REAL ECONOMY vs PAPER ECONOMY

The Bullish Bear: "Came across 'Planet Real vs Planet Paper' in the Taipan Daily, 24th February, 2010.

At a time when Wall Street seems to be totally ignoring Main Street, it's always worthwhile to take a step back and analyse the 'real' vs 'paper' economy.

"

On that ‘extended period’ of low interest rates

FT Alphaville: "

From an investment outlook by William Browder, founder and chief executive of Hermitage Capital Management, and presented at last month’s LCF Rothschild emerging markets funds conference:

In case you can’t read the fine print, the slide references this 2003 Federal Reserve paper about the effects of budget deficits on interest rates. Put simply, the paper asserts that a one percentage point rise in the projected deficit-to-GDP ratio generates a 20 – 40bps increase in the 10-year bond rate rates.

Of course, that’s purely based on deficit measures, and completely ignores the potential need for loose monetary policy in times of financial stress — something which the world’s central banks have responded to in force via quantitiative easing, as the below Hermitage slide should also show:

And since we’re talking developed country deficits, QE and emerging markets — which tend to be linked to hard commodities — you can probably guess where Browder is going. One more slide:

Full presentation in the Long Room. (Muchos gracias to Eminence Noire)."

Promises, Promises

Aleph Blog: "

My piece on bank reform will have to delay until Monday evening. I am still working on it. Tonight’s piece is on entitlements and pensions globally and locally.

I asked recently if anyone had data on other countries of the world to analyze where other countries were in terms of debt plus unfunded liabilities as a percentage of GDP. I got a few good suggestions, but then I stumbled across this article in the New York Times that provided the graph to the left.

The article is about Greece, but the graph covers all of Europe and the US. I am not sure where the author got the 5x GDP estimate for the US, but I have e-mailed him. My own estimate was 4x GDP.

Either way the US and the EU are more comparable than different by this measure. They are both in the 4-5x GDP zone. But the EU contains some real basket cases such as Poland, Greece, Slovakia, Slovenia, and Latvia. Oddly, Spain looks good on this measure, and Ireland and Italy are better than the EU average.

Now, recognize that these figures are from 2004, so they could be worse by now — they are unlikely to be better. Here is the original article from Jagadeesh Gokhale, the fellow who calculated the European figures at the Cato Institute. Quoting from his paper:


No EU government has made the necessary investment. As an alternative, the next-best option is for these countries immediately to gradually but significantly increase saving and investment. In particular, the average EU country could fund its projected budget shortfall through the middle of this century if it put aside 8.3 percent of its GDP each and every year. Despite this adjustment, a budget shortfall is likely to emerge after 2050, requiring additional fiscal reforms.


What will happen if EU countries do not set aside these funds? Unless they reform their health and social welfare programs, they will have tomeet these unfunded obligations by increasing tax burdens as the larger benefit obligations come due. Although spending averages 40 percent of GDP today:

• By 2020, the average EU country will need to raise the tax rate to 55 percent of national income to pay promised benefits.
• By 2035, a tax rate of 57 percent will be required.
• By 2050, the average EU country will need more than 60 percent of its GDP to fulfill its obligations.

Later, he continues:

In comparison, the United States’ shortfall for Social Security and Medicare alone has been somewhat smaller than the EU average, at 6.5 percent of future GDP. But as a result of the expansion of the Medicare program to cover prescription drugs, the U.S. fiscal imbalance is now 8.2 percent of future GDP. Putting this in perspective, to close its fiscal imbalance:

• The United States would need to save and invest an amount equal to 8.2 percent of its GDP beginning now and continuing every year forever to pay expected future benefits without future tax increases.
• This could be accomplished by more than doubling the current 15.3 percent payroll tax on employers and employees, immediately and forever.
• Alternatively, the federal government could immediately stop spending nearly four out of every five dollars on programs other than Social Security and Medicare — eliminating most discretionary spending on such programs as education, national defense, environmental protection and welfare — forever.

Each year that the United States does not take action to reduce the projected shortfall, it grows by more than $1.5 trillion, after adjusting for inflation.

If you are a wonk on these matters, I recommend that you read the paper. But the article from the New York Times motivated the issue in other ways. A hairdresser in Greece retires at age 50? In the US, aside from the military, the only people I know of that retire with a full pension at age 50 are oil wildcatters, and those that similarly punishing hard work. Also, it is backward for women to retire earlier than men; they live a lot longer.

There is no way that we are going to get governments to run 8% of GDP surpluses per year to deal with these crises. I hate to say this, but if some of the profligate European governments want to deal with this situation, they will need to change their constitutions or laws that guarantee pension payments at a certain level and age, and extend the age and drop the benefits. Political suicide, I know. But do you care if the Eurozone fails? Do you care if your nation fails? I’m not saying that one group has to bear pain while another does not, but aside from those that work at physically demanding jobs, there is no reason why everyone can’t work until age 75. Yes, 75, leaving aside disability. Retirement should be the last 10 years of life on average, not the last 20, much less 35.

When someone stops working, the rest must pick up the slack. Is there any way for a culture to work where those who work must support 2+ people excluding themselves? Many Western governments are staring at cultural failure, and can’t see the forest for the trees. They see the short run funding difficulty, but do not see the long-term problem that is lurking to begin to bite in the next decade. The sad thing is — it’s too late. Aside from cutting benefits, or raising benefit ages, there is no way out.

The Divided States


The Barron’s cover article dealt with high state and municipal pensions. Though I wrote a piece on this recently, talking about the Pew report study, among other things, this article makes the valid point that the state and municipal discount rates on pension liabilities are likely too high, averaging 8% or so. The nominal GDP growth rate of the economy of the whole is probably the best estimate of where discount rates should be — what shall we say? 4-5%/year? In this low rate environment, earning 8% forever is ludicrous. But at 4-5%/year we are talking about a deficit of ~$3 trillion, not $1 trillion.

