What Is The Correlation Between Oil Prices And Inflation?

Many investors believe that the movement in oil prices can give them advance signals into how inflation will change in the future. Is there any truth to this, though? Well, Mehmet Pasaogullari and Patricia Waiwood from the Federal Reserve of Cleveland recently ran the numbers to help answer that question once and for all. Here is the summary of their findings, which you can read more about here:

Some analysts pay particular attention to oil prices, thinking they might give an advance signal of changes in inflation. However, using a variety of statistical tests, we find that adding oil prices does little to improve forecasts of CPI inflation. Our results suggest that higher oil prices today do not necessarily signal higher CPI inflation next year, although they do help to explain short-term movements in the CPI.

Being able to predict changes in inflation could make investors a lot of money, but apparently using oil prices to foretell those changes isn't the golden goose some people thought.

US Housing Starts Improve

The latest Commerce Department reports shows that U.S. housing starts are on the upswing, although experts note that basing predictions on data so early in the year may lead to drawing erroneous conclusions. Even so, single-family home construction starts have climbed more than 27% when compared to the same time last year, which competes with levels not seen since 2008. Permit issuance is also up and is tracking closely to starts, although both numbers still remain at one-third the amount seen prior to the start of the U.S. recession in 2006. For more on this continue reading the following article from Iacono Research. 

The Commerce Department reported(.pdf) that housing starts rose 0.8 percent in February to an annual rate of 917,000 units and permits for new construction, a key leading indicator for the home building industry, jumped 4.6 percent to a rate of 946,000, the highest level since June 2008.
From year ago levels, housing starts are up 27.7 percent and permit issuance is 33.8 percent higher.



Starts for single-family homes rose 0.5 percent to a rate of 618,000 units, also the highest level since 2008, accounting for about two-thirds of the overall total, however, home building remains about one-third below the pre-housing bubble pace of about 1.5 million units per year.

It is once again worth pointing out that not too much should be inferred from housing data at this time of the year due to dramatically lower activity in most of the country during the winter months and the outsized impact of seasonal adjustments. Nonetheless, this offers more evidence of ongoing improvement in the housing market as builders ramp up their plans for new construction in the months ahead.

This blog post was republished with permission from Tim Iacono. 

US Fiscal Policy Fine, Experts Say

Partisan economics is nothing new and every administration faces complaints from opponents that it’s either spending too much or too little, depending on the desired media outcome. In 2013, many economists agree that the U.S. fiscal policy is finally shaping up and that it’s a lack of employment and rising health care costs that are the real issue. Deficit hawks complain that liberals in big government are spending too much, but a comparison in real dollars shows the Bush years increasing the most of the last three administrations. Some even argue that President Obama is cutting too much and that a recovery requires more investment. For more on this continue reading the following article from Economist’s View. 

Peter Orszag:

Healthcare is America’s real problem, by Peter Orszag, Commentary, FT: Healthcare costs are the core long-term fiscal challenge facing the US... This is why the recent deceleration of these costs is so encouraging...

The good news is that recent developments in health costs are better than many appreciate. Cost growth has slowed dramatically...

Last year, the Congressional Budget Office estimated that the gap between revenue and expenditure in the next 75 years would amount to 8.7 per cent of GDP. Since then, enacted revenue increases and an improved underlying budget outlook have reduced the gap to perhaps 7.5 per cent.

Achieving the lower health-cost growth would knock another 2.5 per cent of GDP off, bringing the long-term fiscal hole down to 5 per cent of GDP – a greater impact than any policy change currently being debated in Washington. ...

Martin Wolf:

America’s fiscal policy is not in crisis: ...The federal government is not on the verge of bankruptcy. If anything, the tightening has been too much and too fast. The fiscal position is also not the most urgent economic challenge. It is far more important to promote recovery. The challenges in the longer term are to raise revenue while curbing the cost of health. Meanwhile, people, just calm down.

By the way, where were the deficit hawks during the Bush years? Here's what Martin Wolf means by "If anything, the tightening has been too much and too fast":

[via Kevin Drum]

The deficit hawks don't want you to know this, but our biggest problem right now is not the deficit, it's jobs.
This blog post was republished with permission from Economist's View.

European Commission Addresses Economy

The European Commission’s 2012 report on employment and social development has impressed economists as an accurate summary of what has gone wrong with the Eurozone economy in the last year and what will become of it this year, although it’s still questionable whether the insights gleaned from the report will be used to help make the situation better. Economist Jonathon Portes’ interpretation of the report is that a lack of aggregate demand as the result of macroeconomic policy mismanagement as the source of current woes, and that the poorest countries are getting worse, even if other areas are recovering. For more on this continue reading the following article from Economist’s View. 

Jonathan Portes (he also provides discussion of each of these points):

European labor markets: six key lessons from the Commission report, by Jonathan Portes: I haven't always been complimentary about the European Commission - either its economic analysis or its policy advice. So it's nice to be able to be wholeheartedly positive about the excellent report "Employment and Social Developments in Europe 2012"...

The report is really worth reading. But it's close to 500 pages, and the main messages deserve as wide an audience as possible, so I thought I'd try to highlight them with some commentary. To my mind, the key ones are the following:

1. Economic weakness in Europe, and the consequent rise in unemployment, are mostly to do with a lack of aggregate demand, which in turn is the result of mistaken macroeconomic policies - especially aggressive fiscal consolidation...

2. Although financial markets may have stabilized - who knows for how long - things are getting worse, not better, in the real economy of the crisis countries...

3. Countries with more generous welfare states, but also more flexible labor markets, have fared best...

4. Following on from this, structural reforms in labor markets are required in many countries - but they need to be based on evidence! Segmented labor markets are a problem and raise youth unemployment...

..and even in recession, minimum wages at a sensible level do more good than harm. ...

5. Where they were allowed to operate, the "automatic stabilizers" worked...(in both macroeconomic and social terms)...

...while where they were overridden, in the pursuit of "self-defeating austerity", things have got worse...

6. Latvia, Ireland (and even Estonia) may look like "success stories" to some in the Commission, and perhaps to the financial markets (at present) but the reality in terms of jobs and incomes is rather different. ...

Too bad fiscal policymakers didn't do their homework and learn these lessons about austerity, social insurance, automatic stabilizers, and so on before putting harmful or ineffective policy in place (or failing to implement policy when action is called for, e.g. to reduce unemployment). Wish I thought they were doing their homework now.
 

This blog post was republished with permission from Economist's View.

Policymakers’ Risk Fiscal Cliff

The debt ceiling, which refers to how much the U.S. federal government may go into debt, has become a bargaining chip in the final round of debate over how to avoid the fiscal cliff. Republicans have promised not to agree to raise it until President Obama offers deeper spending cuts. In a recent message to Congress, the president told Republicans that there would be no negotiating for raising it later if they allow negotiations about the fiscal cliff to fail now, and many economists feel taking the debt ceiling off the table is a smart move for the White House, if only to ensure that if a recession is to result that it comes now instead of at the end of Obama’s second term. For more on this continue reading the following article from Economist’s View. 

One more from Tim Duy:

The Debt-Ceiling Gamble, by Tim Duy: Ezra Klein reports that the White House is drawing a line in the sand on the debt-ceiling, and they really, really mean it:

The Obama administration is utterly steadfast on this point: They will not suffer a repeat of 2011, when they conducted negotiations over whether the United States should default. If Republicans go over the cliff and try to open up talks for raising the debt ceiling, the White House will not hold a meeting, they will not return a phone call, they will not look at the e-mails.

