Donald Trump has always made his fortune ripping off the gullible rubes.  And it appears that there is not a more gullible set of rubes than the ones on Wall Street.

The Fed Tapers; Markets Cheer

Last time Ben Bernanke suggested that it might be time to start tapering QE3, markets freaked out and tight money types took it as evidence that he needed to start tapering right away.  Clearly, they said, markets had become hooked on easy money and it was time to take their drug of choice away, no matter how much it hurt.  Besides, they said, how could anyone possible know when it we could taper safely.  Better to taper now and get it over with.

Well, now Bernanke has started his taper and markets are cheering, presumably because they take it as his endorsement that the economy is getting stronger.  All of this should be taken as a sign of when it will be safe to taper.

When market engage in bizarre perverse, through-the-looking glass behavior, it is a sign that all is not well. When they cheer bad news as a sign that the Fed will engage in more monetary expansion and become alarmed at good new because they fear the expansion will stop, it is a sign that the economy is too weak for monetary expansion to stop.  When they start behaving normally -- cheering good news and becoming distressed over bad news, it is a sign that things are returning to normal and taper may be safe.  When you discuss possible taper and markets panic over having their support withdrawn, it is a sign that taper is premature.  When you discuss taper and markets cheer it as a sign that the economy is getting stronger, it is a sign that taper is safe.

When you discuss taper, or reject taper and hard money types freak out, it is a sign that hard money types are being typical hard money types and should be ignored.

Another Possible Lesson from the Roaring 20's

I recall a short time, when Alan Greenspan was chairmen of the Federal Reserve, when there was talk of achieving an inflation rate of zero.  This meant disallowing any wage increases on the grounds that they were inflationary.  Fortunately, this did not get very far.  I think there were two reasons for it.  One was that productivity was growing very fast at the time, an it was becoming apparent that only wage increases in excess of productivity growth are inflationary.  But even granting that real wages should grow with productivity, why should real wage growth take the form of nominal wage growth?  Why not keep nominal wages steady and let real wages grow by falling consumer prices?  The answer, so far as I can tell, is that the Fed eventually came to realize that sooner or later, recession always strikes, and when it does, inflation falls. A little inflation in good times is therefore necessary as a buffer against deflation in the next recession.

And deflation is harmful for several reasons.  For one thing, prices and especially wages are sticky and tend to resist falling, so downward pressure on them introduces distortions into the system.  For another, deflation is an inflation of debt and makes the debt burden more onerous.  Borrowing and investment also become onerous, as real interest rates are necessarily higher than nominal interest rates.  And finally, deflation means that holding onto cash effectively pays interest, so people are more likely to hold onto cash and less likely to invest it.

Which leads me to the 1920's.  I had previously heard the Austrian theory that the Great Depression was the result of the horrendous inflation that occurred during the 1920's boom.  That leaves the slightly awkward question of how there could have been such terrible inflation in the 1920's if the consumer price index was, in fact, falling.  Their usual answer is that although the CPI fell, it did not fall as much as it would have if their favored policies had been implemented.  But that raises other awkward questions, such why did other economic booms (before and since) have higher rates of inflation without being followed by such a severe depression.

Indeed, the 1920's have been described as "the only deflationary expansion of the entire 20th century."  Others see the price decline in the 1920's boom as the beginning of the deflation that would prove so ruinous.

Speaking for myself, I am reluctant to consider the late 1920's as a time of deflation because, although the consumer price index was falling, wages and property values continued to rise.  It might instead be seen as a time of very low (even negative) inflation, in which productivity growth was passed onto into real wage growth as much in the form of falling prices as rising nominal wages.

In other words, is it possible that the 1920's should really be seen as a warning about the dangers of very low inflation during good times?  Was the deflation of the 1930's perhaps so devastating because there was no inflationary cushion whatever to soften the impact of downward pressure?  I have not seen any economist proposing this theory.  But perhaps it needs some investigation.

So, another April, another lousy employment report.  Is this the sequester draining resources out of the economy, or yet another spring slump.