As the article points out, workers in the public sector earn more on average than those in the private sector. The need to have high pensions to attract workers is no longer valid.

Also, the states and municipalities are taking above average risks to try to earn their target rate, even though doing so is highly unlikely. As it says in the article:

Finance professors Robert Novy-Marx at the University of Chicago and Joshua Rauh of Northwestern University asserted in a recent paper that the funding gap for state pension plans alone might exceed $3 trillion, in part because state funds are using an unrealistic long-term annual investment return of 8% to compute the present value of future payments to retirees, as is permitted in government standards for pension-fund accounting.


This establishes a “false equivalence” between pension liabilities and the likely investment outcomes of state investment portfolios, which are increasingly taking on more risk by beefing up their exposure to stocks, private-equity deals, hedge funds and real estate. Using a much lower expected return — say, one at least partially based on the riskless rate of return on government securities — would both properly and dramatically boost the present value of the pensions’ liabilities while decreasing their likely ability to meet them. The academic pair, using modern portfolio theory, claim that state funds, as currently configured, have only a one-in-20 chance of meeting their obligations 15 years out.

As I said above with countries, so it might be with states. Some states will have to repeal statutory or constitutional guarantees on pensions in order to survive. I don’t like saying this, but I don’t think there is any choice eventually. Do you want your state or municipality to survive or not? Even Chapter 9 and/or ERISA should be amended to allow for adjustment of pension obligations in municipal bankruptcy. States also should be able to use Chapter 9, or, a new Chapter of the Bankruptcy code for States.

That is why bond investors are getting skittish over General Obligation bonds, and moving to Revenue bonds, if the revenues are stable enough, and protected for bondholders. They don’t trust the states and municipalities.

Now, this comes after years of underfunding the pension funds. Few truly were farsighted, and set aside the assets, rather than having more current spending, or deceasing taxes.

Where does this leave us? In no good place. Is there a solution? Yes, but only that of shared pain. We have to decide whether we take structured pain now, through benefit cuts and higher taxes, or, take unstructured pain when the riots arrive, time to be determined. Cultural failure is a real possibility; civilization is more veneer than solid when everyone argues for their self interest, and few argue for the good of the whole."

Caixin:

By Andy Xie 03.15.2010 18:20

Our Next Economic Plague: Japan Disease

Growing old is hard, but watching formerly vibrant economies choke on debt and wither away is downright ugly

Japan's nominal GDP fell 6 percent to 475 trillion yen last year, while its real GDP declined 5 percent. Meanwhile, nominal GDP in the United States decreased 1.3 percent to US$ 14.2 trillion and real GDP fell 2.4 percent.

If you travel across Japan and the United States, you get the impression that America is in much worse shape: Americans cannot stop screaming about their woes, while the Japanese face economic sufferings quietly. Maybe this is due to cultural differences. Regardless, Japan is in dire shape. Its nominal GDP is now lower than it was in 1992 when the nation's property prices first began to decline.

Japan's status is frightening because its problems will spread to all of us in the future. Everyone knows what it's like to grow old. And history is full of examples of empires that grow old, wither and die. For modern economies, though, this is a new concept.

There are clearly factors behind the aging of an economy. All of these factors are now at work in Japan. And looking at Japan today, it's clear that it's no fun for an economy to grow old.

People can postpone aging with expensive cosmetic products, Botox and, if you are really desperate and rich, surgery. But are there ways to postpone the aging of an economy, or avoid aging completely, sort of like Maggie Cheung?

New Disease

Decades ago, the Netherlands had oil wealth. Strong export revenue pumped up its exchange rate while its industries shriveled under high costs. The Dutch took advantage of the high currency value and enjoyed life by buying a lot and not working much. When the oil ran out, hard times hit. Nowadays, when a country enjoys too much of God's gifts and forgets to work for a living, it's called Dutch disease. When an economy exhibits senile characteristics, I think it should be called "Japan disease."

Most analysts link Japan's problems to its super bubble in the 1980s. At the peak, Japan's property values accounted for more than 40 percent of the world's total. Land under the Imperial Palace was worth more than all of California. Seven of the ten richest men in the world were Japanese property developers. No doubt, Japan went overboard. But could that bubble still be having such a strong effect two decades later?

Keynesian economists blame Japan's problems on its on-and-off fiscal stimulus. They argue that, if Japan had kept the stimulus long enough in the 1990s, Japan's economy would be healthy today. Keynesians say an economy is like a car without a battery: Momentum is everything. When an economy stalls like a car hitting a rubber traffic cone, forward movement can resume if one pushes hard and long enough.

Structuralists blame Japan's problems on a lack of reform. If Japan could get rid of all bad debt, promote shareholder rights and deregulate markets, it would trigger waves of efficiency that encourage innovation and power the economy forward. The Koizumi government did embrace many reforms that the structuralists advocated. Japan did experience a period of growth. In hindsight, much of the growth during the Koizumi era was due to a booming global economy that increased Japan's exports. In particular, China's demand for Japanese equipment and U.S. demand for Japan's cars were probably more important than the reforms.

I think the Keynesians are totally wrong about Japan. Keynesianism is a prescription for a short-term economic hiccup. It's like a painkiller, not a cure. It tries to minimize output loss during a down cycle. It doesn't mean much for an economy in the long run. Without Keynesian stimulus, an economy is supposed to adjust properly. Using Keynesianism to explain or cure long term economic problems is just plain wrong.

Unfortunately, most economists who run central banks today are in this school of thought. They act while looking through a stimulus prism. When a crisis hits, it is right to pump some stimulus. But they are maintaining stimulus in hopes of strengthening economies again. That's wrong. Structural problems, in particular high indebtedness, are preventing strong growth. Sustaining stimulus would lead to inflation, not high growth.