The Administration is looking to take the debt ceiling off the table forever. This is good policy; that Congress should be able to pass laws authorizing spending but not authorizing the required debt is beyond ridiculous. Also ridiculous - and irresponsible - is the willingness of the Republicans to use the debt ceiling to hold the economy hostage. Ending this travesty should be a priority for the White House.
Klein adds that the White House is ready for the fight now while their strength is up:

Boehner and the Republicans don’t want to give up the leverage of the debt ceiling forever, or for 10 years, or even, as John Engler, head of the Business Roundtable and a former Republican governor suggested, for five years. But the White House isn’t very interested in compromising on this issue, as they figure that if there needs to be a final showdown over the debt ceiling, it’s better to do it now, when they’re at peak strength, then delay it till 2014 or 2015, when their own vantage might have ebbed.

I would add another advantage. Better - from a political point of view - to have a recession at the beginning of President Obama's second term that can be blamed entirely on the Republicans. A recession in the first half of 2013 means that, most likely, the Democratic presidential nominee can run on the back of an improving economy by 2016. Alternatively, they run the risk that this recovery, anemic as it is, gets long in the tooth by 2016. Even worse would be that they agree to let the Republicans once again hold the economy hostage two years from now. Politically, if I had to pick between a recession now or closer to the next election, I would pick now.

 This blog post was republished with permission from Economist's View.

Fed Talks Thresholds, Operation Twist

Economists are predicting what the Federal Reserve will tackle at is next Open Market Committee (FOMC) meeting and the two first guesses include policy guideline discussions and a look at Operation Twist. On the first topic, many Fed execs want to make clear that unemployment cannot be the only beacon for determining threshold levels. Regarding Operation Twist, or how the Fed will hand large-scale asset purchases, many economists feel that the move to an outright asset purchase program signifies an easing of current policy, although a final determination must involve the outcome of the fiscal cliff. For more on this continue reading the following article from Economist’s View. 

Tim Duy:

Monetary Policy to Become Easier Next Week?, by Tim Duy: There are two important issues to be discussed at next week's FOMC meeting. One is the issue of specific thresholds as future policy guides. The second is the replacement for Operation Twist. Clearly, support is building for specific thresholds, and I believe policymakers will work out the details within the next meeting or two. Also, I think the general sense is that the Fed will continue to purchase long-term Treasuries after Operation Twist is complete. But will they continue to purchase the full $45 billion a month? That seems like it should be an open question, but it looks like momentum is building in that direction.
St. Louis Federal Reserve President James Bullard offered his thoughts on both these topics yesterday. On the first point, he offers support for replacing the forward guidance with a set of thresholds. I don't find this to be surprising. Bullard has never been a huge fan of the time commitment implied in the current statement. Not only does it send a pessimistic signal about the economy, in theory it should respond more flexibly to evolving economic events. But in practice, the Fed is only willing to alter the date in the event of a substantial shift in the economic outlook.
Bullard cites the 6.5/2.5 unemployment/inflation thresholds recently described by Chicago Federal Reserve President Charles Evans. I am not sure that Bullard specifically endorses these figures, but he may sense the political wind is blowing in that direction. He nicely describes six challenges to a threshold regime:

1. The Fed needs to make clear that in the long-run the Fed cannot target unemployment.
2. He believes the threshold should be on actual outcomes, not forecasts.
3. The Fed needs to communicate that policy is about more than just two variables. For example, he suggests the possibility of raising interest rates to limit asset price bubbles.
4. Unemployment is not the only measure of the labor market. The Fed takes a broader view of labor markets into consideration.
5. Unemployment can remain high, such as in Europe (I think this is really just a restatement of point one).
6. Beware that thresholds will be viewed as triggers, which they are not.

I think these are valid concerns the Fed needs to address as the communication strategy evolves. Bullard then shifts gears to Operation Twist. Currently, large scale asset purchases come in two flavors. One is $40 billion a month in outright mortgage purchases (QE3), the other a monthly swap of $45 billion in short-term Treasuries for an equal amount of long-term Treasuries (Operation Twist). The former is open-ended, the latter concludes this month. Should it be fully converted to an outright asset purchase program? San Francisco Federal Reserve President John Williams gave his opinion last month:

Meeting with reporters following a speech at the University of San Francisco, MNI asked Williams whether he thinks the FOMC should replace the Operation Twist Treasury purchases dollar for dollar upon their expiration Dec. 31. He answered strongly in the affirmative.
"My view is based on the expectation that we won't see substantial improvement in the labor market" for awhile, Williams said, adding that therefore "my view is that we should continue with purchases of long-term Treasuries after December into next year."
Williams said he favors "just purely buying long-term Treasuries at the rate we're buying."
Asked to clarify, Williams said he favors buying MBS and Treasuries "at the same rate we're doing now" -- $85 billion per month.

Boston Federal Reserve President Eric Rosengren agreed yesterday. Operation Twist changes the composition of the balance sheet, not its size. If the Fed converts to an outright asset purchase program, they will more than double the pace of net purchases. In my opinion, this appears to be a substantial easing of policy. Bullard feels similarly:

...on balance I think it is reasonable to think that an outright purchase program has more impact on inflation and inflation expectations than a twist program....
...Replacing the expiring twist program one-for-one with outright purchases of longer-dated Treasuries is likely more dovish than current policy.

I think that is correct; the conversion of Operation Twist should be considered a more aggressive policy. Yet inflation expectations (with the usual caveats about TIPS based expectations) continue to wane:

Perhaps financial market participants do not expect the Fed to commit to the full $85 billion in purchases. But this does not seem to be the case. There has been more than enough Fedspeak to suggest that additional easing is coming. Which leads me again to wonder if monetary policy is now at full throttle? $40, $50, or $85 billion a month. Does it make a difference? Or is the expectation of additional easing simply offsetting expectations of tighter fiscal policy?

Bottom Line: The Fed is gearing up to convert Operation Twist to an outright purchase program. A complete conversion should be considered a more aggressive policy stance. If the Fed wants to hold policy constant, then we would expect a less than one-for-one conversion. There are reasons to expect the Fed would go the full monty. Notably, the fiscal cliff drama already appears to be affecting the economy, even though it is more risk than reality. But why are inflation expectations sliding? And what does that imply about the effectiveness of additional easing at this juncture? Important but as of yet unanswered questions.

 This post was republished with permission from The Economist's View.

Early Holiday Spending Stats Lower

Perhaps bolstered by signs of an economic recovery, analysts who had been expecting strong pre-holiday consumer sales figures were disappointed to see a sharp decline in spending this year. Gallup reports that Black Friday numbers were considered fair, but that subsequent spending has not been as strong as the last three years based on American self-reported spending. Experts say the decreased sales could be linked to Cyber Monday deals and trepidation about the looming fiscal cliff and what it may means for the housing market as well as the broader economy. For more on this continue reading the following article from Iacono Research. 

The folks at Gallup threw a cat amongst the pigeons today with the release of this survey on how many American consumers opened their wallets last week and how big their December credit card bills might be. (Does anyone pay cash anymore?) Though spending was higher this year during the week before Thanksgiving, self-reported spending during the holiday week fell from averages of $79 per day in 2010 and $83 per day last year to just $67 per day last week, not even besting the level of $69 in 2009.



Such issues as Thanksgiving coming relatively early this year and growing “Cyber-Monday” sales could be behind the sharp decline and, of course, there’s lots of time between now and Christmas for Americans to spend more, though, with the “fiscal cliff” looming and financial markets shaky, that is by no means assured.

This blog post was republished with permission from Iacono Research.

Expert Ponders Fed Policies, Plans

Economist Tim Duy would like to reconcile the Federal Reserve’s near-term and long-term plans for fiscal responsibility with the real state of the U.S. economy but has trouble connecting the dots. He believes its attempt to hit very specific targets will likely fail to due to its inability to communicate needs across channels as well as a seeming disconnect with the fact that the economy is not in a mode of full recovery. He argues that increased government spending may be able to break the cycle of stagnation that is being caused by restricting natural inflation, otherwise fiscal austerity and another recession may take root. For more on this continue reading the following article from Economist’s View.

Tim Duy:

On Coordinated Monetary and Fiscal Policy, by Tim Duy: Note: This began as an effort to tie together various themes in my writing. Unfortunately, short and succinct did not work. So I apologize in advance for the length of this post.

