practice, this would mean having neither inflation nor deflation. Of course, prices go up and down all the time - but whenever inflation rises it means that prices are going up more and down less. Deflation, of course, has an opposite effect. Moreover APS is not some pseudo price fixing law - prices can go up and down as much as the market dictates. However, for APS to run effectively, the market's ability to affect prices must have a neutral - rather than inflationary or deflationary - effect.

But in order to maintain Absolute Price Stability, central banks must essentially set their inflation targets to zero ("zeroflation") and work hard at maintaining that goal. In practice, this means that interest rates will have to increase while inflation drops to zero. While small amounts of inflation or deflation may be tolerated in the short term, the overall long term goal is to have prices remain where they are. Rather than measuring inflation via the traditional CPI, inflation could be measured as the number 100 in an index. If Absolute Price Stability is achieved on, say, 1 August 2010, then the index would read 100. As inflation or deflation is experienced, that number will go up or down slightly (eg 99.85, 100.25). The long term goal for central banks, however, would be to keep the index at 100, with monetary policy (the raising or lowering of interest rates) being used to achieve this.

So what has Absolute Price Stability got to do with preventing contractions?

Well, since APS requires that interest rates remain relatively high in order to keep inflation low, the natural effect upon the economy would be to dampen economic growth. Rather than investing in shares or in property, or spending money to buy consumer goods, people are more likely to save money. Why? Because they will be in an environment with higher than usual interest rates - the high interest rates reward those who put their money into savings accounts. Keeping money stored in savings accounts and term deposits gives households and businesses a "buffer" against any unforeseen events. Moreover, it means that companies who employ people are more likely to have a cash buffer protecting their business and thus the job security of its employees. Together, this means that both households and businesses have their own form of safety net in case of problems.

To be sure, such practice will hardly speed up the economy in the short term - and that's exactly the point. Any economy who practices Absolute Price Stability will discover that the first few years will be hard. Moreover, the most obvious short term effect of APS will be a dampening of economic activity - even a recession - as higher interest rates begin to bite. It also means that any recovery will be rather slow. From that point on, however, Absolute Price Stability - which is essentially a contractionary policy to start with - will ensure that the economy grows at a slow and steady rate while unemployment drops at a steady rate as well. This process is pretty much covered by Keynesian economics.

It may seem strange that I am advocating a policy that will cause an economic downturn and result in higher levels of unemployment. It may seem even stranger that my reason for advocating this policy is to protect employment. But the reason is that APS is a dynamic policy that results in a downturn first and a sustained recovery later; it results in higher unemployment first and then long term low unemployment later. It is the sacrifice of the now to ensure that the future is better prepared for.

APS will, all things being equal, prevent the economy from contracting - and thus keep the economy running well enough to provide long term job opportunities. Will APS erase contractions enitrely? Will it remove "peaks and troughs" in economic growth? All things being equal, APS will, I believe, be able to achieve this. However, any form of supply shortages (such as oil) will cause the economy to contract, in spite of the practice of Absolute Price Stability. Thus all things are not really equal, although I would still argue that maintaining zeroflation is essential even if the economy is contracting due to any supply shocks.

I need to point out that zeroflation is not deflation - it is simply keeping prices stable, neither rising nor falling. Nor will APS necessarily result in a static or declining money supply - zeroflation is essentially supplying exactly enough money as the economy demands, no more (inflation) and no less (deflation). Zeroflation is quite achievable in an economy in which the money supply is growing.

The only country that has managed to experience zeroflation is Japan, and that only after their mid 90s "long recession", which included a period of destructive deflation. Since Japan's recovery, GDP growth has been quite modest compared to other nations, but their unemployment rate has remained low (and at around 4% is lower than the US) and the standard of living remains high (as shown by GDP per capita - US$33,800 in 2007 - and a high placing in the United Nations Human Development Index). Yet despite the fact that Japan's society is benefiting from its zeroflation economy, many in the US continue to believe that Japan's economy is a "basket case" and is unable to grow at its full potential. (The fact that Japan's economy has long recovered from its 1990s recession seems to have eluded many American commentators).

This combination of zeroflation and low growth has allowed Japan to have a more sustainable economy that has provided long term jobs for its people. While the Japanese are hardly choosing zeroflation (it has essentially been forced upon them by circumstances and does not exist by design) and while the economy still has some major imbalances (namely massive public debt), current economic conditions are reasonably good. Of course, this is not to say that exogenous factors won't affect them - they export to the US so they will obviously feel some pain from the US recession - but their current zeroflation environment will help them cope with any changes they will experience.