Japan's problems escape easy explanation or solutions. There are so many and interlinking problems that the situation is intractable. Japan is just getting old and older. Rebirth is possible, but it requires wholesale destruction of a status quo that Japan is unwilling to give up. It's just not worth it. When the price is too high, one prefers retirement to youth.

Aging Process

An economy ages in many ways. The most common are tied to the exhaustion of factors such as production-labor, capital and resources. When an economy begins to develop, labor is the abundant resource. Hence, it makes sense to develop labor-intensive industries. When labor surplus is exhausted, it makes sense to develop capital intensive industries. When capital stock is high enough, investment cannot drive growth anymore. Economists call it diminishing returns, or more of the same yields less output. This type of aging doesn't worsen. Economists say a steady state equilibrium emerges when consumption and investment are balanced just right, sort of like permanent middle age.

Moreover, youthfulness is possible for a mature economy. Through innovation, an economy can produce more with the same inputs. This so-called total factor productivity (TFP) is an elixir for a mature economy. It determines how fast a rich economy gets richer. A 1 percent TFP is considered mediocre, 2 percent is good, and 3 percent is super.

Many economists argue for freer and cheaper economic structure to stimulate innovation. But, in the Internet era, innovations rapidly disseminate around the world. It's not clear if innovation benefits can be contained in any country anymore. For example, even though the United States is more innovative than Europe, it hasn't outperformed by much. Its celebrated prosperity during the Greenspan era turned out to be an old-fashioned bubble, not a reflection of superior innovation.

Diminishing returns define the aging of an economy in relation to capital accumulation. Population aging, now a more popular concern, is a relatively new phenomenon. Merely decades ago, life expectancy was not high enough for a society to have a large population of retired people. The world is transiting from the old equilibrium of a small retirement population to the new equilibrium of the retirement population similar in size to the working population. The transition is an aging process. When the new equilibrium is reached, i.e. the ratio of retired to working populations is stable, it is an aged economy.

In addition to increasing life expectancy, a declining birthrate is another modern phenomenon with major economic implications. Initially, a declining birthrate is beneficial, as fewer resources are required to raise the young. This is the so-called demographic dividend. For example, rising female participation in the labor force can be attributed to the declining birthrate. But when a low birthrate lasts two decades, it begins to decrease the labor force, which reverses the benefits of the prior two decades.

Both aging and the reversal of the demographic dividend are in full force in Japan. Its labor force is declining by 0.5 percent per annum and its population of those aged 65 and over (now 23 percent), is rising by 0.6 percent per annum. In theory, the demographic headwind may decrease Japan's economic growth rate by about 1 percentage point. The reality is far worse, as Japan's long stagnation indicates, because of other changes that accompany an aging society.

When a society ages, its resource allocation increasingly favors the old. Healthcare costs, for example, rise exponentially. Broadly, an old population is unwilling to take risks, which makes social or economic change difficult. Underlying forces in an aging society favor unproductive expenditures and less competition.

Rising social burdens in an aging society obviously fall on the working population, i.e. the tax burden on the working rises over time. The diminishing reward for work decreases labor supply, as workers choose more leisure. A vicious cycle in labor incentives is quite possible.

The changes in an aging society are far greater than what the arithmetic of the so-called dependency ratio – the ratio of non-working to working citizens – suggests. A society changes in many ways to become more conservative, less hard-working, and less innovative. The society ages.

But Japan's problems will spread to other major economies. Major European economies, for example, are not far behind Japan. Unemployment and retirement benefits are more generous there, so the loss of economic vitality comes more quickly.

Rising national debts in developed economies are driven by aging. The benefits they promised during the high growth period cannot be supported by government revenues anymore. They resort to borrowing to keep promises. Japan's national debt at about 200 percent of GDP is the highest in the world. Other developed economies seem to be on the way there. The average fiscal deficit in Europe is 6 percent of GDP. Britain's is 12 percent, and America's is 10 percent. While most analysts blame oversized deficits on the recession, they could last for many years to come. Japan's deficit in the 1990s was viewed similarly. With such high deficits, it won't take long for them to catch up with Japan.

Graceful Aging?

Despite dismal economic performance, Japan may find ways to sustain an aged economy, i.e. age gracefully. If you travel through second-tier cities in Japan, you'll be impressed by how few young people there are on the street and how old the workers are in the service sector. Indeed, most taxi drivers seem to be around 70. Hotels and restaurants are often maintained by ladies in their 60s and 70s. These are surreal pictures of an economy of old people.

Tokyo presents a different picture. It seems as vibrant as other major cities in the world. But its dynamism is from sucking young people from second-tier cities. And as Tokyo is the nation's service center, its economy cannot avoid symptoms of an aged society.

Aging has disastrous consequences for asset prices. Property, for example, must be a permanent bear market. Declining population means declining demand for property. As property is a long-lasting asset, permanent surplus is likely, exerting a constant downward pressure on property prices. Japan's property prices have been declining at about 7 percent per annum for nearly two decades. The rental yield happens to be similar to the price decline. Foreigners are enticed by Japan's high rental yield from time to time. Few have made money.

An aged economy is a stagnant economy. Hence, corporate profits are likely to be stagnant. Without growth, stocks should be very cheap, say, around 10 times earnings and 5 percent dividend yields. Japan's stocks were trading at above 70 times earnings at their peak. They have been falling for two decades. Foreigners are sometimes attracted to the improving valuation of Japan's stock market. Periodic foreign buying causes market upturns, but all have turned out to be value traps.

Aging gracefully seems to be the path that Japan is pursuing. Other economies may not be able to do so. Italians have been demonstrating to defend a retirement age of 55. Greeks are waging pitched street battles against police to defend government benefits. Europe will have more trouble than Japan down the road. The Greek debt crisis is a leading indicator for Europe as a whole.