There are certainly trends in my writing. One is that the Federal Reserve spent much of this year behind the curve by failing to adapt their large scale asset purchase program or their communication strategy to the reality of a persistently weak economy. The Federal Reserve effectively dealt with that issue at the last FOMC meeting.

To be sure, I can quibble with some of the specifics, such as a lack of more explicit economic targets and a clear commitment to near term-irresponsibility by allowing inflation to rise above 2 percent when (or if) the economy gathers steam. On the first issue, I am coming around to the thinking that while explicit targets (other than inflation or nominal GDP) might sound good in theory, in practice trying to tie policy to a constellation of price and output targets risks becoming a communications nightmare. The Fed needs to tread very carefully on this point; it may be best for them to fall back on that old adage about pornography. We will know a "sufficient and sustainable" recovery when we see it.

The second issue, a promise to be irresponsible on inflation, remains unlikely as long as the Fed continues to stress it will take actions "in the context of price stability." I don't view a temporary increase in inflation as necessarily undermining neither the Fed's long-term inflation targets nor a nominal GDP target. And I think that the failure to make such a promise could very well disrupt a reversion of the economy to pre-recession trends. This I will discuss further later.

Another trend in my writing is that there needs to be some coordination between fiscal and monetary policy. Putting aside what I believe will be an aberration in the third quarter, authorities are already engaged in some degree of fiscal austerity:

and have effectively promised to do more. Should it even be reached, a compromise to the fiscal cliff will likely still be further austerity. I think that we should be wary about underestimating the impact of such austerity, especially as it is increasingly evident that multipliers are larger than expected at the zero bound. Fiscal austerity would likely be a key factor in maintaining the relatively tepid pace of the recovery into 2013. Moreover, fiscal austerity wastes the opportunity provided by a low interest rate environment. The Federal Reserve has already promised to buy a steady stream of assets from the financial markets. All Congress needs to do is sell debt into that stream. No explicit coordination necessary.

Another issue that I can't run away from is the potentially negative impacts of a sustained zero interest rate environment. It would be a mistake to believe that monetary policy does not have distributional impacts. Low interest rates obviously hurt savers:

Moreover, we should be concerned about distortions to the capital allocation process. Encouraging excessive risk taking now will come back to haunt us later. That said, it is necessary to balance such negative impacts against the positive impacts. Nor is it clear that the Federal Reserve is driving this train; the absence of an aggressive monetary policy might very well weaken the economy such that interest rates fall further. In any event, I am challenged to see how a different monetary policy would be effective; tightening policy at this juncture would likely be disastrous for the economy.

Finally, another issue to which I have already alluded is a belief that the US economy is on a suboptimal path:

This is obviously controversial. For example, St. Louis Federal Reserve President James Bullard has repeatedly said there is only one path, and we are on it. The appropriate monetary and fiscal reaction functions are obviously different in a such a world. In such a world monetary policy leads only to potentially greater inflation with little impact on growth.
Jumbled as it might seem due to the nature of blogging, somewhere in the background I have a framework that ties this altogether. And I was reminded by a colleague that I had seen that framework presented by another colleague, George Evans. The associated paper, "The Stagnation Regime of the New Keynesian Model and Recent US Policy" is here.
Evans begins with a New Keynesian in which expectations are formed by adaptive learning. An outcome of the model is that a sufficiently large negative shock can push the economy into a deflationary trap. Interestingly, agents learn their way into the trap by forming pessimistic expectations of future economic outcomes. My interpretation is that agents learn to live in what is often called the "new normal" and as a consequence make decisions that ensure the the new normal is a stable equilibrium.
The model is subsequently modified to account for nominal wage rigidities such that the low equilibrium trap, the stagnation regime, has an inflation floor. Another characteristic of the regime is low levels of output and consumption in which welfare is potentially much lower than the preferred equilibrium.
How can we break out of the stagnation regime? A temporary increase in government spending that is sufficiently large to allow a self-sustaining process to take over. The economy reaches an escape velocity such that agents learn there way allow a dynamic path to the preferred locally stable, higher equilibrium. At such a point, government spending can revert to normal without threatening a recession.
Monetary policy can also come into play, but Evans is less optimistic that the Federal Reserve is capable of breaking the US economy out of the trap. He notes that even promises of low rates forever may not be enough if the economy has suffered a sufficiently large negative shock. Evans adds that quantitative easing can support the economy via lowering long-term rates and stimulating demand, but also warns:

An additional problem, however, is that there are some distributional consequences that are not benign. Households that are savers, with a portfolio consisting primarily in safe assets like short maturity government bonds, have already been adversely affected by a monetary policy in which the nominal returns on these assets has been pushed down to near zero. A policy commitment at this juncture, which pairs an extended period of continued near zero interest rates with a commitment to use quantitative easing aggressively in order to increase inflation, has a downside of adversely affecting the wealth position of households who are savers aiming for a low risk portfolio.

There is a lot to digest in a short paper, but I encourage making the effort.
Thinking in terms of this model, it is immediately clear that one should be very concerned with impending fiscal austerity unless you believed the economy had already reached escape velocity (I don't). Moreover, you should be concerned about austerity even in context of the evolution of monetary policy into QE3 as it is not clear that the Fed can by itself push the economy to escape velocity. The Fed is literally stuck between a rock and a hard place, with the stimulative force of lower rates for borrowers traded off against lower income for savers, a point that Ed Harrison often makes. And the more we lean on monetary policy, the tighter that space gets. Yet we have little choice with a political environment that favors austerity over stimulus.
In addition, one should be concerned about the fragility of any recovery based upon a Fed-induced effort to achieve escape velocity. This is especially the case if the Fed has not promised (and whether such a promise is credible is another question) to be irresponsible in the transition to the higher equilibrium. Consider that the CBO projection for GDP growth is 4.8% in 2015. This, I suspect, is the kind of number needed to achieve escape velocity. But consider the Fed's reaction function in the face of such growth in the context of 1.) price stability and 2.) internal concerns about the ability to unwind quantitative easing. I think under those circumstance policymakers would error on the of tighter, faster rather than allowing a temporary acceleration of inflation.
The last paragraph brings up an interesting question. Even if the Fed promised to allow inflation to accelerate and did so, eventually they would tighten policy just the same. Which means the same recession, just a year later. 2015 or 2016. 2017 at the latest.
The problem is that the recovery is pretty much held together by debt refinancing, cheap mortgages and higher asset prices; by such measures, monetary policy has been successful! To be sure, there has been some debt reduction on the part of households:

But it is limited in comparison of the ability of households to utilize lower interest rates to reduce the cost of financing that debt:

I think in the near-term those who believe the monetary authority is the only answer will appear correct as the recovery progresses. Indeed, Annie Lowrey at the New York Times reports that household debt is now increasing for the first time since the Great Recession began. From a broad macroeconomic perspective, this is a near-term positive, and creates reason to believe that monetary policy will cushion the impacts of whatever flavor of the fiscal cliff we experience.

But I don't think this will be a stable long-term result. Obviously, I could be wrong, but it seems to me that we are using the same trick we have been using since the mid-1980's - lowering debt financing costs, thus allowing for a greater debt burden. This trick will continue to work as long as there is room to push interest rates further down. Now that we are at the zero bound in short-term rates and the Fed has been forced to move quite far out the yield curve to implement monetary policy, it is likely this is the last time that trick will work. There will not be much room to refinance our way out of trouble the next time around. Hence why I concerned about still being at the zero bound when the next recession hits.

Moreover, I would find it unlikely that we pass through another two or more years of zero interest rates without seeing capital mis-allocations, assets bubbles, and excessive risk taking. In such an environment, I don't think the Fed is going to be particularly successful in moving the economy off the zero bound without triggering a fresh recession.