At this present time, monetary policy is being questioned. Here in Australia the Labor government has vowed to cut spending in order to control rising inflation, a move back to pre-1996 behaviour whereby Australian governments would aim to use fiscal policy as the way of attacking inflation, rather than the Howard years of paying off debt and leaving it to the Reserve Bank to control prices. In America, the Federal Reserve under the chairmanship of Ben Bernanke seems to have jettisoned any concern about inflation altogether and seems to be trying to create as much money out of thin air as possible in order to prevent a recession. Meanwhile the European Central Bank continues its strict anti-inflationary policies inherited from its immediate predecessor, the Bundesbank, all the time while European unemployment levels remain stubbornly high in comparison to other industrialised nations.

With inflation rising worldwide and economic stagnation a certainty, many will wonder at what influence central banks will have in the future to influence the economy. I don't think it is time to ditch the lessons we learned from the 1970s just yet - strong, independent central banks with an exclusive focus on price stability are more important that this generation realises. If Absolute Price Stability is to be introduced, these central banks need to be trusted more, not less, than what they are now.


© 2008 Neil McKenzie Cameron, http://one-salient-oversight.blogspot.com/

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American Twinkie Farms

From the Department of it-makes-sense-to-someone:

Americans have begun to ask why the farm bill is subsidizing high-fructose corn syrup and hydrogenated oils at a time when rates of diabetes and obesity among children are soaring, or why the farm bill is underwriting factory farming (with subsidized grain) when feedlot wastes are polluting the countryside and, all too often, the meat supply. For the first time, the public health community has raised its voice in support of overturning farm policies that subsidize precisely the wrong kind of calories (added fat and added sugar), helping to make Twinkies cheaper than carrots and Coca-Cola competitive with water. Also for the first time, the international development community has weighed in on the debate, arguing that subsidized American exports are hobbling cotton farmers in Nigeria and corn farmers in Mexico.

I would argue that lowering agricultural subsidies in order to improve overseas trade is one of the positive results of globalisation. Both Australia and New Zealand have reduced agricultural subsidies to zero and lead the world in market-based agribusiness. Not all forms of globalisation are useful - that I concede - but if Western nations removed their agricultural subsidies they would encourage the development of agriculture in third world nations. It would be far better, for example, for places like the Ivory Coast to grow rice or some other form of grain crop than it is for them to harvest coca beans for chocolate production. But, because of the way agricultural subsidies work, rich American farming corporations receive a form of government welfare to grow crops that would not be competitive in a real marketplace.

There are all sorts of benefits of removing agricultural subsidies. The first is a lowering of government spending which, in places like Europe, Japan and the US, would help to balance federal budgets more easily. The second is that farmers themselves get to choose what they want to plant and when, rather than having their work determined by government action. The third is, as I mentioned, the growth of grain crops in the third world (which would help feed their own nations while enriching their economies). The fourth is that farmers would be more easily able to adjust their crop according to climatic conditions. The fifth is that this form of government intervention is encouraging the wrong sort of crop being grown, leading to the example above whereby Twinkies cost less than carrots and Coke costs less than (bottled) water.

As many of you know, I consider myself a bit lefty in my economics. I'm more of a pragmatist. History has proved that food production is best left to the marketplace (although I concede that consumers often make unhealthy choices - consumption is certainly one area the government can modify). Both Europe and the US should look at the experience of Australian and New Zealand farmers, who are now the most entrepreneurial in the world and who survive and prosper because of their own business acumen, not because of government handouts.

Click here to view a summary of agricultural subsidies.

Revaluing the Yuan (and also the Yen)

From the department of realignment:

Finance ministers from the G7 group of leading industrial countries have called on China to allow its currency to rise in value more quickly.

This would make Chinese goods less competitive and could help curb China's international trade surplus.

The G7 said it could also help reduce inflationary pressures in China because it would make imports cheaper.

The deputy governor of China's central bank said it was committed to gradual revaluation alongside economic reform.

But, added Wu Xiaoling, "moving the exchange rates in the absence of economic restructuring policies will hurt China".

In a statement issued after a meeting in Washington, the G7 also said their own economies remained fundamentally strong but there was an acknowledgement that oil prices and the US housing market are potential problems.

I believe that one of the most fundamental principles of economics is balance. Economic imbalances include things like hefty current account deficits and government debt. However, imbalances can also be hefty current account surpluses and large government savings.