And Another Thing I Don't Understand About the Economy

How do you manage to have a household survey that shows an 873,000 job gain in September and an employer survey showing 114,000?  Oh, yes, and how can that possibly add up to a 0.3% decline in unemployment in one month despite more people entering the job market?

Don't get me wrong.  I'm not one of these conspiracy theorists.  It's just really weird.

The first decision of Hell Week has taken place.  The people of Greece have blinked. Once again, they have chosen slow strangulation over jumping off the cliff and hoping to survive.

As many people have pointed out, the Greeks have essentially two options.  They can stay the course, squeezing their economy harder and ever harder in hopes of convincing their investors they are sincere.  Or they can default on their debts and leave the euro.  Everyone agrees that the immediate aftermath of such a default and devaluation will be catastrophic.  But no one knows what the longer range consequences will be.  Our experience with sovereign default and devaluation is sparse, but revealing.  Consider:

Russia, 1998:  The transition from Communism was disastrous in Russia. Coal miners and many other workers went unpaid.  Interest on sovereign debt alone exceeded tax revenue by 40%.  In much of Russia, the financial system had broken down so far that money ceased circulating altogether and the economy went on a barter system.  In an effort to keep the ruble at its currency peg and stem capital flight, interest rates were raised to as high as 150%, with devastating effects on any part of the economy that still had a working finance system.  None of this was sustainable.  On August 17, 1998, the Russian government default on its debts and let the ruble fall.  The immediate aftermath was catastrophic.  Inflation hit 84%.  Food prices rose by 100%. Import prices quadrupled. Many banks failed, and people lost their savings.  Yet recovery was rapid.  Much of the country was on a barter system and therefore unaffected by financial upheavals.  The rise in import prices allowed domestic industry, up till then undermined by cheap imports, to recover.  High oil prices also helped.

Argentine, 2001-2002:   Argentina was long troubled by severe inflation, and in 1991 it took the truly drastic step of making it "freely convertible" to U.S. dollars, i.e., requiring the central bank to have one dollar on hand for every peso in circulation, and to make the conversion for anyone who requested it.  Unfortunately, having so many dollars on hand required a lot of foreign borrowing, which ran up a lot of debt.  Furthermore, as the dollar went up, imports became cheaper and cheaper, gradually undermining domestic industry.  By 1999, investors were becoming increasingly nervous about Argentina's ability to make its payments.  Interest rates went higher and higher, causing great damage to the economy.  The shrinking economy cause increasing budget deficits.  The IMF demanded cuts and more cuts, which shrunk the economy even more.  As the currency peg looked less and less stable, people began converting their pesos into dollars, causing a general run on the currency.  The government froze bank accounts.  As in Russia, the situation was unsustainable.  The government defaulted in December 2001 and abandoned the currency peg in January, 2002.  The immediate aftermath was catastrophic.  The currency crashed, inflation surged to about 80%, peaking in April at 10% per month.  As foreign debts surged, many companies failed.  Unemployment hit 25%.  Yet recovery was rapid.  Exports surged once the peso fell.  More expensive imports allowed domestic industry to recover.  Growth rates exceeded 8% per year from 2003 to 2007.  High soy bean prices helped.

Iceland, 2008:  Iceland's 2008 financial crisis is considered the worst (relative to the size of the country) of all time.  Icelandic banks ran up 50 million euros of foreign debt, backed by an 8.5 million euro economy.  With foreign debts so much larger than its total economy, the central bank was unable to back Iceland's banks.  The Icelandic government nationalized the banks, found them unsalvageable, and allowed them to default on their external debts.  The internal banks have been reconstituted.  (The government did not default on its sovereign debt, but did allow the banks it was responsible for to default on theirs).  The currency plunged.  The immediate aftermath was catastrophic.  Supermarkets had no currency to buy imported goods.  People started hoarding. Half the shops were empty.  Yet Iceland is recovering surprisingly well, returning to an economy of fishing and aluminum smelting from one of banking.

Ecuador, 2008:  This one is less familiar and the outcome is still unclear.  But Ecuador apparently took advantage of the 2008 financial crisis to buy back its bonds at 35% of value.  Outcome remains unclear.

