An analysis of the past 30 years

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

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

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

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

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

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

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

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

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

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

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

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

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

But here's another graph: Public debt.

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

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

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

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

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

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

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

In light of this, what would OSO do?

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

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

Not good news:

Negotiations over a broad deficit reduction plan collapsed in acrimony on Friday after House Speaker John A. Boehner suddenly broke off talks with President Barack Obama, raising the risk of an economy-shaking default.

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

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

“I want them here at 11 a.m. tomorrow,” Mr. Obama said. “They are going to have to explain to me how it is that we are going to avoid default.”

Anyone who has played Sim City 2000 will remember the importance of maintaining a tight budget. But if your city in the game gets to a point where you're running out of money you have a number of serious choices to make in order to balance the budget. One option you have is to cut funding to roads. When you do so, this guy (your roads and transport secretary) pops up and yells at you:

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

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

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

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

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

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

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

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

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

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

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

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

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

Market Cap heading for adjusted US dollar fall?

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

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

I concur with Rebecca

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

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

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

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

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

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

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.

US Dollar history since 1980 - and how it affects GDP

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The thinking is rather simple:

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

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

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

So what's my idea then?

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

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

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

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

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

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

So, to summarise:

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

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

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

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

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

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

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

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

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

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

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

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

Update 00:15:00 UTC

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

The USDX and US Real GDP: Has the US been in recession since December 2002?

I'm a big fan of tying down absolute values. For me, it is no reason to cheer GDP growth in the US if the US Dollar has dropped by enough to wipe out relative gain internationally. This is because I see currency value as an international way of valuing. Let me give you an example.

Let's pretend that Country A has a GDP of 100 while country B has a GDP of 100, and that both countries have parity in currency value. If the currency remains locked together, then any increase in GDP in either country can be compared to one another. So country A, for example, may increase their GDP to 102, while country B increases to 101. Thus country A has the better GDP.

But what happens if you take currency changes into account? Let's say the while Country A's GDP has increased as per above, what would happen if their currency had dropped during that same period? In order to make an accurate comparison between country A & B, this change of currency must be taken into account. So the equation would look like this:

(Change in Real GDP) x (Change in Currency Value) = (Actual GDP Change)

And here's a table that explains how the difference might work in practice:

So while Middle Earth's GDP has increased faster than Narnia, the devaluation of Middle Earth's currency ensures that, in comparison with Narnia, it has actually experienced economic decline while Narnia has grown.

This sort of activity is naturally the case when GDP is compared internationally. Of course this has been augmented by the use of "Purchasing Power Parity" to ensure that differences in GDP comparison are more realistic.

Anyway, a while back I began to add the uncertainty of currency value into the analysis of US GDP. The USDX is the index best used for comparing the US Dollar's value compared to other currencies. So into the spreadsheet I went, multiplying real GDP by the 12 month USDX average from 1981 Q4 until now. This is the graph that results:

Historically you can see the effects of the Plaza Accord in the mid 1980s, followed by the mid 90s expansion and the tail-off since the early 2000s. According to this graph, US GDP peaked in 1986 Q1 (170.89), bottomed out in 1991 Q1 (134.67), peaked again in 2003 Q3 (239.54), and bottomed out again in 2009 Q3 (189.34). Since then it has risen only slightly (currently 191.91).

Of course, population issues need to be added into the equation, which is where GDP per capita comes into play. Here is Real GDP per capita adjusted by the USDX in the same way:

This obviously follows the same trend as the graph before, but you can see that the effects of a higher population have led to even less of a growth in GDP per capita from 1981 until today. According to these figures, Real GDP per capita, adjusted by the USDX, is currently 143.03, which implies only a 43.03% gain since 1981. In fact the current situation is lower even than the mid 1980s peak that was brought down by the Plaza Accord. This graph shows that a peak was reached in 1986 Q1 (164.52), which bottomed out in 1993 Q1 (121.81), peaked again in 2002 Q4 (190.29), and bottomed out again in 2009 Q3 (142.02).