Now, it would be easy to take this as criticism of the Federal Reserve. It isn't. The Fed should have moved to open-ended QE long ago to end the problem of arbitrary end dates to policy and needed to clean up its communication strategy to make clear the economic outcomes would define when QE would end. And, probably most importantly, the Fed is compensating for a dysfunctional US political process. I know there is one view (see Raghuram Rajan) that the Fed is simply enabling that process. Perhaps Congress would do the "right" thing if push comes to shove. But what is the "right" thing? If Congress were left to its own devices, would it take us down the road of fiscal stimulus sufficient to spring the economy from the stagnation trap? Or would they continue down the road of additional fiscal stimulus, driving the economy deeper into the trap? My sense is that Congress would find additional austerity to be the path of least resistance. Pete Peterson has won. The Congressional deck is stacked against the economy. And I think Federal Reserve Chairman Ben Bernanke knows this.

Putting all the piece together, I tend to think that neither fiscal nor monetary policy by itself will support a sustained recovery in which the interest rate environment normalizes and fiscal stimulus can be eliminated without fear of renewed recession. The two need to work hand in hand; the Federal Reserve has provided the monetary environment conducive to additional fiscal stimulus. Congress and the Administration now need to take advantage of the environment. Or, alternatively, if the fiscal authorities are not issuing sufficient new financial assets such that there is upward pressure on interest rates, they need to be issuing more.

In conclusion, the above framework both praises the direction of monetary policy without discounting concerns about the dangers of the permanent zero bound policy. A framework that allows for both accepting near-term growth on the back of monetary policy but also concern about the sustainability of that policy. A framework that decisively rejects additional austerity on a simple basis that it will not help normalize the interest rate environment. If nominal rates were 8% then yes, fiscal austerity would help normalize the interest rate environment. But that simply isn't the current situation. Perhaps, if we are lucky, it will be a problem in the future.

I realize that it would probably be easier if I could find myself either advocating the primacy of monetary policy in determining the level of output or deriding the Federal Reserve for the evils of the quantitative easing. Or if I could fully embrace fiscal stimulus as the only solution or austerity as the only solution. Picking one of those quadrant and defending it absolutely would probably make me more friends that straddling all four quadrants at once. But absolute devotion to one quadrant is probably not the right answer. I tend to believe that the right answer is a more complicated mix of monetary and fiscal policy than is currently employed. And don't think we can get to that right mix if we lock ourselves into an ideological box. Hence why I try to avoid such boxes.

Again, sorry for the long post.

Fed Battles Inflation

Quantitative easing (QE) has been the weapon of choice of the Federal Reserve and its chairman, Ben Bernanke, to stave off another recession, maintain stable prices and keep interest rates low. The method of flushing the market with currency seems to work in the short term, and some economists argue it can work in the long term, but many people are worried inflation has to come sooner or later, and relying on artificial money generation must be a ticking economic time bomb. Bernanke disagrees (although at this point it’s hard to say whether he has a choice), noting that inflation has been kept at bay for years using (QE). Naysayers argue only time will tell and that QE is too new to predict its consequences, but for now the Fed is willing to take the risk. For more on this continue reading the following article from Economist’s View.

David Altig of the Federal Reserve Bank of Atlanta argues that the Fed's quantitative easing and twist polices were necessary to preserve price stability (Dave will be in Portland, Oregon on Thursday along with Bruce Bartlett and others at the annual Oregon Economic Forum (scroll down) that Tim Duy puts on, and I am disappointed I can't be there this year -- I'm headed to the St. Louis Fed today for a conference):

Supporting Price Stability, by David Altig: All of the five questions that Chairman Ben Bernanke addressed in his October 1 speech to the Economic Club of Indiana rank high on the list of most frequently asked questions I encounter in my own travels about the Southeast. But if I had to choose a number one question, on the scale of intensity if not frequency, it would probably be this one: "What is the risk that the Fed's accommodative monetary policy will lead to inflation?"
The Chairman gave a fine answer, of course, and I hope it is especially noted that Mr. Bernanke was not dismissive that risks do exist:

"I'm confident that we have the necessary tools to withdraw policy accommodation when needed, and that we can do so in a way that allows us to shrink our balance sheet in a deliberate and orderly way. ...
"Of course, having effective tools is one thing; using them in a timely way, neither too early nor too late, is another. Determining precisely the right time to 'take away the punch bowl' is always a challenge for central bankers, but that is true whether they are using traditional or nontraditional policy tools. I can assure you that my colleagues and I will carefully consider how best to foster both of our mandated objectives, maximum employment and price stability, when the time comes to make these decisions."

While the world waits for "take away the punch bowl" time to arrive, here is another question that I think worthy of consideration: "Looking back over the past several years, what is the risk that the Fed's price stability mandate would have been compromised absent accommodative monetary policy?"
As the Chairman noted in his speech, it isn't easy to take the evidence at hand and argue any inconsistency between the Federal Open Market Committee's (FOMC) policy actions and its price stability mandate:

"I will start by pointing out that the Federal Reserve's price stability record is excellent, and we are fully committed to maintaining it. Inflation has averaged close to 2 percent per year for several decades, and that's about where it is today. In particular, the low interest rate policies the Fed has been following for about five years now have not led to increased inflation. Moreover, according to a variety of measures, the public's expectations of inflation over the long run remain quite stable within the range that they have been for many years."

To the question I posed earlier, I am tempted to take those observations one step further. Without the policy steps taken by the FOMC over the past several years, the "excellent" price stability record would indeed have been compromised.
Consider the so-called five-year/five-year-forward breakeven inflation rate, a closely monitored market-based measure of longer-term inflation expectations. If you are not completely familiar with this statistic—and you can skip this paragraph if you are—think about buying a Treasury security five years from now that will mature five years after you buy it. When you make such a purchase, you are going to care about the rate of inflation that prevails between a period that spans from five years from today (when you buy the security) through 10 years from today (when the asset matures and pays off). By comparing the difference between the yield on a Treasury security that provides some insurance against inflation and one that does not, we can estimate what the people buying these securities believe about future inflation. The reason is that, if the two securities are otherwise similar, you would only buy the security that does not provide inflation insurance if the interest rate you get is high enough relative to inflation-protected security to compensate you for the inflation that you expect over the five years that you hold the asset. In other words, the difference in the interest rates across an inflation-protected Treasury and a plain-vanilla Treasury that does not provide protection should mainly reflect the market's expected rate of inflation.
When you look at a chart of these market-based inflation expectations along with the general timing of the FOMC's policy actions, from the first large-scale asset purchase in 2008–2009 (QE1) to the second asset purchase program (QE2) in 2010 to the maturity extension program (Operation Twist) in 2011, the relationship between monetary policy and inflation expectations is pretty clear:

Enlarge

In each case, policy actions were generally taken in periods when the momentum of inflation expectations was discernibly downward. A simple-minded conclusion is that FOMC actions have been consistent with holding the bottom on inflation expectations. A bolder conclusion would be that as inflation expectations go, so eventually goes inflation and, had these monetary policy actions not been taken, the Fed's price stability objectives would have been jeopardized.

Statements like this do not come without caveats. A perfectly clean measure of inflation expectations requires that Treasuries that do and do not carry inflation protection really are otherwise identical. If that is not the case, differences in rates on the two types of assets can be driven by changes in things like market liquidity, and not changes in inflation expectations. Calculations of five-year/five-year-forward breakeven rates attempt to control for some of these non-inflation differences, but certainly only do so imperfectly.

Perhaps more pertinent to the current policy discussion, inflation expectations have, in fact, moved up following the latest policy action—which I guess people are destined to call QE3. But unlike the periods around QE1, QE2, and Twist, QE3 was not preceded by a period of generally falling longer-term breakeven inflation rates. So this time around there will be another, and perhaps more challenging, chance to test the proposition that monetary accommodation is consistent with price stability. As for previous actions, however, I'm pretty comfortable arguing the case that the price stability mandate was not only consistent with accommodation, it actually required it.