Is it possible to prevent or reverse economic aging? I doubt it. Declining birthrates and rising life expectancy are powerful forces. However, it is possible to slow the aging process. Immigration, for example, is often cited as a solution. Immigrants are supposed to come from developing countries. But aging is discernible in emerging economies, too.

China's demographics, for example, will be quite similar to those in developed economies in less than 20 years. India may be another 20 years behind.

Wrong policies could exacerbate the aging process. High property prices during high growth periods represent the worst policy for the long term. Japan's high property prices in the 1970s and '80s increased the cost of child-rearing and decreased birthrates. China has both high property prices and a one-child policy, so its long term consequences will be severe. While Chinese people are excited about property now, the market could enter a bear market worse than Japan's when the full force of aging hits, probably in less than 15 years.

Aging is supposed to be deflationary. Japan's experience supports that theory. However, deflation is possible only because governments can borrow to cover the cost of aging. When debt is unsustainably high, inflation is inevitable. Inflation is a form of reneging on promised benefits. I'm afraid the world is heading that way.

What will economists 40 years from now think of us?

TheMoneyIllusion:

When you read this you’ll see why I couldn’t resist falling off the wagon. Paul Krugman has again called for the US to pressure the Chinese to revalue the yuan. The reasoning is even more puzzling than usual:

Some still argue that we must reason gently with China, not confront it. But we’ve been reasoning with China for years, as its surplus ballooned, and gotten nowhere: on Sunday Wen Jiabao, the Chinese prime minister, declared — absurdly — that his nation’s currency is not undervalued. (The Peterson Institute for International Economics estimates that the renminbi is undervalued by between 20 and 40 percent.) And Mr. Wen accused other nations of doing what China actually does, seeking to weaken their currencies “just for the purposes of increasing their own exports.”

As you may recall, back around 2005 a number of Congressman were insisting that the Chinese revalue the yuan by 27%. In fact, they did revalue their currency by 22% over the next 3 years. But now we are told they need to do another 20% to 40%. And people wonder why the Chinese are so frustrated with the West. Does this game ring any bells? I seem to recall that back around 1970 the US government kept insisting that the Japanese trade surplus was caused by an undervalued yen. Then the yen was revalued 20%, but the “problem” continued. Then another 20%, then another 20%, then another 20%, then another 20%. The yen has now gone from 350 to 90 to the dollar. My math isn’t very good, but that sure seems like a lot of 20% revaluations. And the Japanese still run a current account surplus that is more than half the size of China’s surplus, despite having less than 1/10th China’s population. I think it’s fair to say that international economists have become increasingly skeptical of the notion that simply by manipulating nominal exchange rates you can eliminate current account imbalances that represent deep-seated disparities of saving and investing. But I guess hope springs eternal. Maybe this time it will finally work.

Krugman also repeats his argument that US monetary policy is paralyzed, and this time he rather bizarrely extends the argument to most of the major economies in the world:

Most of the world’s large economies are stuck in a liquidity trap — deeply depressed, but unable to generate a recovery by cutting interest rates because the relevant rates are already near zero. China, by engineering an unwarranted trade surplus, is in effect imposing an anti-stimulus on these economies, which they can’t offset.

Does Krugman really think the US is “stuck” in a liquidity trap? Obviously not, otherwise why would he have started criticizing the Fed for what he claims is an excessively restrictive monetary policy? No his policy views depend on which audience he is addressing. When talking to Bernanke, he suggests the Fed do much more, when talking to the Chinese he pleads that the Fed has done all it can. I can just see the frustration in Chinese central bankers reading this NYTarticle: “Those Americans must think we are a bunch of fools. Don’t they know we are Western-educated, and can read English newspapers? Do they really think that when they say one thing to their own Fed, and something completely different to us, that we won’t understand?”

But this time it’s even worse, as Krugman now claims that ”Most of the world’s large economies are stuck in a liquidity trap.” At least with the US you can sort of make the liquidity trap argument. And perhaps with Japan, if you ignore that fact that the BOJ recently rejected their finance minister’s request for a more expansionary monetary policy. But who else? I don’t think there is anyone who believes China, India, Brazil or Russia are stuck in liquidity traps. Australia and South Korea have been raising rates. Nor is there anyone claiming Germany, France, or Italy are stuck in liquidity traps. The ECB raised its policy rate to 4.25% in July 2008, and then cut it to 3.75% when the global economy collapsed in October 2008. Yes, rates have since gradually come down much further, but at no time in 2008-09 did it look like the zero bound was constraining the ultra-conservative ECB. Indeed the ECB has frequently emphasized that it doesn’t want to cut rates further and that it is focused on keeping inflation below 2%. So even if you wrongly believe that countries with zero percent interest rates are “stuck” with tight money, that condition only applies to a few countries.

So what does Krugman suggest we do?

In 1971 the United States dealt with a similar but much less severe problem of foreign undervaluation by imposing a temporary 10 percent surcharge on imports, which was removed a few months later after Germany, Japan and other nations raised the dollar value of their currencies. At this point, it’s hard to see China changing its policies unless faced with the threat of similar action — except that this time the surcharge would have to be much larger, say 25 percent.

This comment surprised me. I had thought that nobody still believed the dollar was overvalued in 1971. I do realize that back in 1971 many of Krugman’s fellow liberals believed that the US economy was suffering from an “overvalued” dollar, but I also thought that this view had been pretty well discredited by Mundell and others. Keep in mind that in 1971 we had 6% unemployment and 4% inflation. Does that seem like an economy that needs to devalue its currency? In any case, Krugman got his way; the Europeans gave in and revalued their currencies. And I suppose you could say the “problem” was solved. By 1979 I don’t recall too many people worrying about the dollar being overvalued. Although come to think of it I don’t recall that pesky Japanese current account surplus going away either. There must be a lot of distinguished European economists who like reading Paul Krugman. Imagine their reaction this morning upon reading where he appears to praise Nixon’s crude attempt to force the Europeans to revalue their currencies in 1971 in order to solve America’s 6% unemployment problem.