All of this is by way of saying that if Greece defaults and devalues, there is plenty of precedent to suggest that, after a traumatic beginning, it could turn out well in a surprisingly short time.  Or maybe not.  None of the successful defaulters had trading partners going through a major crisis at the same time.   All of them had currencies that at least physically existed.  Greece does not.  All the other countries were simply abandoning a single currency peg.  Greece threatens to break up an entire currency union.  So what worked in these other cases might not work for Greece.

This paper is one of many arguing that an Argentine-style default and devaluation would work for Greece.  But it offers another interesting, unconventional insight.  It quotes George Soros, who knows international creditors well and understands how they think, as saying that creditors want to make default as painful as possible in order to discourage it.  For any private borrower, creditors can seize collateral, but for a country that is not possible, so pain is the only "collateral" available.  The paper goes on to comment:

The European authorities look at Greece’s situation mainly from a creditor’s point of view. From this point of view it is not necessarily bad that the adjustment is painful. Furthermore, if the Troika [European Commission, European Central Bank and IMF] were to provide a program that allowed Greece to recover quickly, then Portugal, Ireland, Spain, and Italy would also expect something similar. That is another concern that the European authorities are likely taking into account, which can motivate them to back policies that are bad for Greece.

The European authorities also have ideological and political interests that can have a large impact on their policies. These two are difficult to separate, but they are very much on display in the documents and statements of the troika. Ideologically/politically, they want a smaller government in Greece, with less regulation, much lower wages, and weaker unions. . . . To the extent that these ideological/political priorities are more important to the European authorities than an economic recovery in Greece, there could be a lot of continued and even permanent, unnecessary suffering for the majority of Greeks.

From a creditor perspective, the worst case scenario would not be Greece defaulting, leaving the euro, and never recovering.  It would be Greece defaulting, leaving the euro, and bouncing back as rapidly as Russia, Argentina, and Iceland did under similar circumstances.   That would be disastrous because it would encourage other countries to do the same.

And yet, as the examples above illustrate, creditors have not generally been successful in their attempts to make default as painful as possible.  In all these cases, default has proven to be the better option, and recovery has been remarkably fast and strong.  All of which would seem to create another  incentive for creditors, although they show no sign of interest in it.  Make the alternatives to default less painful.

Hey, one can dream!

Why Are Conservatives So Afraid of Currencies Falling?

An article I saw recently [once again, can’t find link] commented that an economy experiences recession when its domestic consumption and investment have fallen below capacity. That leaves essentially three options for recovery. (1) Government can step up spending to make up for the gap in the private sector. (2) The central bank can expand the money supply to lower interest rates and encourage more borrowing and investment. (3) The currency can fall to make exports cheaper and make up the drop in domestic production by exporting more.

All three options have some tendancy to occur spontaneously. A shrinking economy causes revenues to drop and unemployment payments to rise, forcing government to borrow more to make up for the lack of private borrowing. Lack of private borrowing tends to make interest rates drop and thereby make government borrowing easier, even in the absence of action by the central bank. And currencies of distressed economies fall, boosting exports. The point of the article was that the European Union is hard at work cutting off all three options for distressed members. Another point may be that conservatives seem determined to cut off all three options in all circumstances.

I understand the first one very well. If you regard all government spending as a great evils, then naturally you will regard increased government spending to boost the economy as a monstrosity. The second one is a little more difficult, but not too hard to understand. A central bank, though an independent agency, is ultimately part of the government, so monetary expansion is still government intervention in the economy. Besides, conservatives are famously inflation averse, and monetary expansion is, after all, inflationary, or at least potentially so.

But what is the problem with currency devaluation? It doesn’t call for government action, just for government sitting by and letting nature take its course. And it revives the economy, not by actions in the public sector, but by a private sector boost from exports. Indeed, one of the earliest and strongest champions of flexible exchange rates was no less a conservative and libertarian than Milton Friedman.* Friedman argued as far back as 1953 that it made more sense for exchange rates to adjust to the needs of an economy than the economy to adjust to maintain a fixed exchange rate.