China has a massive current account surplus - nearly US$250 billion. What this means is that China sells more than it buys, and it invests more than it borrows. This sounds like a good thing but it's not. This is because for every dollar that China saves, someone else borrows it. Japan is in a similar situation with a current account surplus of nearly US$200 billion. Both China and Japan have hefty current account surpluses and that is not good.

The reason it is not good is because both China and Japan have helped create a situation in which the United States runs a hefty current account deficit - nearly US$800 billion. One nation's deficit (US) is another nation's surplus (China and Japan). In order for the world economy to be put on an even keel, these hefty deficits and surpluses need to be made neutral. In other words, both China and Japan need to save less and spend more, while the United States needs to save more and spend less.

At this present moment in time the United States is the world's biggest consumer. Although the US is also a producer, the economy is geared more towards consumption than production. China and Japan's economies are geared more towards production than consumption.

The world economy therefore needs the United States to consume less, and for China and Japan to consume more. This is more difficult than it sounds, though, since it needs a currency realignment - that is, the US Dollar needs to depreciate against the Yuan and the Yen.

It is not Congress or the President or even the Federal Reserve who determines the value of the US Dollar, but that amorphous thing called the "Marketplace". The Forex market essentially determines the value of the US Dollar against all other currencies. But while the US Dollar's value is not controlled by the US government, it is influenced very powerfully by the governments of China and Japan.

China's Yuan is a "pegged" currency, which means that its value is set by the Chinese government. The Chinese government, which has been steadily industrialising the country for the past 25 years, set the Yuan quite low in order to make Chinese industrial products cheap and competitive. To prevent black-market trading between the Yuan and the US Dollar, the Chinese government has essentially ensured that large amounts of money are invested back into the United States. To put it simply, China is lending America the money it needs to purchase Chinese goods.

The Japanese Yen is not pegged, but the Japanese central bank has been buying up billions in US government bonds for some time. The practice is essentially the same as China - Japan lends America the money it needs to buy Japanese goods.

The governments of Japan and China have essentially entered into the Forex market and are major influencers in how it is run. The continual purchase of US bonds by the governments of China and Japan has meant that the US Dollar is overvalued while the Yuan and the Yen are undervalued.

If China and Japan are to increase their consumption of goods and services, then both the Yuan and the Yen need to appreciate in value. The first thing that both countries need to do is to stop buying US bonds. The second thing that needs to be done is for China to unpeg its currency and let the Yuan's price be set by the Forex market.

Of course it would be remiss of me to point out that the United States is not guiltless in this process either. It has been government policy for some time to have a strong dollar and to gear the US economy towards consumption over and above production. This has resulted in a large current account deficit which has, eventually, led to a plunging US dollar. The US could've quite easily chosen to rebalance things out by buying up Yen or other currencies but they chose not to. Even basic actions like refusing to sell bonds to the Chinese and Japanese governments were not thought up.

The problem with this sort of realignment is that the move from imbalance to balance will require time to adjust. For Americans, it will require higher rates of saving and lower rates of consumption. For China and Japan it will require higher rates of consumption and lower rates of saving. Rebalancing a global economy - a process which is already underway with the plunging US Dollar - will produce pain long before it produces gain.

The MAD solution

Here's something just reported from the BBC about Iran:

The Iranian president, Mahmoud Ahmadinejad, has said that Iran is not heading for armed conflict with the United States.

In an American television interview, he said Iran was not on a path of war with the US and that Iran had no need of nuclear weapons.

He is due to address the UN General Assembly in New York on Tuesday.

The US is leading moves to impose further sanctions on Iran because of its nuclear development programme.

"It's wrong to think that Iran and the US are walking towards war. Who says so? Why should we go to war? There is no war in the offing," the Iranian leader said in the interview with CBS television.

He also denied Iran had nuclear arms ambitions.

"You have to appreciate we don't need a nuclear bomb. We don't need that. What need do we have for a bomb?" Mr Ahmadinejad asked.

"In political relations right now, the nuclear bomb is of no use."

I personally think that neither Iran nor North Korea have the technological know-how or economic strength to create a nuclear weapon. But even if they do, they would have problems delivering it to their target, not to mention that the natural response to a nuclear attack on a neighbour would be nuclear attack on their own soil.

Owning your own nuke is, however, a great leveller when it comes to international military power. Iran and North Korea cannot threaten major world powers with their conventional armies but they certainly can with a nuke or two.