What is notable from these last two graphs is that the last peak goes back eight years. In other words, the recent downturn, extreme in nature, has been cushioned by a rise in the dollar. Conversely, the "mild" recession of the early 2000s has been made worse by a long term decline in the value of the US dollar. These two assertions fit into the USDX history.

It would be fair to say that if Real GDP and Real GDP per capita (both adjusted by the USDX for international - absolute - comparison) did advance and decline in the years shown on that graph, then surely that would've been felt at a national level. Without really giving any links, consider this:

• US GDP per capita adjusted by the USDX grew in the early 80s. This implies that between 1981 and 1986, there was a period which could be described as "a good economy". That certainly fits.
• US GDP per capita adjusted by the USDX declined between 1986 and 1993. This implies that the period that could be described as "a bad economy". That fits too.
• US GDP per capita adjusted by the USDX then grew between 1993 and 2002. This implies that the period could be described as "a good economy". Despite a few issues (notably the 2001 recession), that fits as well.
• US GDP per capita adjusted by the USDX has then declined between 2002 and 2009. This implies "a bad economy" which fits too, though the property bubble helped smooth out the 2005-2007 period. Certainly this period had below-average GDP growth.
  

Though this issue has been on my mind for some months now, I am not fully convinced that my logic or argument is correct, which is why I am writing a disclaimer here. Part of my thinking is that a 1% growth in the value of a currency is the same as a 1% growth in the value of GDP, which may be in error. Certainly there is clear evidence that a GDP decline results in higher unemployment while a drop in currency value may not result in such an event. It is also affected by my opinion that common currencies like the Euro should be a logical economic goal, or at least have fixed currency rates governed by a currency board and operating by international standards.

Anyway, tell me where I'm wrong on this... if I am wrong.

Random thoughts on Krugman and Treasuries

This came to me about halfway through watching Taxi Driver with Robert DeNiro:

Paul Krugman argues that further spending is necessary to stimulate the economy and prevent further contractions. Those who disagree with him, including myself, warn that excess government borrowings (in the form of increasing Debt/GDP ratio) will lead to a deterioration in market expectations that the debt will be paid off. Krugman's response is that if the market is spooked with treasuries, then why aren't bond rates going through the roof? He rightly points out that bond rates have fallen, not risen, in recent months.

My response to Krugman requires a bit of explaining on how bond markets work. When I first began to wrap my mind around bond investing, one thing which seemed incongruous was the fact that bond rates went down when the market purchased them, and went up when the market sold them off. It took me a while to realise that, while bonds are subject to the laws of supply and demand, the price measurement is inverted, which means that the interest rates on bonds drop whenever there is an increase in demand, and increase whenever there is a drop in demand.

In other words, if during a market day bond rates drop from, say, 2.8% to 2.7%, this means that there has been an increased demand for bonds. If the bond rates increase from, say, 2.8% to 2.9%, this means that there has been a decreased demand for bonds.

Bonds, like all investments, are driven by supply and demand. Moreover they are also subject to basic market failure which includes investment bubbles.

Many economists, Krugman included, warned the world that property prices in the US had developed a bubble and that a correction was overdue. In 2007 the market corrected and house prices began falling, which eventually led to the 2008 credit crisis and the subsequent "Great Recession". Those who predicted that property prices would not fall, or who then argued that the correction would be minor (Bernanke - I'm looking at you) were left with egg on their face. Moreover, market "experts" pre 2007 argued very strongly that the rise in property prices would continue and that the market was NOT going abandon it. Their reasoning was simple: "if the market was spooked, then why are property prices still rising?"

Let me just repeat that:

"If the market was spooked, then why are property prices still rising?"

Now compare that to what Krugman is saying:

"If the market is spooked, then why are bond rates falling and not increasing?"