 This blog post was republished with permission from Economist's View.

Significant Shift in Employment Pattern

quasi-employment status as the recently unemployed searches for new full-time work, but the latest labor report shows a significant number of people going from being employed to not wanting a job. Some experts believe this is due to more people retiring now that the U.S. is climbing out of the recession, but others are more skeptical and think that it may be the sign of more bad news to come in the jobs market and for the economy as a whole. For more on this continue reading the following article from Iacono Research. 

Friday’s August labor report (as detailed here last week) has spawned some interesting discussion about the possible cause of the 30-year low in the labor force participation rate, stemming from the household survey’s odd collection of data in which totals for all three of these groups fell – employed, unemployed, marginally attached workers (those still wanting to work but who have given up looking).

Usually, the newly jobless go from being employed to unemployed and then, sometime later, to marginally attached (and out of the labor force), but, last month an unusually large number went directly from having a job to not wanting one. This is depicted below via this item at macroblog and this offering from the Wall Street Journal economics blog also discusses the subject.

Retirees are probably the biggest factor in this surge and it makes sense that a large number of individuals delayed retirement in recent years due to the financial crisis and are now packing up office boxes and picking up their last paycheck. Others are no doubt going back to school or quitting work to raise a family, but, perhaps the most curious thing about this recent change is that the last time it occurred was just when the 2008 recession was starting back in late-2007.

Is this s a good sign or a bad one?

Well, it might be good and it might be bad because, as indicated by the red arrows above, previous surges in the number of people moving from employed to out of the labor force have come when times were good with a peak occurring when recessions began. This likely means that people are comfortable enough today to pack it in, but, more importantly, that a new recession may not be far off.

This article was republished with permission from Tim Iacono.

No Fed Plan for QE3, Experts Say

The economy is “muddling along” according market observers, and experts say this state of affairs is not enough to force the Federal Reserve to initiate yet another round of quantitative easing in September. The latest Federal Open Market Committee meeting minutes indicate the Fed is closer to action, but more critics are starting to believe that action is going to be muted. Many think a prediction can be found by looking at what way centrists are leaning because it could go either, especially considering the persistent high rate of unemployment. For more on this continue reading the following article from Economist’s View. 

Tim Duy:

Chances of QE3 Diminishing, by Tim Duy: I have made the case that neither the doves nor the hawks that are important for the course of monetary policy. It is the center that is the key, and that center needs to be pulled in one direction or the other by Federal Reserve Chairman Ben Bernanke. If the 2Q12 slowdown proved to be temporary, I doubt Bernanke is inclined to pursue more QE in the absence of clear financial market disruption. And with that in mind, although economic performance continues to be no better than lackluster, recent data has dispelled the worst fears that we are heading into recession. This combined with stable financial markets argues against additional easing in September.
If the center is the key, we need to see where the center is moving. This should provide some insight into Bernanke's leanings as well. On July 13, Atlanta Federal Reserve President Dennis Lockhart said:

So, as one policymaker, here's my situation: my support for the current stance of policy rests on a forecast that sees a step-up of output and employment growth by year-end and into 2013. If the economy continues on the track indicated by the most recent incoming data and information, that forecast will become untenable, as will the policy premises underlying it. So, as I said at the outset, this is a challenging juncture for policymaking.

The data since that time has shifted Lockhart's views, with likely no small part of that change due to the employment report. Today:

As of July, there are more than 4½ million fewer payroll jobs than in November of 2007. Most of these job losses were in the private sector. The share of unemployed workers who have been out of a job for more than 27 weeks has fluctuated between 40 and 50 percent over the entire course of the recovery.
I think this condition can be attributed, at least in part, to fundamental imbalances that have not yet been corrected, a situation that presents formidable challenges for monetary policymakers. There is a risk to monetary policy being employed too aggressively and without effect to address economic problems that can be resolved only by fiscal reforms that involve making tough choices about the allocation of public resources. Monetary policy can exert a powerful positive influence on an economy, but as Chairman Bernanke has pointed out, monetary policy is not a panacea.

It is not that Lockhart believes the economy is surging forward. It is muddling along. But muddling along at a rate that does not justify additional easing. Nor is it clear that such easing would be effective as the remaining problems are beyond the scope of monetary policy. The logic appears to be that employed by Bernanke - the benefits of addition easing at this point do not exceed the risks. And while for the hawks those risks are inflation, for the middle ground I suspect the risks are to the functioning of financial markets. And while we are on the topic of financial markets, from Bloomberg:

“Anytime you see the equity markets rise, I think what it tells you is there is more appetite for risk,” Lockhart told reporters after his speech. “And in the current context, I would interpret that to be some comment on more confidence that Europe will work through its problems without a major incident of some kind.”

Europe has stabilized, reducing one of the clear risks to the outlook. Perhaps I have been too hard on ECB President Mario Draghi. Of course, I thought the same thing after the two rounds of LTRO, and that didn't stick. Once bitten, twice shy. But that can wait for a later post. The upshot is that equity markets have been on a nonstop trip higher:

We are not seeing a repeat of last summer's weakness that prompted Operation Twist. And while I don't have access to a Bloomberg terminal, Zero Hedge does, and noted this headline:

LOCKHART SAYS DISINFLATION, DEFLATION NOT NOW A CONCERN

Back to the charts:

TIPS are not signaling an imminent decline in inflation expectations. To be sure, this is at odd with the steady decline in inflation expectations as measured by the Cleveland Federal Reserve:

but that measure is not likely to weigh heavily in FOMC discussions. Policymakers are more likely to take their signals from financial markets.
The Reuters coverage of Lockhart's speech included this line:

Central bank officials gather in Jackson Hole, Wyoming, late next week for an annual conference on monetary policy. Many analysts believe Bernanke will use a speech there to lay out a third round of quantitative easing via bond buys, or QE3.

I find it very unlikely that Bernanke gives such direction on QE3. I think the current economic and financial environment bears little resemblance to the famous Jackson Hole speech of 2010. Given the change in the tenor of the data and the financial markets, it is hard for me to believe that his risk/benefit calculus is currently in favor of additional quantitative easing. I think he might take action if he could find another tool that he thought would be more effective than additional quantitative easing, but I don't see such a tool on the horizon. Maybe he will pull something out of his hat next week, but I doubt it.
Bottom Line: Closely following the doves would lead one to conclude that QE3 was imminent. This dovish chatter keeps the possibility of QE on the table. But really this has been the case for months. That should lead one to conclude that the bar to additional QE is high, very high. The middle, led by Bernanke, is just not pulling in that direction. Indeed, recent events seem to be pulling the middle away from additional QE. Assuming the FOMC holds steady in September, I think we will be able to measure the conviction of the doves by any dissents. If San Francisco Federal Reserve President, the most dovish voting FOMC member, does not dissent, he must not have a strong conviction that additional easing is necessary. And if the doves lack such conviction, why should we expect it from the middle ground?

 This blog post was republished with permission from Economist's View.

Election-Year Politics Pin Down Fed

Political gridlock has been the order of the day while the U.S. attempts to crawl out of an economic slump, but intensified obstructionism during the run up to the election has made progress even harder. Officials at regional Federal Reserve branches have been feeling the pinch and some have appealed to their colleagues in Washington to set aside political differences and enact policy to jolt the economy. It has become apparent to many that the Fed is standing fast until after the election and many find this behavior unacceptable given the state of the U.S. market. For more on this continue reading the following article from Economist’s View. 

Tim Duy:

Is the Election Holding Back the Fed?, by Tm Duy: Boston Federal Reserve President Eric Rosengren is stepping up his call for additional policy action at the next meeting. Via the Boston Globe:

Eric Rosengren, the head of the Federal Reserve Bank of Boston, is issuing an unusual public plea to his colleagues in Washington, urging the nation’s central bankers to ignore election-year pressures and do more to jump-start the muddling economy.
Less than a week after Federal Reserve policy makers elected not to take new steps to stimulate the economy, Rosengren in an interview added his voice to a handful of dissenters, saying the central bank has to act at its next meeting in September to revitalize the economy. The Fed should not worry, he said, if the move is seen as influencing the presidential election.
“We don’t get to pick the timing of a global slowdown,” Rosengren said. “If there’s a slowdown and you have an independent central bank, the appropriate response is to act. I think that’s exactly what we should do.”

