Thursday, April 22, 2004

SHOW ME THE MONEY $$$ Edition, part I



I.
IT'S THE ECONOMY STUPID!


As regular readers may have noticed, the oldman hasn't posted anything about the economy for a while even though the last month's number revisions to the jobs numbers actually vindicated previous personal estimates.

The reason why is that I realized something. People who were cluelessly bumping around promoting their ideas and looking past the real problems, were going to continue to do so. The problem is that their ideas simply don't work in the real world.

Instead of asking rather tangential questions, such as whether or not a handful of jobs are created in some sort of trade synergy or not, we should ask ourselves if we simply aren't flat out hands down simply being outcompeted economically. (Friedman - NYT)

A while back the oldman was intent on writing a series of articles explaining everything and how we could get out of the fix. Then he realized this was useless because most people didn't even understand the question. What's the point of an answer when people don't even understand what question it goes with?

Some people such as Nathan Newman (see sidebar about growth/inflation) clearly understand that the economy is not being properly measured and this is creating a real estate bubble. Others such as Brad Delong, have written wringing their hands about the real estate bubble. Well, it's too late to do much about it since even Samuelson has written about a real estate bubble. Since Samuelson has figured it out, then apparently it's so overwhelming that it's completely obvious and no one can stop this train now.

In May of 2003, a report was submitted to Congress examining the potential for a real estate bubble. (PDF) The conclusion is that while there were bubble-like aspects of the housing boom that it hadn't spread sufficient to be called a bubble. Well it has since then!

The problem is that people, even emminent economists like Brad Delong, simply don't understand what is really going on in the economy. That is they look at graphs and numbers, and they know fancy mathematical terms, but it doesn't correspond to anything. It's not like they have a real sense of the economy itself.

What is happening with the economy? Well, we're experiencing a top. As Krugman writes in the NYT, even by the weird system by which we calculate inflation it's rising significantly more than interest rates are set at. Even Greenspan however belatedly is admitting that we may need to raise interest rates soon. (MSNBC)

The actual economy is not that robust. It's not bad, but it's not significantly growing for all the weird GDP / growth figures getting passed around. This is because actual capital investment is tepid at best and business expansion slow. This correspond to the real picture being produced of limited job's growth. That's the facts on the ground.

Up in la-la economist land the economy is robust, we're finally starting to produce jobs like gang-busters even though the numbers are juiced as hell by odd assumptions, and trade is benefiting our country. In the real world, we're getting outcompeted by India and China and the top colleges are more and more playgrounds of the rich who are edging out the middle class in class representation. DISCLOSURE: I attended the University of Michigan once upon a time.

It's not about whether "comparative advantage" applies in some minor correction. It's about the main thrust of simple success, growth, and the failure of our country in order to make progress. In simpler terms it's about competitive advantage. I am constantly surprised by the economists who will make Paretto-Optimum Assumptions or Hicks-Kaldor criteria in Game Theory, when the far more likely result of a multiplayer game with near perfect information and no coordination such as price-fixing is likely to be a Nash Equilibrium. The Nash Equilibrae are called the competitive equilbrium after all.

However in the real world, we're at a top. This is interesting because it seems that China is danger of over-heating its economy and Japan's economy might finally after over fifteen years in the doldrums be picking up. However structurally, fiscally, and in monetary policy there's no place for us to go but down at this point. However it doesn't need to be a quick or obvious reversal. As Keynes noted, the market can stay irrational longer than one can stay solvent.

II.
FALSE DICHOTOMY: MONETARY POLICY VS ENCOURAGING BUBBLES


Brad Delong has an article juxtaposing a false dichotomy about America's interest rate policies. The idea is that we have to put up either speculative bubbles or rigidity in monetary policy. This is simply not true.

There's a big player - the elephant in the living room so to speak - regarding this whole business. As a matter of fact, the Fed does have more than one policy instrument. And certainly the Federal government has more than one policy instrument besides the Fed Funds rate.

Greenspan could have eased the bubble bursting by simply raising margin requirements. He could have also promoted tighter lending standards. Indeed a good monetary policy argument is that lending standards should be tightened or loosened in inverse relationship to credit easing and tightening.

It wasn't that there was just - and still is - a lot of money floating around. It's that it was finding it's way into a lot of speculation or floating enterprises that should have gone under. Macro-economic money supply is determined not just by transactions but by the quality of transactions. Dead money so to speak breeds no capital investment profits.

It's the same problem that happened in Japan only more severely so. Part of the problem of the JCB easing to near zero interest rate levels is that the money only prolonged the existence of zombie companies and kept banks from clearing bad loans off their portfolio.

Macroeconomic stimulus through monetary policy requires lending discipline, or else the stimulus does not achieve its Keynesian aim.

Greenspan himself has recently spoken out about the lack of accountability in the market system. Accounting standards, Corporate governance, institutional firewalls against conflicts of interest, tax system reform - all of these are tools to fight bubbles.

Similarly in a period of credit tightening, loosening credit standards can counteract or mitigate an otherwise harsh economic dampening. Recently the IRS spokesperson said that part of the reason why the 90's binge could happen is that the IRS takes about five years to do a complex corporate audit, and they simply hadn't gotten around to auditing the companies in question before they went belly-up circa 2000. They were still auditing 1995 forms.