I suppose you might guess what I am trying to say: Krugman's argument that the market will not be spooked by an oversupply of treasuries (due to increased deficit and government spending) is based upon the same logic that kept the market believing that the property prices will continue to increase, namely that the market obviously knows what is good for it. Paul Krugman, amongst others, knows just how limited and stupid the market can become but argues that, in the case of treasuries, the market does know what it is doing.

The property bubble between 2002 and 2007 was caused by a market failure. Too much money invested into one sector in too quick a time led to an investment bubble that popped and lost a lot of people a lot of money. In the same way US treasuries have developed an investment bubble. The market has dropped rates down to around 2.5%. With such a drastic increase in demand for bonds, the potential for a correction grows daily.

And what happens when investors lose confidence in both US shares and US bonds? A drop in the value of the US Dollar.

US Dollar history since 1999 and some predictions

This is a graph of the US Dollar Index since 1999.

Annoyingly, the St Louis Fed "FRED" online tool does not have a USDX graph to check, so I had to add in all the different currency values onto a spreadsheet and then apply all the various weightings. This graph begins in 1999 because the Euro was not around before then and, while I'm sure there are equations and whatnot to cover this change, I haven't found them yet!

But as you can see the US Dollar reached its peak at around the same time as the dotcom boom went bust in 2000-2001. It fell steadily to around 2005, when it regained value somewhat and then fell further until early 2008. Of course the steep rise in mid-late 2008 was due to the effects of the credit crunch and a small plateau of sorts developed before further devaluation began and lasted until November 2009, when it began to rise again. The figure for May 2010 was 85.33.

One of the predictions I made for 2009 was a devaluation of the currency to below 60 on the US Dollar Index. Of course this didn't happen but I'm reasonably confident that it will devalue below 60 at some point. The long term trend is downwards, with a high  of 118.98 in February 2002 and a low of 72.11 in April 2008 seeing a maximum decline of approximately 40% (though in May 2010 the decline from February 2002 was around 28%).

At the moment, consumer prices in the US have declined for two months and the effect of the Obama stimulus plan has begun to wear off, which means that we are heading for a more muted economic performance. I think GDP in Q2 2010 will be very low and I am expecting at least one quarter of negative growth this year. At best we'll see some further deflation and at worst a second credit crunch to rival Q4 2008, which means that investors are probably going to push the Dollar up again as they run away from stocks - a process which has already begun if you look at the far right hand side of the graph.

The only fly in this predictive ointment is European GDP growth in Q2 2010. I believe that EU growth will be higher than US growth during this period and investors will be surprised by European economic strength - to the point where yields on PIIGS bonds will drop. How long this will last I don't know, but monetary conditions in Europe in the last three months have certainly been very strongly inflationary (Switzerland will head them all, whilst Greece will be reasonably poor) whereas monetary conditions in the US have more or less been neutral (and tending deflationary).

Crud from the Krugster

Paul sez:

What you have to ask is, What would happen if China tried to sell a large share of its U.S. assets? Would interest rates soar? Short-term U.S. interest rates wouldn’t change: they’re being kept near zero by the Fed, which won’t raise rates until the unemployment rate comes down. Long-term rates might rise slightly, but they’re mainly determined by market expectations of future short-term rates. Also, the Fed could offset any interest-rate impact of a Chinese pullback by expanding its own purchases of long-term bonds.

OSO retorts:

A drop in the value of US currency would increase the cost of imports while increasing external demand for US goods and services. Since the US economy is geared towards imports and not exports, any long term drop in the value of the US dollar would lead to a "retooling" period whereby internal demand drops while external demand increases. The mixture of higher import prices and higher demand for US goods will be inflationary which will either result in higher interest rates from the Fed to counteract inflation or (if the Fed is stupid) result in a long term outbreak of inflation which will devalue people's savings and force people to invest in non-monetary assets such as shares or property which will, in turn, lead to yet another investment bubble.