I have to admit that I was caught off-guard by the direct reference to the presidential election. I have seen speculation that the Fed is avoiding action until after the election, and this seems almost like an admission of such hesitation. Is this comment directed at the public, or at his colleagues? My response:

Some Fed specialists said the remarks from Rosengren are unusually pointed in a world where even the simplest statements are carefully worded. Tim Duy, an economics professor at the University of Oregon who writes a column called Fedwatch on the website Economist’s View, said he was struck, in particular, by Rosengren’s publicly urging the central bank to ignore the political situation.
“That would be fine to say internally. But to say that externally, to pull back the curtain and say, ‘They’re doing this for the election,’ I think is a shift and reflects his level of frustration,” Duy said.

Rosengren then goes further and calls for very aggressive policy:

Rosengren said the economy is just “treading water” and among the actions the Fed committee should consider is a repeat of what the central bank did during the recession when it spent trillions of dollars buying securities. The bond-buying program was controversial, and critics complained it did not help much. But Rosengren said anything more modest than that would probably not be enough. “It would be hard to come up with a program with a big enough impact” without big purchases of securities, he said....
...“Facing a world that’s going to be treading water, monetary policy shouldn’t just stand there and watch it happen,” Rosengren said. “We should start talking about more aggressive policy to make sure we get the kind of growth that’s consistent with improvement in the labor markets.”

Rosengren has been moving in this direction for a few months, but these sound like very pointed remarks, the remarks of someone who is very frustrated with the current stance of policy. Interestingly, such level of frustration could also be indicative of the strength of opposition to additional quantitative easing within the FOMC. Indeed, I have long-hypothesized that Federal Reserve Chairman Ben Bernanke could move the middle ground of the FOMC to the doves if he desired, and the fact that he hasn't done so reveals his preference for inaction. Consequently, the bar to further easing has been higher than believed. That continued inaction in the face of ongoing lackluster economic growth and the persistent failure to meet not just one but both parts of the dual mandate could finally be trying the patience of the FOMC doves.
Bottom Line: Who is Rosengren talking to here? It doesn't sound like he is making a case to the public when he says "[w]e should start talking about more aggressive policy." It sounds like he is making a case to the rest of the FOMC. Same with his comments on the election. At a minimum, he is another voice for aggressive easing. But such comments sound like he is frustrated with the path of policy, which would signal the strength of the resistance to further easing. Overcoming that resistance is critical to clearing the path to that easing.
Now we await Bernanke's comments, to see if he gives any ground.

 This blog post was republished with permission from Economist's View.

Spanish Collapse Threatens Eurozone

Spain has switched gears from calling for help with some banks to an overall sovereign bailout and the new tack has investors and financial analysts question the stability of the Eurozone. Some wonder whether Germany will stop forking over money to its struggling neighbors, although to do so would be tantamount to giving up on any possible success on the European financial system’s lasting cohesion. Everyone agrees that small bailouts will not work, and that nothing at all will work without exercising fiscal restraint, but no one seems to be able to offer up a feasible plan. For more on this continue reading the following article from Money Morning.

The market red ink Monday around the globe is the result of a usual suspect - Spain.

These days, if someone even sneezes in Madrid, Barcelona, or Córdoba (one of my favorite places, actually), investors go into intensive care all over the world.

This new Spanish influenza has been wiping out paper value from one end of Europe to the other. This morning came word that many of the regions in the country will need help. Attention is now directed from focused support for banks to wider calls for a sovereign bailout.

And that is where the whole matter can turn nasty. Word is that we should now expect some Italian cities to be requesting money in the near future. Seems California and Pennsylvania are not the only locations where cities can go bankrupt.

The accord reached at the end of June by the Council of Europe (the EU member heads of government) to bail out Spanish banks is already derisively referred to as "bailout lite." As the beer commercials attest, this is going to be "less filling."

Unfortunately, it is the heavier version that Europe now needs.

Germany: Eurozone Debt Crisis Savior

Brussels will now have to come up with another, weightier approach.

The problem with all of this, of course, is that at some point the bellwether of Europe will say "enough is enough" and drag its heels on any further largess to disobedient southern cousins.

If Germany throws in the towel, the Eurozone is in real jeopardy.

Some pundits are already talking about such a reaction. Yet there are positively no indications that Berlin is moving in that direction, at least not yet.

The reason is simple - so simple that most doomsayers simply overlook it.

If Spain or Greece goes under, it is not only one economy that has been thrown under the bus. The cross-border held debt and the continent-wide investment and capital programs will be pulled down as well.

Some in Europe may not like it, but it took decades to reach the point where the EU is largely operating on an integrated currency and banking system. There is no way to break up without destroying the last 30 years of joint action.

Talk about a messy divorce where the family china is thrown about...

The Importance of Fiscal Restraint

Europe needs a genuine bailout in return for strictly enforced fiscal and monetary restraint.

The basis for this is already in place, as part of the anticipated approach adopted in late June. In return for the money, there needs to be collective control of commercial banks.

Now, for those who bemoan the fact that this is an interruption of free-market economics, let me simply point out that it was the unfettered transfer of credit, augmented by insufficient bank reserves and indifferent oversight regulations, that got them where they are in the first place.

Regulatory intervention is not the best way to establish market equilibrium. But there are times when it is required. And this is certainly one of those times.

The current call for sovereign bailouts, and we will see more of this as we move forward, misses the mark. Fiscal restraint coming from the central government and monetary restraint issuing from the central bank are essential. Yet they must be contained in a broader longer-term solution that provides some political shelter for those officials making the decisions.

These are not stupid or callous people. These are elected and appointed administrators restrained by a system that has gone awry. There is a very public price to pay for bucking it. Coverage needs to come from Brussels. We can discuss the academic nuances of economic systems and plot hypothetical courses in the best of all preferred worlds.

Unfortunately, Europe is living in this world.

Collective frustrations aside, more concerted and centralized control over the continent's banking system is the likely outcome. Remember, when all is said and done, the overwhelming majority of the European wealth that needs to be protected is not carried around in pockets or stuffed in mattresses. It sits in bank accounts.

Europe needs to be remembered for more than its castles and picturesque, yet closed, town public squares.

This article was republished with permission from Money Morning.

Libor Scandal Expands

What started with Barclays and an investigation into fixing of the Libor (London Interbank Offered Rate) has now expanded to encompass 20 more large banks. The Bank of England is the latest financial institution to get sucked into the scandal and analysts are split on whether this is good or bad for the global economy. On the upside, it’s good that banks are getting caught out for manipulating rates that impacted $800 trillion in global trades, but the downside may be that disruption in the system could cause runaway inflation or worse problems. Even so, experts agree a hobbled free market is better than a manipulated one. For more on this continue reading the following article from Money Morning. 

Not only are at least 20 more big banks under investigation as part of a massive fraud to manipulate interbank lending rates that affect some $800 trillion in loans and derivatives, but the Bank of England is about to take center stage in the scandal.

And that's bad news for central banks around the world.

Well, actually, it could be good news, as in really good news, if it's the beginning of the end of what central banks do to manipulate free markets to the benefit of their only real constituents, the world's big banks.

First the good news.

It's already come out that traders at Barclays with huge derivatives positions leaned on co-workers who sit on "panels" that submit internal bank borrowing cost data to Thompson Reuters. And Reuters averages the middle lot of submissions to determine Libor (London Interbank Offered Rate) "fixings" (not my word, but actually the established nomenclature for what it apparently is that they do... as in "fix" rates). And it's all under the auspices of the British Banking Association.