Right now we have a system that essentially allows the loosening of credit standards at the same time monetary policy is eased or stimulus applied. This inevitably creates a rampant bubble - asset, debt, real estate, whatever, it's clearly speculative.

By using both policy instrument sets and trading them off against each other, both maximal stimulus and maximal inflation combating can be achieved in a more optimal Keynesian management of the short-term transitions in a national economy.

III.
WHAT ABOUT THE GREENBACK?


Indeed the easing of the Greenback was a necessary and long overdue adjustment in currency exchanges. However it was the precisely the wrong time for such a move to come about. Food and energy is rising even at the warped means of calculation the government uses at about 5% inflation. Part of this is because most people don't understand what dollar hegemony means. It means that the dollar is the "new gold" or a universally accepted currency.

Over and over again I have commentators telling me that the current accounts deficit "doesn't matter" because every US dollar will eventually come back in the purchase of US goods, services, or securities. Putting aside the question of whether or not shifting the monetary inflow from export industries to low-yielding government bonds that fuel reckless spending by warping the yeild curve, it's simply not true. As a matter of fact most people trade the dollar back and forth, without it ever having to come home using it to buy and trade commidities as different as sugar and coffee to crude oil and Persian rugs.

This dollar hegemony has been the hidden third leg of the stool that Greenspan has based his monetary policy upon. The first stool of course was the US Treasury position on the "strong dollar" over consecutive Administrations and the international lending institutions that US policy used in order to promote US interests. The second supporting leg of Greenspan's achievements was his ability to convince the Federal Reserve members in order to follow his lead in lowering interest rates on the basis of low inflation. The third leg was promoting monetary easing that was soaked up by a liquidity hungry world and so prevented inflation that comes from printing too much money. In other words we can buy more than we can sell, primarily because people want the dollars they get from our excess purchases to fund other purchases they need to make in turn using dollars.

Essentially we could print more dollars without inflation because everyone else wanted them. Indeed the world is awash in dollars. Without this global demand, financial inflation and interest rates in the United States would have been significantly higher in the past twenty years.

But the currency adjustment while bringing partially into rein an unsustainable monetary stimulus policy, created a upsurge in a critical commodity. Oil is denominated in dollars and a dollar weakening must correspond to a crude oil price rise, and indeed we have seen such a rise - from about $27-$28 dollars a barrell to over $35 pb. This is the exact rise necessary more or less to cancel out the loss of income from a weakening dollar. The increase in dollar terms of transportation and energy costs however became an economic drag.

If for no other reason, an economic slowdown would have to be expected in the States through the summer months. TANSFAL ... There's no such thing as a free lunch. The attempt to boost the economy through letting the dollar fall without intervention can't win because it means higher oil prices and that will slow the economy. One is merely shifting the costs around inside the economy rather than increasing overall economic competitiveness. The final total fixed cost structure of producing goods and services will remain the same. Yes, the nominal wages of US laborers will go down relative to foreign workers, but the inflation fueled by the rise in import prices especially in oil will eventually cancel that out and then some. Since it takes time for the system to adjust we can expect the initial correction to be mild and then to proceed past the point of matching until it reaches a higher crest before returning to a matching equilibrium long term average.

That means because it takes a while for price increases to work through the system but currency price shifts take place much faster, we can expect an inflation rise to overshoot the value of the currency shift and then crest prolonged above it and then later come back into harmony with it. We can get a quick hit of lower currency cost pricing at the consequence of promoting higher long term inflation before things even out eventually.

Because of this, in the fall interest rates will probably have to rise higher than the structural short term yeild curve expectations would have been. This will in the short term further destabilize the dollar. This will cause further mid-term financially induced inflation. The long term picture is of course controlled by the fiscal outlook, which isn't too rosey. The total result will probably be a period of higher inflation and interest rates than what would have ordinarily been expected until budgetary discipline returns and more capital investment is made in domestic American business operations.

This will depress actual growth and probably send the nation into another liquidation phase- e.g. recession. The only real cure for this will be to tighten lending standards, and this will undoubtedly cause some pain. However this is the cause of the failure of the Federal Reserve and the Government in order to implement sound policy. Tightening lending standards while easing monetary policy, and loosening them while tightening it is probably the best response a managed economy can have.

Right now we're throwing good money after bad. This can be seen by the lowering rates of junk-bond defaults. That may sound like a good thing until you realize that these junk bond companies are staying afloat because that easy credit from the Fed is going to keeping them on life support rather than creating new business operations. These "vampire" or "zombie" companies could be wiped out simply by raising requirements for new or expanded lines of credit.

IV.
WHAT NEXT?


The oldman advised his friends and family over a month ago to take their money out of the stock market (or bond market for that matter), and to delay any real estate purchases not already in the works for about half a year in any bubble-ridden areas.

There was no reason to go around shouting about things simply because it was already a done deal. Next time around, after this debacle we could start afresh with a real look at how best to manage America's economy. However with Greenspan still locked in his triparate program of artificially low interest rates and inflation due to foreign subsidy, we can't really move forward.

So that's where the smart money is, ride out the coming storm.

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