I personally hope the Chinese sell off US bonds and force the dollar down, but to assume this won't lead to the outbreak of inflation and a (potential) increase in interest rates is wishful thinking. So there.

A Savings Glut? More like a global imbalance.

(This is in response to an article in The Guardian).

 In order to argue that a "savings glut" exists, we must assume that a considerable amount of people all over the world have been busy not spending and not borrowing. This finds its expression in the current account status of particular economies - China, Japan and other nations have huge current account surpluses as the people in those nations save and produce rather than borrow and consume.

But economics is always a matter of balance. The international "savings glut" must be balanced by a commensurate "borrowing glut" elsewhere, where people and businesses are borrowing and consuming rather than saving and producing. Again this can be found in the current account - nations with current account deficits are nations who are borrowing and consuming too much.

To argue that the world is suffering from a "savings glut" is to place the blame on one part of the world over another. America has been part of a "borrowing glut" and needs to take responsibility for its part in the world economic crisis.

The reality is that the entire world has been suffering from an economic imbalance. You can't call it either a "savings glut" or a "borrowing glut". China and Japan saved too much, America and Britain borrowed to much, China and Japan produced too much, America and Britain consumed too much.

The ideal situation is for economies to balance themselves out and aim for a equal amount of borrowing and saving, and an equal amount of producing and consuming. This finds expression in a balanced current account, whereby the current account is neither in deficit or surplus over the long term.

Of course there is the idea that some nations should go through a savings phase or a borrowing phase. The problem is that with national currencies, such necessary phases lead to currency speculations and eventual imbalances. Just as it was right for the market to invest heavily in tech stocks back in the mid 1990s, so was it wrong for the market to over-invest in such stocks by the late 1990s. The same goes for currencies.

It is here that the advantage of a shared currency zone comes about. The European Union's current account has been very low since the introduction of the Eurozone in 1999. The Eurozone's current account was last recorded at -0.9% of GDP, which is very low compared to the -6% run by the US over the years and the +6% run by China over the same period. Yet within the Eurozone we see a number of nations running very different current accounts, with Germany and the Netherlands running large current account surpluses and Spain and Greece running large deficits. Yet because these countries are part of one currency zone, such differences do not result in currency speculation.

For nations with their own sovereign currency, the best solution would be for politicians and central bankers to realign their current accounts through fiscal and monetary means. This means that the US needs to reign in its current account deficit. It also means that Japan and China need to reduce their current account surpluses.

Remember - in economics, balance is the key. To argue that a current account deficit is bad and that a current account surplus is good is a return to bad old days of mercantilism. The fact is that both are bad, and that the closer the current account is to zero, the better the economy will be.

In the current situation, nations with large current account surpluses (such as Japan, China, Sweden, Switzerland, Hong Kong, Malaysia, Singapore, South Korea, Taiwan, Thailand) need to revalue their currencies (sell off US dollars and buy their own currencies), lower their interest rates and set up fiscal stimuli. By doing this, these producer nations will begin to consume more and save less. At the same time, nations with large current account deficits (USA, Britain, Australia) should encourage savings by increasing interest rates. While this will depress domestic demand in these countries, economic growth will be focused more on the external demand driven by the stimuli enacted in the first group of countries.

As it stands now, unfortunately, the imbalances remain. The US, Britain and Australia have enacted stimuli while nations with large current account surpluses have protected their industrial base by keeping their currencies low. It's simply more of the same and does nothing at all to solve the problem except in the short term.

---

Why government deficits are a problem

I feel rather alone in the economics world at the moment, especially after reading this:

Think of an economy this way: the people in any economy buy goods and services from one another and from the outside. In any given time period, one person, one company or one group/sector might use credit in order to buy more goods and services than it makes in income. It’s like spending future income by using credit. This puts that individual, company or group/sector in deficit i.e. they have spent more money than they have earned. Now obviously, if one sector is in deficit in a given period (i.e. they have spent more capital than they have earned), then the other sectors are in net surplus (i.e. they have received more cash than they have earned).