What's good is that we now know for a fact that the traders (crooks?) were aided and abetted by their co-workers, the submitters (crooks?), who were overseen by managers and top executives who design most of these schemes (crooks?), and were all blessed by the British Banking Association, an illustrious association of 200 some-odd banks, whose many members (crooks?) are panel members submitting crooked (no question mark necessary) data.

Still don't get why that's good news?

Because it's proof there are crooks out there.

And this time it's easy to see where the "fix" actually occurs.

It's also good news because, according to one multinational banking executive, just quoted in The Economist, it's "the banking industry's tobacco moment."

He was referring to the potential mountain(s) of litigation being drawn up already to claim that gross manipulation of interest rates caused billions, maybe trillions, of dollars of harm to borrowers and financial players of all stripes.

Remember, back in 1998, Big Tobacco had to settle class-action suits related to death and injury from cigarettes and other tobacco use. (These plaintiffs argued that tobacco companies knew of the health risk of smoking and failed to warn consumers.) These lawsuits cost them over $200 billion.

The bad news is the Bank of England, one of the world's stalwart and oldest central banks, is about to face its own potential Lehman moment (at least we can hope). That's on account of the fact that Paul Tucker, deputy governor of the Bank of England (and its supposed next top dog), is going to have to come clean in front of Parliament very shortly.

Mr. Tucker is apparently on record (according to Bob Diamond's phone call notes) suggesting that the Bank of England wanted Barclay's to manipulate it's Libor submissions downward so as to not panic counterparties and the country who might view tight interbank lending conditions as a sign of stress across the entire banking system.

So, here's why the bad news for the central bank (encouraging, no, make that, demanding fraud) is really good news for free markets.

Central banks have done nothing to countermand the trend (nothing but encourage) leading to big banks getting bigger; so big, in fact, that now all of the big banks around the world are all too big to fail.

The bigger the world's banks are (bankers want size, because more size equals more power to price, to manipulate markets, and to pay bigger bonuses), the more important central banks become, both to the big banks, nations, and the global economy.

Central banks are the saviors of big banks that get in trouble, especially when systems and economies are leveraged for profits that backfire, and they all have to be bailed out.

Central banks are supposed to be above what's going on below their ivory towers, but, in fact, they are the puppets being manipulated by the big banks. It's a case of the tail wagging the dog.

Why are central banks pouring money into banks, really? Why aren't governments printing money to pour into ailing economies but instead aiding and abetting central banks?

It's because central banks are independent supra-national bodies who have been ceded monetary power by governments almost everywhere to benefit banks and bankers the world over, who are their only constituents, and for all intents and purposes, effectively "own" legislators and governments.

They're pouring money into banks to keep them solvent. That's what central banks are there for. The banks aren't lending the money (massive reserves are sitting on balance sheets to shore up appearances) because they need it to meet reserve requirements and offset the illiquidity evident in the interbank lending market... the same interbank (Libor) market that the Bank of England wanted to make look more liquid than it was viscous back in 2008.

But it gets worse.

What will happen when the "multiplier effect" takes effect? I'm talking about the potential for massive inflation when all those huge quantities of reserves (stimulus) get lent out instead of shelved on balance sheets.

How about massive inflation?

Heaven help us if all these macro crises are fixed quickly. The flood of idle cash and credits globally will make past inflationary bursts look like a 40-yard dash, compared to miles and miles of potential problems ahead of us.

We need free markets, not manipulated markets. We need to break up all the world's big banks so they can fail when they overleverage themselves and entire systems, nations, economies, and the global economy aren't all brought to their knees.

If we break up all the too-big-to-fail banks, we won't need central banks. We can go back to what are supposed to be free markets dictating interest rates and creating honest, open economies and opportunities everywhere.

Who's with me?

Article written by Shah Gilani

Shah Gilani is considered one of the world's foremost experts on the credit crisis. He not only called for the implosion of the U.S. financial markets, he also predicted the historic rebound that began in March 2009. Shah is the editor of Capital Wave Forecast and Spin Trader. He also writes Money Map Press’s most talked-about publication, the Wall Street Insights & Indictments.

Africa Losing Money, Labor

No one seems to have any faith in the future of Africa, as evidenced by the mass exodus of capital and skilled labor from the country. One economist reports on the all too common phenomenon of capital flight from Africa as money gained in the country is shifted out to other markets for investment, while the same occurs with the talent pool as skilled Africans inadvertently subsidize the growth of other countries by abandoning their homeland for better-paying jobs. Despite substantial amounts of foreign investment and aid, it is estimated that around $700 billion of this money has been funneled out through capital flight over the last four decades. For more on this continue reading the following article from Economist’s View.

This is from Léonce Ndikumana:

Africa Specializing in Capital Exodus?, by Léonce Ndikumana: Even as Africa faces severe shortages of skilled labor at home, it experiences large and increasing outflows of highly-skilled labor migration to industrialized economies in search of better job opportunities. The investments made in the training of these professionals are losses to African countries but translate into hefty gains for receiving countries.  Thus resource-starved African nations are subsidizing developed countries’ industries and social services. ...

Parallel to this exodus of human capital is the illicit export of financial capital from African countries – or capital flight. This is not a new phenomenon, and it shows no signs of abating.

Over the past four decades, sub-Saharan Africa has lost a staggering $700 billion due to capital flight. In addition to trade misinvoicing, smuggling, and embezzlement of revenues from natural resource exports, a substantial part of the capital flight was financed by external borrowing. We estimate that every year 40 to 60 cents of each borrowed dollar spins out of the revolving door as capital flight, often returning to the same banks that issued the loans. On net basis, Africa is transferring more money to the rest of the world than it is receiving in terms of borrowing and aid. Once again, Africa is net financier to the rest of the world rather than the other way around as commonly perceived. And unlike in the case of human capital exodus, financial capital flight generates absolutely no flows in the reverse direction; it is an unmitigated loss to the continent.

Capital flight, and the burden of servicing the debts that financed it, are partly to blame for the conditions that create the other economic problems faced by the continent...  Illicit financial flows drain scarce public resources that could have been used to finance public services including education and health. It partly explains why there are not enough schools, clinics, and medical equipment; it also explains the poor working conditions for doctors, teachers, and other professionals that force them to seek greener pastures abroad.

Stemming capital flight could substantially bridge the financing gaps faced by African countries. ...

It is clear that Africa’s development pathways, characterized by exodus of human and financial capital, are not sustainable in the long run. Obviously African countries have the primary responsibility to devise and implement strategies to keep capital onshore. But the international community also has an equally important responsibility to root out the perverse incentives and opacity in the financial system that enable and perpetuate the financial hemorrhage faced by the continent. This would enhance the efficiency of donors’ support to Africa’s efforts to boost investments in education, stimulate private sector development, employment creation, and generally improve domestic living and working conditions that are necessary for optimal utilization of skilled human capital on the continent. ...

This article was republished with permission from Economist's View.

Current Policies Reflect Depression-Era Behavior

Author Charles Kindleberger’s latest opus, The World in Depression, 1929-1939, draws parallels between the behaviors of policymakers and investors around the globe during the last financial crisis, and highlights three ways in which people make the same mistakes in times of distress. Briefly Kindleberger argues that the persistent nature of an economic downturn is fueled by panic, which leads to contagion of erroneous thought and action. This culminates in the third lapse, which is the development of hegemony that results in the spread of negativity to other countries from more powerful nation states. For more on this continue reading the following article from Iacono Research.

There’s an interesting new preface to Charles Kindleberger’s The World in Depression, 1929-1939 by U.C. Berkely Economics Professors Brad DeLong and Barry Eichengreen over at vox. It argues we’re making many of the same mistakes today as were made 80 years ago and they note three key lessons as detailed below.