Why floating exchange rates would appeal to liberals is straightforward enough. I read the case clearly made in college by a Keynesian writing in 1951. His words were, “We cannot have fixed exchange rates, full employment, and free trade. We can have any two, but not all three.” This was two years before Friedman warned of the dangers of fixed exchange rates. About a decade later, Robert Mundell made the case that these three items are the impossible trinity. He, too, believed that if one had to go, it was fixed exchange rates. So, if you value being able to fight recessions with expansionary policies (fiscal or monetary) you would prefer not to have your hands tied by maintaining a fixed exchange rate. The ability to fight recessions is a high priority for liberals. If that means fixed exchange rates have to go, so be it.

By contrast, conservatives are more driven by fear of inflation. I suppose this might partially explaint conservative fondness for fixed exchange rates -- as a barrier against inflation. Certainly during the same research in which I found the Keynesian quoted above, I also saw a work by a conservative Briton writing in the late 1960’s, a time when his country really had gone too far in fighting unemployment with fiscal and monetary expansion and was developing a serious problem with inflation.** He pitched fixed exchange rates as a necessary discipline to prevent inflationary policies.

But what if inflation is not a big problem? What if the big problem is recession (or even depression), rather than inflation? Even if the goal is to tie governments’ hands and keep them from intervening to fight recession, fixed exchange rates do not, after all, prevent government intervention in the economy. They simply replace intervention to fight recession with intervention to maintain an exchange rate. What’s so free market about that?
__________________________________
*Of course, these days Friedman is looking more and more like a lefty on macro issues.
**US inflation in the 1970’s peaked around 13% annually. British inflation peaked at about twice that rate, or 27%.

More Things I Don't Understand About the Economy

In the recent past, why did pump prices keep rising, even as oil prices were falling?

And now, why do pump prices keep falling, even as oil prices are rising?

What Is It About the Scandinavians?

The difficulty with Keynesian economics is that it is counter intuitive. It goes against the grain to say that the remedy for excessive (private) debt is more (government) debt. People's natural inclination is to believe that if they have to cut back, government should cut back, too. Other remedies also run into resistence. The sort of monetary expansion necessary to power out after a major financial crisis meets resistence because it looks wildly inflationary. Debt relief meets with fierce resistence from anyone not benefitting from it. Making banks write off their losses means taking on on some of the most powerful actors in society who are well-placed to fight back. Krugman and others often despair of whether success is possible under democratic government. After all, Hitler was the most successful Keynesian of them all, and the government that gave the most successful stimulus following this most recent crash was China.

Yet there is one exception -- the Scandinavian countries. They seem to know how to handle this sort of thing within a democratic framework. One simply doesn't hear much about the Scandinavian countries duing the Great Depression. So far as I can tell, this was because they handled it better than most. They Scandinavian countries quickly left the gold standard and began large-scale fiscal stimulus, allowing their economies to recover while everyone else continued to struggle. (Of course, it helped that they had not been devastated by WWI and did not have any war debt).

The Scandinavian countries are also generally considered to have written the book on how to handle a banking crisis. Sweden forced its banks to write off bad loans, which allowed them to reemerge healthy. Norway acted even more forcefully, nationaliing failing banks and refusing to guarantee their liabilities. (It should be noted, though, that full recovery took longer and was painful).

This time around, the Scandinavian countries are once again held up as models. Norway has had the advantage of oil, and of tight banking regulations (enacted in respose to its last crisis). Sweden has also recovered very well after extremely aggressive monetary expasion, strong automatic stabilizers, and letting the currency fall. (Maintaining fiscal discipline in good times helped give the Swedes a buffer as well).

So the question is, why are the Scandinavian countries the only democracies that can act forcefully enough to handle the aftermath of a severe financial crisis. I can only assume the answer is that people there trust their government and institutions more than in other countries, and that their politicians are more willing to put the public good ahead of partisan advantage. (Read the link about how the Swedish parties maintained a common front in the face of the early '90's banking crisis and try to imaging American politicians today doing anything of the kind).