Think about the following questions: How many economists today honestly believe that America’s economic problems in 1971 were due to the European currencies being 10% undervalued? How many economists today honestly think that if the Chinese give us another 25% revaluation that this will significantly improve America’s economy? And how many of you think that 40 years from now, when we look back on the American economy in 2010, that most economists agree with Krugman’s argument that a significant part of our economic problems were due to an overvalued yuan? In contrast, how many people think that 40 years from now most economists will agree with Krugman’s claim that our economic dilemma is due to the stubborn refusal of the Fed to set a higher inflation target?

My claim is that in 40 years most economists will agree with Krugman. I mean the good Krugman. The guy who wrote Pop Internationalism. Not the guy who says we’re “stuck” in a liquidity trap and who ends his NYT editorial with the crude populist slogan “It’s time to take a stand.”

BTW, I notice that Krugman often implies that those who oppose health care reform and unemployment comp. extensions are just a bunch of cruel, heartless, right-wingers. Does Krugman know that if his proposed 25% tariff “works,” and does in fact sharply reduce Chinese exports, that millions of extremely poor Chinese workers will lose jobs in exports industries? Workers who are much worse off than even the bottom 10% of American workers.

One final point. If we do nothing the Chinese will probably revalue the yuan by about 5% to 10% this year, with vague assurances that further increases will occur as conditions allow. If we threaten a trade war there will probably be some compromise in the end, and China will revalue the yuan by 5% or 10% this year, with vague assurances that further increases will occur as conditions allow. But in the second case a lot of bad blood will be stirred up, financial markets will be depressed by uncertainty, and the world recovery might even slow down a little bit. And that’s the best case from his proposal. If a trade war actually does occur I shudder to think what the effect would be on world markets, and the world economy. If you go back another 40 years before Nixon’s threats against the Europeans, there really was a trade war.

Krugman points out that the Treasury must make a decision by April 15th (another reason to dread that date.) Eighty years ago on April 17th, 1930, the US stock market was up 48% over post-crash lows, on hopes for economic recovery. But as the Congressional debate over Smoot-Hawley became more acrimonious the market began dropping sharply. The biggest drop of the year occurred the day after Hoover announced he’d sign the bill. Then other countries started retaliating. By mid-June stocks were down more than 25% from mid-April levels, and hopes for a recovery had been dashed. Let’s not re-enact that fiasco this spring. Instead let’s do what Krugman and I both agree should be done; let’s have our own Fed solve our own problems (of inadequate AD.) That would be a win-win-win-win policy. Good for workers, good for investors, good for foreigners, and good for shrinking our budget deficit. I wish more Americans would “take a stand” against our own monetary policymakers, not foreigners.

HT: Marcus

Update: Marcus just sent me this Ryan Avent post. Last time I criticized Krugman on China I implied that he sounded like a Buchanan-like xenophobe. A liberal blogger I respect pointed out that that was unfair. I suppose he was right, so I held back a bit this time. But here’s what Avent had to say about Krugman’s post:

The general tone of his column—focused on toughness, insensitive to the internal politics of foreign nations, blind to potential negative outcomes, reckless and impatient—is familiar. It looks like nothing so much as the argumentation deployed by the Bush administration as it rushed to war in Iraq. Mr Krugman was prescient and prudent in fighting back against that misguided policy. He would do well to stop for a moment, take a deep breath, and think again before urging America to “take a stand”, damn the consequences.

Note there is no insinuation of racism, rather Avent points to a misguided overconfidence in America’s ability and right to push other countries around. I think Avent’s criticism is completely fair. Read the entire post, it’s much better than mine. I don’t know whether progressives in America realize just how different our sabre-rattling looks to their fellow progressives who live outside of the “big bully.”

Update#2: This Ryan Avent post is also very good.

A Crisis of Understanding

Project Syndicate:

By Robert J. Shiller

NEW HAVEN – Few economists predicted the current economic crisis, and there is little agreement among them about its ultimate causes. So, not surprisingly, economists are not in a good position to forecast how quickly it will end, either.

Of course, we all know the proximate causes of an economic crisis: people are not spending, because their incomes have fallen, their jobs are insecure, or both. But we can take it a step further back: people’s income is lower and their jobs are insecure because they were not spending a short time ago – and so on, backwards in time, in a repeating feedback loop.

It is a vicious circle, but where and why did it start? Why did it worsen? What will reverse it? It is to these questions that economists have been unable to offer clear answers.

The state of economic knowledge was just as bad in the Great Depression that followed the 1929 stock market crash. Economists did not predict that event, either. In the 1920’s, some warned about an overpriced stock market, but they did not predict a decade-long depression affecting the entire economy.

Late in the Great Depression, in August 1938, an article by Ralph M. Blagden in The Christian Science Monitor reported an informal set of interviews with US “professors, banking experts, union leaders, and representatives of business associations and political factions,” all of whom were given the same question: “What causes recessions?” The multiplicity of answers seemed bewildering, and did not inspire confidence that anyone knew what was causing the deepest crisis of capitalism.

The causes given were “distributed widely among government, labor, industry, international politics and policies.” They included misguided government interference with markets, high income and capital gains taxes, mistaken monetary policy, pressures towards high wages, monopoly, overstocked inventories, uncertainty caused by the reorganization plan for the Supreme Court, rearmament in Europe and fear of war, government encouragement of labor disputes, a savings glut because of population shrinkage, the passing of the frontier, and easy credit before the depression.

Although economic theory today is much improved, if we ask people about the cause of the current crisis, we will mostly get the same answers. We would certainly hear some new ones, too: unprecedented real-estate bubbles, a global savings glut, international trade imbalances, exotic financial contracts, sub-prime mortgages, unregulated over-the-counter markets, rating agencies’ errors, compromised real-estate appraisals, and complacency about counterparty risk.