Let’s give these groups/sectors of the economy names: the private sector, the public sector and the foreign sector. Giving the groups names makes it plain that if the public sector is in deficit, the combined foreign and private sectors must be in surplus. Simply put, if you look at all of the households and businesses that make up the private sector and aggregate them together, you can determine if the private sector has a net surplus or a net deficit in any individual time period. And if the private sector has a net surplus, the combined foreign sector and public sector must have a deficit for that time period. The sector financial balances move in concert.

What this means for today is that a government which reduces its deficit in a given time period is forcing an equal reduction in surplus in the private and foreign sectors. So that means, in aggregate, the private sector and the foreign sector will reduce the surplus cash it is taking in over what it spends.

I see this viewpoint as being very blinkered. I mean, if the recession is destroying the ability of the non government sector to save, and if the government runs deficits such saving increases, then what is the point of even having taxes? I mean, why not simply remove taxes completely and have the government simply borrow what it needs and run massive, massive deficits all the time? And if people are worried that the government can't pay the money back, why not simply borrow more money to pay off increasing debt levels?

Businesses can close, individuals can go bankrupt, but governments cannot be allowed to fail. If a government reaches a fiscal crisis it must transfer its problems to individuals and businesses via taxation or inflation. The alternative - letting a government collapse - will result in everything collapsing. If government can survive, then new businesses can eventually form to employ individuals. Without government, such a recovery would be impossible (unless you think anarchy is a good thing).

No business runs itself completely on debt. Acme Widget Corporation can't borrow $1 billion per year to produce widgets that it provides for free for anyone who wants one. In such a scenario, AWC will no longer be able to procure funds and the company will collapse. When it comes to government, you can't just keep borrowing money and running deficits all the time. And although government is "safe" from a financial perspective, any deficits the government run ends up having the negative effects being transferred to the economy. These negative effects are:

1. Internal: Reduced levels of government spending in order to pay back debt.

Let's assume a government runs a fixed deficit year after year and also a fixed amount of spending year after year. This government, spending $10 billion per year and borrowing $1 billion per year, may look reasonably stable in its expenses. The actual numbers themselves don't change much.

This, however, hides what actually occurs. With increased levels of debt comes an increasing amounts of debt servicing, which - if spending is kept fixed - means that the government spends less on important things (defence, law enforcement, education, health, etc) and more on debt servicing. As I pointed out back in 2008, Italy has gotten itself into so much government debt that more than 41% of government spending is directed towards debt servicing. From an accounting point of view, things are balanced... but the reality is less money going to where it is needed.

In short, what occurs when governments run big deficits is more money going towards investors and less money going towards the people. Social problems caused by a poorer population then begin to eat into GDP.

2. External: A devaluation in currency.

Because the national government is linked to the national currency, any increasing risk of government debt default results in scaring international investors. This then results in the international market repricing that nation's currency accordingly - not only does the price of borrowing increase (interest rates) but so too does the value of the currency drop. Inflation hits the nation, along with increased import prices and a drop in real wages.

An inability to control fiscal deficits was one reason why so many Latin American economies had currency devaluations during the 1970s and 1980s. This is why controlling deficits was part of the Washington Consensus.

Now while I'm not a Keynesian per se, I do agree with the idea that governments should run fiscal deficits during recessions to increase aggregate demand. However, I also believe that governments should run fiscal surpluses during periods of growth. You can't be a Keynesian during a recession and then expect to become a Reaganite during a growth period.

Some people have likened the idea of cutting deficits during a recession to be as short-sighted as Hoover back during the depression. But the United States in 2009 is much different to the United States under Hoover in 1930. It's true that Hoover shouldn't have been afraid of government debt and should've embraced deficits. but the level of public debt in the US in 1930 was minuscule in proportion to the economy. By contrast, Obama in 2009 is embracing big deficits, but the sheer amount of money already borrowed since 1981 has placed the US government into a very poor fiscal position. That is why I believe current US government deficit spending is unsustainable.

Living for today makes for bad monetary policy

Ben Bernanke has said that US interest rates will remain where they are - at the historically low 0.25% - for the time being. By contrast, Australia's interest rates have been going up. What's going on?

The only real reason to adjust interest rates is in response to inflationary pressures. The latest CPI figures from the US indicate that prices have remained relatively stable over the past month (+0.2%) while the 12 month result is still negative (-1.3%). From that data alone, keeping interest rates where they are appears to be the right move.

But as regular readers know, I'm not a fan of Ben Bernanke. Bernanke not only misjudged the severity of the current downturn while it was happening, he was also partly responsible for the creation of the downturn, being part of the Fed board that approved Greenspan's negative real interest rate regime. My lack of confidence in him knows no bounds.

Good monetary policy doesn't just depend upon current data - it should also look to the future, and the future for the US Dollar is not bright. I have predicted a dollar crash for many years now and while I am happy to be wrong in predicting the when, I stand behind my predictions of what will happen. Whenever currencies drop in value, the result is more expensive imports which is then translated into higher inflation. Inflation can only be dealt with by restricting money creation, which means that interest rates will have to rise. In short, America's future involves inflation.

Given that my predictions about a US dollar crash are correct, Bernanke's decision to keep interest rates low smack of reactivity rather than proactivity. Had Bernake raised interest rates 25 basis points, he would be acting in response to a future event. Instead, he's stuck in the present.

Such activity is not new. The negative real interest rate regime under Greenspan between 2002 and 2005 was based upon present concerns and ignoring the potential for future problems. It also ignored the teachings of history - that negative real interest rates were a recipe for financial and economic disaster (a point which The Washington Consensus makes). If a dollar crash is coming (and the current data shows nothing but a downward trend), then Bernanke should be doing better - adjusting interest rates in response to a future inflationary environment makes perfect sense.

Recovery?

The signs are there that the US economy is beginning to recover. The last quarter GDP came out at 3.5% - which, though it might end up being revised downwards over the next few months, does indicate some level of economic growth. Moreover, other signals, such as manufacturing increases, seem to indicate a potential recovery.

I can see two possibilities before us.

The first possibility is that growth will continue over the next few years but the rate of growth will be low. Any form of Keynesian spending of the sort practised by Obama and congress will result in an economic slump over the medium term. The hope, of course, is that the spending will stimulate the economy enough for it to be self-sustaining and thus end up paying off the debt accrued by the stimulus in the first place. Given the sheer level of US public debt (which is approaching my predicted 55% of GDP), I doubt that the benefits will end up outweighing the losses. Yet the US economy has had the ability to surprise in the past so I can't discount the idea that GDP will return to growth over the next 4-6 quarters. What I am certain of is that such growth, if it occurs, will be hobbled. I can't see anything beyond 2% being achieved. In terms of unemployment, such hobbled growth will result in only a slight improvement over the current situation, which is, of course, terrible.

The second possibility is that the 3.5% growth is merely a blip on the way further downwards. This means that Q1 2009 and beyond is likely to see a return to recessionary conditions. One of my predictions for 2009 was for the US Dollar to drop below 60 on the US Dollar Index which, in hindsight, appears to be too pessimistic. Nevertheless, the fall in the US Dollar this year has been the steepest on record and there seems to be little evidence that it has reached the bottom. As I have pointed out over the years, with bond yields too low and business profits rare, why would investors wish to invest in America? The US is still ripe for capital flight given the superior conditions elsewhere (or at least "less bad" conditions). The US Dollar cannot continue to fall without some inflationary pressure and, when it comes, will require increasing interest rates in an already poor economic situation (increasing interest rates always dampens economic growth).

What I can't see is any possibility of the US returning to consistent 3-4% GDP growth. The damage caused by runaway public spending since Reagan, a badly unregulated financial market and cheap borrowing cannot be ignored. There is a time for the US to reap what it has sown, and the harvest has only just begun.

Thoughts on the impending collapse of the US Dollar

Of all countries in the world, none has the same knee jerk, reds-under-the-bed, the sky is falling attitude towards raising taxes as America does.

Some might argue - and with good reason - that raising taxes during a recession is a bad idea. However, when you consider that current estimates of the budget deficit exceed 10% of GDP, what else can you do?

It's all very well to say that Roosevelt ran deficits back in the 30s that helped stimulate the economy - but back then budget deficits were hovering around 3-5% of GDP.

According to "Historical Tables of the FY 2009 Budget", there was only one time since 1930 in which the US government ran budget deficits in excess of 10% of GDP, and that was between 1942 and 1945.

With the budget deficit likely to exceed 10% of GDP, the United States is embarking on a fiscal situation that rivals the Second World War, and exceeds that of any year of the Great Depression.

According to recent stats from The Economist magazine, four nations are expected to have budget deficits in excess of 10% this year. They are the United States (13.7%), Britain (11.3%), Ireland (12.4%) and Iceland (12.6%).

Huge deficits of the size being predicted cause international investors to baulk. In the case of Iceland, investors pulled out and caused the Krona to crash. This has resulted in inflation nearing 20% in Iceland.

The Pound is already taking a pounding over Britain's increasingly unstable economy, while Ireland's financial troubles are fortunately subsumed by their adoption of the Euro.

In short, the huge budget deficit that the US is running will end not in a boost to the economy but result in the ruin of the US Dollar.

Who controls the US Dollar?

Not the White House; not Congress; not the Federal Reserve.

Rather, the Bank of Japan and the People's Bank of China. Source.

The only thing keeping the US Dollar at its current valuation are foreigners.

How long will it be before the politicians and economists in Japan and China see such a situation as unprofitable?

Back to normal - everything is stuffed

For my international readers, you may have noticed a slight drop in the quantity and (let's face it) quality of my blog posts lately. This is because Australia in January is pretty much closed down. Because we live on the upside down part of the Earth, the seasons here are the opposite of that in the Northern Hemisphere. This means that we have Christmas AND summer holidays at the same time. Add to this the fact that our convict forefathers decided to arrive on January 26th 1788 and we basically have a 4-5 week period of nothing but hot weather and holidays.

If anyone wants to invade Australia, do it during early January.

But now that Australia Day is over and done with, the kids are about to go back to school and Australia returns to normal again. My son is about to enter 3rd grade (the equivalent of "the third grade" in America) and my daughter about to go into pre school. This means that I should be able to blog better and more often.

Anyone who has been perusing the economic news lately knows that there have been some massive job cuts announced - not just here in Australia but all over the world, especially in the US. 2008 Q4 GDP will be released this Friday and I am expecting a big drop - at the very least a contraction of 1.0% or more.

I also remain convinced that the US Dollar is ripe for a crash, even though the currency has firmed in recent weeks. As I have pointed out before, there is no real reason why anyone would want to hold US Dollars at the moment - treasury yields are ultra low, the US Property market has popped and the Share Market has crashed. While the rest of the world isn't too wonderful economically either, the US is the centre of the storm and will suffer more and suffer longer than the international community. Although I am not a financial advisor (yet) I would counsel investors to invest in Euro, Yen and precious metals and sell off their US assets before the crash gets underway.

The upcoming dollar crash will be the final "event" that will plunge the US and the world into the second great depression. High oil prices (2004-2008), the bursting of the subprime bubble (2006), the credit crisis (2007-2008), de-leveraging (2007-2008) and the Bear Market (2008) were all previous events that have hit the US in the last few years.

Despite my natural relief that Bush is no longer occupying the White House I have little confidence that President Obama will be able to achieve much in the first 2 years in terms of repairing the economy. Big spending seems to be the only solution and this will frighten the markets further considering the sheer amount of debt the Federal Government has already gotten itself into before the credit crisis hit - and this fear will put downward pressure on the dollar.

Once the dollar has crashed, the only recourse will be to follow the policies outlined in The Washington Consensus, which will inflict upon America harsh austerity measures. A dollar crash will force the Federal Reserve to raise interest rates and force the Federal Government to rein in spending - the very opposite of what is currently being applied (low interest rates and lots of deficits spending).

While a part of me remains Keynesian, the Austrian part of me argues that policies and practices that created the problem in the first place should not be used to solve the problem. in other words, if America's situation was caused by unrestrained spending and injudicious borrowing, then why assume that more spending and more borrowing will solve the problem? Balance needs to be restored - and that means that America needs to save more and borrow less, to produce more and to consume less. It is therefore more important for China and Japan to stimulate domestic spending in their own countries - a process that will increase US exports and reduce imports to the US - than for the US to indulge in more spending.

This is not to say that some deficit spending may be required in the US - just not as huge an amount that is being touted.

But, the dollar will crash and no one listens to me anyway. It'd be nice if I could make money out of being right.

US Unemployment

Today is yet another doomsday - the December 2008 unemployment figures are due and the expectation is something bad.

November 2008 rate was 6.7%.

I predicted that US unemployment would reach 7.0% in 2008, and with the final month's stats now due I think it is very likely that the 7.0% rate will be broken.

OSO's low estimate: 7.0% (the average the entrail readers estimate)

OSO's high estimate 7.6% (which would equal the highest monthly increase since January 1975, where it increased from 7.2% in December 1974 to 8.1% in January 1975).

If the rate ends up exceeding 7.6% (and these are unusual times, so the chances are that it might) then all those comparisons to the great depression will become even louder.

I think the markets have factored in anything up to 7.2%. Shares and US Dollar are hardly going to move with any rate between 7.0% and 7.2%. Less than 7.0% will be bullish. Higher than 7.2% will be bearish. Higher than 7.6% will see some major moves, especially in the US Dollar.

Regardless of the result, if you're American I would continue to advise investment in Euro, Yen and Gold.

The release will be available here at 0830 EST / 1330 GMT.

China cooling on US debt

Naked Capitalism has the lowdown here. Quotes:

Separate and apart from China's changing fortunes, the continued purchase of US debt was becoming controversial in bureaucratic and popular circles. The tone increasingly was that China had been snookered into buying lousy US paper. And since the regime had depended on continued growth to maintain legitimacy and social cohesion, the officialdom will need to find scapegoats for the downturn. Regardless of where one thinks the truth really lies, it's a no-brainer that the US will become a leading culprit.

...

I hate to say this, but if China were to be rational about their Treasuries, they are a sunk cost. Will China realistically ever see 100 cents per dollar invested? The answer is certain to be no. The US is out to create inflation (as a matter of policy, to avoid deflation taking hold). In addition, the massive federal deficits in the pipeline, plus the high odds of a somehow cosmeticized bailout of the Fed down the road (it has been hoovering up crappy assets certain to be worth less than their reported value) will necessitate a default via inflation. And since China has run double digits inflation, they really can't complain if we go that course. And that's before we consider that the powers that be, like just about every economy in the world, presumably want their currency to be weaker (a weaker dollar would also erode the value of US government paper). How that race tot the bottom plays out is anyone's guess.

In short, the US economy is pretty much in China's pocket. With a massive trade imbalance going back decades, this was always going to happen, but no one listened.

Either China will have a disproportionate influence on what Congress and the Fed do from now on, or the dollar will crash.

As I have said before - there is no logical reason why anyone would want to invest in the US at the moment - the sharemarket has crashed, the property bubble has popped and treasuries are offering less than 1% interest. At some point investors will realise that they can make more money outside the US.