Why Doesn’t Anyone Remember the Debt Crisis of the ‘80’s?

As I watch Europe’s sovereign debt crisis play out, I get the most depressing feeling of déjà vu. We’ve been through this before. The historically-minded make comparisons to the crisis in the 1930's. Paul Krugman also talks about the Asian financial crisis from the 1990's. But I keep thinking back to the first debt crisis I was old enough to remember -- the Latin American debt crisis of the 1980's. What has that episode been forgotten? The parallels are disturbing.

That crisis had its roots in the 1970’s, when oil prices spiked and Arab countries ended up with way more money than they could absorb. So they put the money in banks and the banks, not knowing what else to do with it, made large loans to Latin American countries. In the 1980’s, the bill came due, and none of the countries could pay.

Crisis is perhaps the wrong word for what ensued, because it implies something urgent and quick. The Latin American debt problems dragged on and on and on. Year after year, they lacked enough income to pay their debts, so the IMF made loans to meet the immediate demand on condition that they undertake “structural reforms.” Structural reforms generally meant balancing the budget on the backs of the poor. The IMF’s outlook was generally that poor people eating was a hideous misallocation of resources and why were these countries squandering resources on their domestic populations when banks were facing shortfalls to their payments.

Prior to the "crisis," Latin American countries had experienced rapid growth, concentrated very heavily at the top with little benefit reaching the middle class and almost none reaching thepoor. Then, suddenly, the loans were cut off and the poor and middle class were informed that all that time they had been living beyond their means and would have to start making sacrifices. Asking sacrifices of the people at the top was ruled out because that would lead to capital flight. In short, the call was for a system in which people at the top received the benefits in good times and people at the bottom bore the burdens in bad times and were greeted with tear gas and billy clubs if they protested. All of this, of course, was hailed as the triumph of freedom and democracy.

Yet despite the obvious parallels with today, when I read Paul Krugman’s The Return of Depression Economics about international financial crises leading up to the present, the omission surprised me. Although he condemns the IMF for its handling of the Asian crisis in the 1990's for insisting that the affected countries squeeeze their domestic economies, he treats this as if it were in some way surprising. Why doesn't he mention that what the IMF did in Asia in the '90's was no different than what it did in Latin America in the '80's? Perhaps he thinks the IMF’s actions in Latin America in the 1980’s were justified to clean up badly mismanaged economies. Certainly, many of those countries tried to make up for the loss of foreign loans by printing money and saw inflation go from double digits to triple digits to quadruple digits, and sometimes even into quintuple digits. That kind of inflation does call for painful measures to stop it. And it is also true that ultimately the conservative forces emerged triumphant from the misery of the ‘80’s, broke the inflationary spirals, balanced their budgets, and restored growth. Maybe Krugman thinks it was all just as well.

Throughout the ‘80’s debt “crisis,” profligate Latin American countries were compared unfavorably to the virtuous Asian countries that grew at a mighty clip without running up a lot of foreign debt. Why couldn’t the Latin Americans imitate the more virtuous Asians? Why did they insist putting the needs of their domestic population ahead of attracting foreign investment? Then, in the late ‘90’s, the Asian crisis hit. Suddenly it turned out that Asian countries weren’t so virtuous after all. Suddenly they started being treated to the same lectures about the need to mend their ways as Latin America. Suddenly, once again, the IMF was asking them to squeeze, squeeze, squeeze and then couldn’t understand why their economies shrunk instead of growing. But the reaction was not altogether the same. Yes, Asian countries were blamed for being corrupt and not “transparent” enough. But people began to suspect that maybe foreign investment was a mixed blessing. Maybe, after all, you could get too much of a good thing. Maybe capital flows were turning into capital stampedes. Maybe some capital controls were in order to keep foreign capital out. And maybe the IMF prescription of squeezing one’s domestic economy as much as possible to please foreign investors might do more harm than good.

Furthermore, although the Latin American debt crisis was considered over, the Asian crisis ended up whipsawing back to Latin America yet again. Brazil, Argentina, and Uruguay all came under pressure and the IMF came back with its old formula of squeezing their domestic economies harder and harder to please foreign creditors. But foreign creditors seemed strangely uninterested in investing in economic devastation. This time the outcome was quite different. The crisis escalated much faster and became more acute. Argentine and Uruguay defaulted on their debts and devalued their currency. Brazil did not default, but found the IMF’s squeeze unbearable and devalued their currency instead. The political outcome was also differet. Brazil, Argentina and Uruguay all elected government of the (moderate) left that put priority on paying of their loans from the IMF to ensure it would not be able to meddle any more. All three have been prospering ever since. (Although if the world economy tanks again, all bets are off).

Other actors also seem to have been more affected by the Asian than the Latin American debt crisis. Asian countries limited their foreign debts, stockpiled foreign currency, and responded to the 2008 crash by fiscal and monetary expansion. And it worked; their economies bounced back quickly. And the IMF appears to have learned something and has been much less insistent that peripheral Europe squeeze their domestic economies than anyone else.

But, alas, everyone else seems intent on playing out the same mistakes that have been made over and over since the 1980’s. So I have to wonder whether we will learn anything from them and, if so, at what cost. Any why no one seems to remember that this drama has been replaying itself, again and again, at least since the 1980’s in Latin America.

Inflationary Behavior and the 70's

According to everything I have been told, when inflation becomes high, you strt to see certain classic infationary behaviors. People increase consumption, reduce savings, and lose their fear of debt. All this makes perfect sense. There is no point saving money if the inflation monster is just going to eat it. Physical things hold their value much better than cash. (One might say that people ae not so much consuming instead of saving, but keeping their savings in tangible form). And there is no reason to avoid debt if inflation will continually shrink it.

These behaviors are individually rational responses to inflation, but collectively they make it worse. That is because inflation is not just a matter of how much money is in circulation, but also of how fast it is circulating. When money is losing its value fast, everyone wants to get rid of it. This makes it circulate faster, which, in turn, raises the inflation rate. Living beyond one's means is a rational response to inflation, but also a cause of it.

I understand that. Here is what I don't understand. The 1970's were a time of exceptionally high inflation, peaking at 13%. 1980 can be considered the very height of the inflation, right before Paul Volcker tightened the belt and broke the inflationary spiral. There were dark mutterings at the time about the need to live within our means. Inflation has been modest ever since. Yet a funny thing happened between then and now.

Here is a graph of our inflation rate, confirming that it spiked in the 1970's and has been modest ever since.

Here is a graph of personal consumption as a percentage of GDP. It clearly shows that consumption as a share of our economy remained generally steady thoughout the highest inflation years and began steadily rising after inflation was brought under control.
Here is a graph of our total debt as a pecentage of GDP, showing that it rose modestly during the inflationary years and then exploded afterward. Of course, it was also at this time that our government abandoned all fiscal prudence, so government debt is no doubt reflected as part of this table.

Here is a table of household debt as a percentage of GDP. Once again, it expands only modestly during the inflationary years and makes its explosive growth only afterward. Granted, once may say, that debt stayed unnder control because inflation was continually eroding it; that is, after all why people lose their fear of debt during high inflation.
Here, then, is the changest graph of all. People are supposed to give up saving during high inflation because asavings continually lose their value and therefore become pointless. Yet savings held up remarkably will thoughout the 1970's and only began to decline after inflation was tamed (eventually going negative by 2005). In short, during the 1970's, we saw double digit inflation and very little inflationary behavior. Since then, inflation has been modest, but inflationary behavior has gotten worse and worse. The runup in debt may be attributed to ever easier credit, but why the ever increasing consumption? Why the ever falling savings? Why did we engage in more and more classic inflationary behavio the further inflation receded into memory?

Things I Don't Understand About the Economy

This should be a new category.

Here's one of them. All reports say that first quarter growth this year was terrible, scarcely going anywhere at all. Yet for the first time since the crash, new unemployment applications fell to levels indicating healthy job creation and unemployment fell by a percentage point.

In the second quarter growth, though weak, ticket up. Yet unemployment applications spiked and job creation ground to a hault. What is going on here?