First, panic. Kindleberger argued that panic, defined as sudden overwhelming fear giving rise to extreme behavior on the part of the affected, is intrinsic in the operation of financial markets. In The World in Depression he gave the best ever “explain-and-illustrate-with-examples” answer to the question of how and why panic occurs and financial markets fall apart. Kindleberger was an early apostate from the efficient-markets school of thought that markets not just get it right but also that they are intrinsically stable. His rival in attempting to explain the Great Depression, Milton Friedman, had famously argued that speculation in financial markets can’t be destabilizing because if destabilizing speculators drive asset values away from justified, or equilibrium, levels, such speculators will lose money and eventually be driven out of the market.  Kindleberger pushed back by observing that markets can continue to get it wrong for a very, very long time. He girded his position by elaborating and applying the work of Minsky, who argued that markets pass through cycles characterized by self-reinforcing boom, next by crash, then panic, and finally by revulsion and depression. Kindleberger documented the ability of what is now sometimes referred to as the Minsky-Kindleberger framework to explain the behavior of markets in the late 1920s and early 1930s – behavior about which economists otherwise might have arguably had little of relevance or value to say. The Minsky paradigm emphasizing the possibility of self-reinforcing booms and busts is the organizing framework of The World in Depression. It then comes to the fore in all its explicit glory in Kindleberger’s subsequent book and summary statement of the approach, Mania, Panics and Crashes.

Kindleberger’s second key lesson, closely related, is the power of contagion. At the center of The World in Depression is the 1931 financial crisis, arguably the event that turned an already serious recession into the most severe downturn and economic catastrophe of the 20th century. The 1931 crisis began, as Kindleberger observes, in a relatively minor European financial center, Vienna, but when left untreated leapfrogged first to Berlin and then, with even graver consequences, to London and New York. This is the 20th century’s most dramatic reminder of quickly how financial crises can metastasize almost instantaneously. In 1931 they spread through a number of different channels. German banks held deposits in Vienna. Merchant banks in London had extended credits to German banks and firms to help finance the country’s foreign trade. In addition to financial links, there were psychological links: as soon as a big bank went down in Vienna, investors, having no way to know for sure, began to fear that similar problems might be lurking in the banking systems of other European countries and the US. In the same way that problems in a small country, Greece, could threaten the entire European System in 2012, problems in a small country, Austria, could constitute a lethal threat to the entire global financial system in 1931 in the absence of effective action to prevent them from spreading.

This brings us to Kindleberger’s third lesson, which has to do with the importance of hegemony, defined as a preponderance of influence and power over others, in this case over other nation states. Kindleberger argued that at the root of Europe’s and the world’s problems in the 1920s and 1930s was the absence of a benevolent hegemon: a dominant economic power able and willing to take the interests of smaller powers and the operation of the larger international system into account by stabilizing the flow of spending through the global or at least the North Atlantic economy, and doing so by acting as a lender and consumer of last resort. Great Britain, now but a middle power in relative economic decline, no longer possessed the resources commensurate with the job. The rising power, the US, did not yet realize that the maintenance of economic stability required it to assume this role. In contrast to the period before 1914, when Britain acted as hegemon, or after 1945, when the US did so, there was no one to stabilize the unstable economy. Europe, the world economy’s chokepoint, was rendered rudderless, unstable, and crisis- and depression-prone. That is Kindleberger’s World in Depression in a nutshell. As he put it in 1973:

“The 1929 depression was so wide, so deep and so long because the international system was rendered unstable by British inability and United States unwillingness to assume responsibility for stabilizing it in three particulars: (a) maintaining an open market for distress goods; (b) providing counter-cyclical long-term lending; and (c) discounting in crisis…. The world economic system was unstable unless some country stabilized it, as Britain had done in the nineteenth century and up to 1913. In 1929, the British couldn’t and the United States wouldn’t. When every country turned to protect its national private interest, the world public interest went down the drain, and with it the private interests of all…”

Though I enjoyed and highly recommend Mania, Panics and Crashes: A History of Financial Crises, I’ve not read this account of The Great Depression that, according to DeLong and Eichengreen is told mostly from a European point of view. That oversight is now being corrected via Amazon’s One-Click ordering.

This article was republished with permission from Tim Iacono.

Americans View Taxes as Immoral, Experts Say

Although Americans are not taxed nearly as much as people in other Western countries, particularly Canadians and the British, there is nothing that vexes U.S. citizens more than more taxes. Experts say this is because middle-class Americans view taxes as more of a moral issue than other cultures, and one that is always tinged with a hint of exploitation. A recent survey showed that the middle class feels it is stuck paying for handouts to a lazy welfare class while the class above them manipulates tax laws in their favor. In the end, Americans view taxes as a matter of right and wrong, and the current tax structure appears immoral. For more on this continue reading the following article from Economist’s View.

This reinforces points I (and others) have made about why people oppose taxes:

 Why are some people morally against tax?, EurekAlert: ...Americans are famously hostile to taxes even though they are not heavily taxed in comparison to Canadians and the British. ...Dr Jeff Kidder and Dr Isaac Martin, from Northern Illinois University and the University of California-San Diego, explore how middle class feelings of exploitation lie behind this hostility.

"Everyday tax talk among the middle class is not simply part of a wider ideological view about economics or free markets," said Kidder. "Tax talk is morally charged and resonates with how Americans see themselves and their place in society."

The researchers conducted 24 semi-structured, open-ended interviews with taxpayers in the Southern states who owned or managed small businesses to discover how they talk about taxes in everyday life. Entrepreneurs are a demographic group which is typically strongly anti-tax, while the Southern States provide many supporters for the radical Tea Party.

Respondents saw themselves as morally deserving and hard-working people, sandwiched between an economically more powerful group that manipulates the rules for its own benefit and a subordinate group that benefits from government spending but escapes taxation.

"We found that people associate income tax with a violation of the moral principle that hard work should be rewarded," said Kidder. "Our research shows that when Americans lash out at 'takeovers,' 'massive taxes' and 'bailouts,' they are looking at these issues from the perspective of a hard-working middle class besieged on all sides. Tax talk is about dollars, but it is also about a moral sense of what is right."

It is typically believed that those who are anti-tax will also be hostile to government aid for the poor and minorities. However, rich recipients of bailouts were also disparaged as people who did not deserve money because they did not work for it.

"A lot of the tax talk you will hear from politicians this election season makes no sense as arithmetic," Martin said. "But it makes sense as an appeal to the moral sensibilities of small business."

"Our research shows that tax talk is not actually about individual self-interest, but about our respondents' sense of the proper relations among groups," concluded Kidder.

Here's how I put it a bit over a year ago:

...People believe they paid for programs such as Social Security and Medicare. They put in contributions each month, the government saves that money somewhere, somehow, and when they use these programs they aren't consuming from "government," they are consuming their own contributions. ...

So it's true that people want the budget cut, but only the parts where people are forced to pay for "underserving" recipients of these government services. The feeling is that they get up every day and do what's needed to support themselves and their families. They go each day to jobs they hate, hate, hate, hate with a passion because that's how life is, and they don't appreciate seeing their hard-earned money taken away and given to people who don't even try, people who could work if they wanted to, but rely on the system instead.

Now, I happen to think that is a very wrong view of the circumstances of the typical aid recipient, but true or not I do think it is the source of the opposition to many social programs. People don't object to Social Security and Medicare because they believe they paid for these programs in full, or close to it. Same for disability, food stamps, and other programs. They paid into these programs for years, just like medical insurance, and now it's their turn to consume some of the funds they put in... It's the people who consume without contributing that raise their ire and cause objections to these programs. It's the "handouts" that are the problem. ...

And as noted above, the same applies to handouts to the wealthy. (Which reminds me of my mom criticizing my uncle as I was growing up -- a very well off and very Republican farmer -- for complaining about welfare recipients while taking crop subsidy payments himself. She used to tell me he was on welfare too, except he didn't need it. I'll just add that financial executives in too big to fail banks didn't need it either.)

This blog post was republished with permission from Economist's View.