More likely than not, many or most of these people would be mostly or partly right, for the economic crisis was caused by a confluence of many factors, the chance co-occurrence of a lot of bad things, which pushed the financial system beyond its breaking point. At that point, the trouble grabbed widespread attention, destroyed public confidence, and set in motion a negative feedback loop.

Our attention, after all, is naturally drawn to the worst events. Precisely because the worst events are statistical outliers, their causes are probably multiple.

Consider the question of predicting events like the January 2010 earthquake in Haiti, which killed more than 200,000 people. It captured our attention because it was so bad in terms of lives and property damage. But if one went beyond trying to predict the occurrence of earthquakes to predicting the extent of the damage, one could surely devise a long list of contributing factors – including even political, financial, and insurance factors – that resembles the list of factors that caused the global economic crisis.

Indeed, the crisis knows no end to the list of its causes. For, in a complicated economic system that feeds back on itself in many ways, events that start a vicious cycle might be as seemingly trivial as the proverbial butterfly in the Amazon, which, by flapping its wings, sets off a chain of events that eventually results in a far-away hurricane. Chaos theory in mathematics explains such dependency on remote and seemingly trivial initial conditions, and explains why even the extrapolation of apparently precise planetary motion becomes impossible when taken far enough into the future.

Weather forecasters cannot forecast far into the future, either, but at least they have precise mathematical models. Massive parallel computers are programmed to yield numerical solutions of differential equations derived from the theory of fluid dynamics and thermodynamics. Scientists appear to know the mechanism that generates weather, even if it is inherently difficult to extrapolate very far.

The problem for macroeconomics is that the types of causes mentioned for the current crisis are difficult to systematize. The mathematical models that macroeconomists have may resemble weather models in some respects, but their structural integrity is not guaranteed by anything like a solid, immutable theory.

The most important new book about the origins of the economic crisis, Carmen Reinhart’s and Kenneth Rogoff’s This Time Is Different, is essentially a summary of lessons learned from virtually every financial crisis in every country in recorded history. But the book is almost entirely non-theoretical. It merely documents recurrent patterns. Unfortunately, in 800 years of financial history, there is only one example of a really massive worldwide contraction, namely the Great Depression of the 1930’s. So it is hard to know exactly what to expect in the current contraction based on the Reinhart-Rogoff analysis.

This leaves us trying to use patterns from past, dissimilar crises to try to infer the likely prognosis for the current crisis. As a result, we simply do not know if the recovery will be solid or disappointing.

Japan’s Slow-Motion Crisis

Project Syndicate:

By Kenneth Rogoff

TOKYO – If you listen to American, European, or even Chinese leaders, Japan is the economic future no one wants. In selling massive stimulus packages and bank bailouts, Western leaders told their people, “We must do this or we will end up like Japan, mired in recession and deflation for a decade or more.”

Chinese leaders love pointing to Japan as the prime reason not to allow any significant appreciation of their conspicuously undervalued currency. “Western leaders forced Japan to let its currency rise in the second half of the 1980’s, and look at the disaster that followed.”

Yes, nobody wants to be Japan, the fallen angel that went from one of the fastest growing economies in the world for more than three decades to one that has slowed to a crawl for the past 18 years. No one wants to live with the trauma of the deflation (falling prices) that Japan has repeatedly experienced. No one wants to navigate the precarious government-debt dynamic that Japan faces, with debt levels far above 100% of GDP (even if one factors in the Japanese government’s vast holdings of foreign-exchange reserves.) No one wants to go from being a world-beater to a poster child for economic stagnation.

And yet, visitors to Tokyo today see prosperity everywhere. The shops and office buildings are bustling with activity. Restaurants are packed with people, dressed in better clothing that one typically sees in New York or Paris. After all, even after nearly two decades of “recession,” per-capita income in Japan is more than $40,000 (at market exchange rates). Japan is still the third-largest economy in the world after the United States and China. Its unemployment rate remained low during most of its “lost decade,” and, although it has shot up more recently, it is still only 5%.

So what gives? First, things look a lot grimmer when one gets two hours outside of Tokyo to places like Hokkaido. These poorer outlying regions are hugely dependent on public-works projects for employment. As the government’s fiscal position has steadily weakened, the jobs have become far scarcer. True, there are beautifully paved roads all around, but they go nowhere. Old people have retreated to villages, many growing their own food, their children having long abandoned them for the cities.

Even in Tokyo, the air of normalcy is misleading. Two decades ago, Japanese workers could expect to receive massive year-end bonuses, typically amounting to one-third of their salary or more. Now these have gradually shrunk to nothing. True, thanks to falling prices, the purchasing power of workers’ remaining income has held up, but it is still down by more than 10%. There is far more job insecurity than ever before as firms increasingly offer temporary jobs in place of once-treasured “lifetime employment.”

Although hardly in crisis (yet), Japan’s fiscal situation grows more alarming by the day. Until now, the government has been able to finance its vast debts locally, despite paying paltry interest rates even on longer-term borrowings. Remarkably, Japanese savers soak up some 95% of their government’s debt. Perhaps burned by the way stock prices and real estate collapsed when the 1980’s bubble burst, savers would rather go for what they view as safe bonds, especially as gently falling prices make the returns go farther than would be the case in a more normal inflation environment.

Unfortunately, as well as Japan has held up until now, it still faces profound challenges. First and foremost, there is its ever-falling labor supply, owing to extraordinarily low birth rates and deep-seated resistance to foreign immigration. The country also needs to find ways to enhance the productivity of those workers it does have.

Inefficiency in agriculture, retail, and government are legendary. Even at Japan’s world-beating export firms, reluctance to confront the ingrained interests of the old-boy network has made it difficult to prune less profitable product lines – and the workers who make them.