The theory behind this is called Mutual assured destruction, or MAD for short. It was MAD that, more or less, kept both America and Russia from nuking each other between 1950 and 1990. Even if one superpower had less nukes than the other, any pre-emptive nuclear attack from one superpower would still result in a substantial nuclear response. Put simply, if you choose to destroy your enemy, he had enough nukes to destroy you at the same time.

North Korea and Iran may or may not have nukes. But even if they do, there is little chance that they would use them aggressively. Iran could, I suppose, choose to use their nukes against Israel and North Korea could use their nukes against Japan - but we know that if they do then the response would be swift and complete. American nukes would rain down on either North Korea or Iran for their attack. North Korea and Iran know this and, if they had nukes, they would know that such an action on their part would be suicidal.

Yet MAD grants protection to a nuclear Iran or North Korea. If America chooses to attack either nation there is always a chance that these nations would use their nukes to defend themselves - either through launching an attack against a neighbour (such as Israel or Japan) or upon invading enemy forces (such as a US Carrier group in the Persian gulf or US troops north of the 38th parallel).

In other words, if Iran or North Korea gain nuclear weapons, they will essentially guarantee their own safety against outside aggression. They are unlikely to use such weapons in an aggressive war - or even develop them enough to sell to terrorists.

Air Conditioned Clothes

From Japan - where else?

Kuchoufuku has a wide range of products including jackets, pants, white shirts (for both men and women), and workshirts with dual fans that create constant air flow. Combined with the bed, it’s now possible to spend nearly every second of your day being fanned with cool air for those hot and humid summers.

Japan's growth slows

Not good news:

Japan's economy grew by just 0.1% from April to June, increasing speculation that the central bank will delay an interest rate rise until September.

The Bank of Japan had been expected to raise rates from 0.5% to 0.75% this month, but analysts said the weak data would probably delay the move.

This is not good news. Japan's economy depends upon exports and any weakness in world consumption (especially the US) will result in lower growth for Japan.

Considering the trade imbalances already inherent between Japan and the US, it stands to reason that a better solution would be a rise in the Yen to allow Japanese domestic spending to grow, drawing in goods and services from outside, including the US.

Money Supply and Inflation

Money is one of those things that keeps growing in an economy. There's always more of it. But money just can't grow willy-nilly, the economy forces money to multiply. Money has two problems. The first is when there is too much of it. In this case, the oversupply of money reduces its value, which means that it no longer buys as much as it used to. This phenomenon is called inflation. The second problem is when there isn't enough of it. In this case the undersupply of money causes its value to skyrocket. This phenomenon is called deflation.

Now, check out this graph I have shamelessly linked from The Economist (here). This graph measures the growth of money in Japan, the United States, the Euro Area (that part of Europe which uses the Euro as its currency) and Britain.

If you take my comments about money supply at face value, you'll probably conclude that Britain, having the greatest increase in money supply (about 13% more than it was 12 months ago), would have the highest inflation, while Japan would have the lowest.

Yet this is not really the case. Britain's current inflation rate is 2.4%, Europe's is 1.8%, the US is 2.7% and Japan's is -0.2% (source). So while there are some correlations, the highest level of inflation (the USA) has not expanded its money supply at such a high rate. Why?

It's got to do with supply and demand. One country's demand for money might be higher (or lower) than another's. This means that, in the US, an expansion in the money supply of around 6% has meant inflation of 2.7%. Yet an expansion of 11% in the European money supply has led to inflation of only 1.8%. In short, it means that some nations have, for a variety of reasons, a higher threshold than others when it comes to inflation.

And if that is the case, then it follows that some nations' economies can grow faster while keeping inflation in check than others - after all, money supply is a reflection on economic growth.

So, what can we deduce from this graph and the inflation figures?

The most obvious thing to deduce is that the drop in the value of the US Dollar has placed a restriction on US economic growth. At the same time, and as a corollary, the increasing value of the Euro has led to less restrictions on European economic growth. Therefore we can actually expect, at some level, that the growth of the European economy will come at the expense of growth in the America economy.

This is reflected in recent stats. Economic growth in the US has averaged 1.8% in the last 12 months, while it has averaged 3.0% in Europe over the same period (source).

What is interesting to me is that Japan seems to have the sort of "zero-inflation monetary policy" that I advocate. Despite their money growth being the slowest of all four, their economy has grown by 2.6% which is quite respectable compared to the US.