As the population ages and shrinks, more people will retire and start selling those government bonds that they are now lapping up. At some point, Japan will face its own Greek tragedy as the market charges sharply higher interest rates.

The government will be forced to consider raising revenues sharply. The best guess is that Japan will raise its value-added tax, now only 5%, far below European levels. But is it plausible to raise taxes in the face of such sustained low growth?

Investors who have bet against Japan in the past have been badly burned, grossly underestimating the Japanese people’s remarkable flexibility and resilience. But the fiscal road ahead looks increasingly perilous, with political consensus fraying badly in recent years.

In the end, are foreign leaders right to scare their people with tales of Japan? Certainly, the hyperbole is overblown; the Chinese, especially, should be so lucky. But nor should apologists for deficits point to Japan as reason to be calm about outsized stimulus packages. Japan’s ability to trudge on in the face of huge adversity is admirable, but the risks of crisis ahead are surely greater than bond markets seem to recognize.

We Can't Inflate Our Way Out of the Debt Crisis ... So What CAN We Do?

George Washington: "

As I wrote last August:

Commonly-accepted wisdom says that we can inflate our way out of our debt crisis.

***

But as I have previously noted, UBS economist Paul Donovan has demonstrated that governments can't inflate their way out of debt traps, saying:

The problem with the idea of governments inflating their way out of a debt burden is that it does not work. Absent episodes of hyper-inflation, it is a strategy that has never worked.

Megan McArdle points out:

It is a commonplace on the right that we're going to have enormous inflation, not because Ben Bernanke will make an error in the timing of withdrawing liquidity, but because the government is going to try to print its way out of all this debt.

Joe Weisenthal notes that it doesn't quite work this way:

As this chart shows, instances of declining debt-to-GDP rarely coincide with periods of inflation. If it did If it did, we'd see more dots in the lower right-hand quadrant.

The bad news for central bankers is that creating currency isn't like, say, diluting shareholders in a company. You're always rolling your debt, and the market's response to an inflationary strategy is (not surprisingly) higher interest rates. It's a treadmill, and it's extremely hard to get ahead.

Inflating your way out of debt works if you're planning to run a pretty sizeable budget surplus--big enough that you won't have to roll your debt over. Otherwise, your debt starts to march upward even faster, as old notes come due, and you have to roll them at ruinous interest rates. Hyperinflation might wipe out that debt, but also your tax base.

Financial Week notes:

Analysis shows even a sizable hike in CPI won't do much for companies or households that owe money.

Analysis released by Leverage World, a publication of debt research firm Garman Research, showed that companies that have issued debt at a coupon rate of 8%, as is typical for non-investment grade issuers, would have to see inflation hit 23% to inflate away the amount of debt they owe in 5.5 years. That’s the average amount of time that investors would have to hold such debt to compensate for the risk of default.

But investors would refuse to do so under such a scenario, Chris Garman, principal in the research firm, noted—not with yields on such debt currently running at 18%.

As Mr. Garman put it in the publication, inflation at that level “would crush the appeal of an 8% coupon.”

And while issuers would have to roll over their debt, they would find it impossible to do so. As he put it in an interview with Financial Week, “They’re staring down the barrel of an 18% coupon.”

Investment grade companies are in better shape. The same can’t be said for other public—or government—borrowers. Indeed, overall debt levels for the private and public sectors now run at roughly 3.5 times nominal GDP. That compares with 1.5 times from 1945 to 1980 and in the early 1920s.

To return to that level, Mr. Garman estimated that inflation would have to rise to around 12% or GDP increase by 75% over the next five years. Either scenario, he said, is hardly likely to materialize.

At a more realistic level of 3% real GDP growth and 2% inflation, Mr. Garman said, it would take 15 years before the overall U.S. debt level fell back under 1.7 times nominal GDP.

“There has been some talk of a rise in inflation as a panacea for distress and default,” he wrote in his report.

His analysis shows that such expectations vastly underestimate what’s required.

Prominent economist Michael Hudson wrote in February:

The United States cannot “inflate its way out of debt,” because this would collapse the dollar and end its dreams of global empire by forcing foreign countries to go their own way. There is too little manufacturing to make the economy more “competitive,” given its high housing costs, transportation, debt and tax overhead. The economy has hit a debt wall and is falling into Negative Equity, where it may remain for as far as the eye can see until there is a debt write-down...

The Obama-Geithner plan to restart the Bubble Economy’s debt growth so as to inflate asset prices by enough to pay off the debt overhang out of new “capital gains” cannot possibly work. But that is the only trick these ponies know...

The global economy is falling into depression, and cannot recover until debts are written down.

Instead of taking steps to do this, the government is doing just the opposite. It is proposing to take bad debts onto the public-sector balance sheet, printing new Treasury bonds to give the banks – bonds whose interest charges will have to be paid by taxing labor and industry...

The economy may be dead by the time saner economic understanding penetrates the public consciousness.

In the mean time, bad private-sector debt will be shifted onto the government’s balance sheet. Interest and amortization currently owed to the banks will be replaced by obligations to the U.S. Treasury. It is paying off the gamblers and billionaires by supporting the value of bank loans, investments and derivative gambles, leaving the Treasury in debt. Taxes will be levied to make up the bad debts with which the government now is stuck. The “real” economy will pay Wall Street – and will be paying for decades.

Wolfgang Münchau writes:

What I hear more and more, both from bankers and from economists, is that the only way to end our financial crisis is through inflation. Their argument is that high inflation would reduce the real level of debt, allowing indebted households and banks to deleverage faster and with less pain...

The advocates of such a strategy are not marginal and cranky academics. They include some of the most influential US economists...

The best outcome would be a simple double-dip recession. A two-year period of moderately high inflation might reduce the real value of debt by some 10 per cent. But there is also a downside. The benefit would be reduced, or possibly eliminated, by higher interest rates payable on loans, higher default rates and a further increase in bad debts. I would be very surprised if the balance of those factors were positive.

In any case, this is not the most likely scenario. A policy to raise inflation could, if successful, trigger serious problems in the bond markets. Inflation is a transfer of wealth from creditors to debtors – essentially from China to the US. A rise in US inflation could easily lead to a pull-out of global investors from US bond markets. This would almost certainly trigger a crash in the dollar’s real effective exchange rate, which in turn would add further inflationary pressure...

The central bank would eventually have to raise nominal rates aggressively to bring back stability. It would end up with the very opposite of what the advocates of a high inflation policy hope for. Real interest rates would not be significantly negative, but extremely positive...

Stimulating inflation is another dirty, quick-fix strategy, like so many of the bank rescue packages currently in operation ... it would solve no problems and create new ones.

And Mike 'Mish' Shedlock argues:

Inflationists make two mistakes when it comes to government debt. The first is in assuming government debt is more important than consumer debt. (It will be after consumer debt is defaulted away, but it's not right now.) The second is that it's not so easy to inflate government debt away either...

Inflationists act as if unfunded liability costs and interest on the national debt stay constant. Also ignored is the loss of jobs and rising defaults that will occur while this 'inflating away' takes place. Tax receipts will not rise enough to cover rising interest given a state of rampant overcapacity and global wage arbitrage.

Yet in spite of these obvious difficulties, the mantra is repeated day in and day out.

Inflating debt away only stands a chance in an environment where there is a sustainable ability and willingness of consumers and businesses to take on debt, asset prices rise, government spending is controlled, and interest on accumulated debt is not onerous. Those conditions are now severely lacking on every front.

CNN Money sounded a similar theme yesterday:

Some have suggested that the country could just 'inflate its way' out of its fiscal ditch.

The idea: Pursue policies that boost prices and wages and erode the value of the currency.

The United States would owe the same amount of actual dollars to its creditors -- but the debt becomes easier to pay off because the dollar becomes less valuable.

That's hardly a good plan, say a bevy of debt experts and economists.

'Many countries have tried this and they've all failed,' said Mark Zandi, chief economist at Moody's Economy.com.

It's true that inflation could reduce a small portion of U.S. debt. The International Monetary Fund (IMF) estimates that in advanced economies less than a quarter of the anticipated growth in the debt-to-GDP ratio would be reduced by inflation.

But the mother lode of the country's looming debt burden would remain and the negative effects of inflation could create a whole new set of problems.

For starters, a lot of government spending is tied to inflation. So when inflation rises, so do government obligations, said Donald Marron, a former acting director of the Congressional Budget Office (CBO), in testimony before the Senate Budget Committee.

'[W]e have an enormous number of spending programs, Social Security being the most obvious, that are indexed. If inflation goes up, there's a one-for-one increase in our spending. And that's also true in many of the payment rates in Medicare and other programs,' he said.

Inflation would also make future U.S. debt more expensive, because inflation tends to push up interest rates. And the Treasury will have to refinance $5 trillion worth of short-term debt between now and 2015.

'[The debt's] value could go down for a couple of years because of surprise inflation. But then ... the market's going to charge you a premium interest rate and say 'you fooled us once but this time we're going to charge you a much higher rate on your three-year bonds,'' Marron said.

The Treasury is increasing the average term of its debt issuance so it can lock in rates for a longer time and reduce the risk of a sudden spike in borrowing costs. But moving that average higher won't happen overnight. And, in any case, short-term debt will always be part of the mix.

Another potential concern: Treasury inflation-protected securities (TIPS), which have maturities of 5, 10 and 20 years. They make up less than 10% of U.S. debt outstanding currently, but the Government Accountability Office has recommended Treasury offer more TIPS as part of its strategy to lengthen the average maturity on U.S. debt.

The higher inflation goes, of course, the more the Treasury will owe on its TIPS.

Just last week, the CBO noted that interest paid on U.S. debt had risen 39% during the first five months of this fiscal year relative to the same period a year ago. 'That increase is largely a result of adjustments for inflation to indexed securities, which were negative early last year,' according to the agency's monthly budget review.

What's more, the knock-on effects of inflation are not pretty. A recent report from the IMF outlined some of them: reduced economic growth, increased social and political stress and added strain on the poor -- whose incomes aren't likely to keep pace with the increase in food prices and other basics. That, in turn, could increase pressure on the government to provide aid -- aid which would need to keep pace with inflation.

If We Can't Inflate Our Way Out of the Problem, What CAN We Do?

So if we can't inflate our way out of this mess, what should we do?

The above-quoted CNN article says:

So where does that leave lawmakers? Facing tough choices.

Deficit hawks and market experts have been calling on lawmakers to come up with a strategy to stabilize the growth in U.S. debt, which would be implemented only after the economy recovers more fully.

The idea is to signal to the markets that the country is serious about getting its longer term debt under control so that the burden of paying it back doesn't consume an ever-increasing share of the federal budget.

The recommended exit strategies are pretty basic, if unpopular: tax increases and spending cuts.

But why raise taxes and cut essential services when we can stop unnecessary wars and unnecessary interest costs instead?

As I recently pointed out:

Why aren't our government 'leaders' talking about slashing the military-industrial complex, which is ruining our economy with unnecessary imperial adventures?

And why aren't any of our leaders talking about stopping the permanent bailouts for the financial giants who got us into this mess? And see this.

And why aren't they taking away the power to create credit from the private banking giants - which is costing our economy trillions of dollars (and is leading to a decrease in loans to the little guy) - and give it back to the states?

If we did these things, we wouldn't have to raise taxes or cut core services to the American people.

Stopping all wars which are not absolutely essential for the protection of the United States from massive and imminent attack is crucial.

And abolishing the central bank (or putting it within the Treasury department) and taking over the money and credit creation functions from the private banks may be an important part of the solution to our debt trap. See this, this, this, this, and these: