EclectEcon

In March of this year, Ed Leamer predicted that the US would narrowly avoid a recession [link via Newmark's Door, still my first read each day]. This forecast clearly reflects updated information, given his discussion over two years earlier, in which he expressed dismay about the US housing bubble and forecast a recession.

But here are two very different forecasts (among the many) about whether the U.S. will have a recession during the next year or so.

• Ironman at Political Calculations posted a graph showing (according to his model) that the threat of a recession has passed.
  


• At the same time, Steven Pearlstein writes,

So much for that second-half rebound.

Truth be told, that was always more of a wish than a serious forecast, happy talk from the Fed and Wall Street desperate to get things back to normal.

It ain't gonna happen.

Not this summer. Not this fall. Not even next winter.

This thing's going down, fast and hard. Corporate bankruptcies, bond defaults, bank failures, hedge fund meltdowns and 6 percent unemployment. We're caught in one of those vicious, downward spirals that, once it gets going, is very hard to pull out of.

Others, especially those at RGE Monitor, tend to share Pearlstein's view. I might, too, but they have been predicting this recession for quite some time. If they are right, how long will we have to wait for it???

Meanwhile, Ironman's model seems to have predicted reasonably well....

Romanian monetary policy seems to have messed up after having done so well for awhile. From the RGE Monitor,

# Plojhar (via Bloomberg): More rate increases will be needed, up to 11% this year, in face of overheating, high inflation, and a potential renewed currency weakness
# March inflation came in higher-than-expected at 8.63% yoy
# Danske: Inflation likely to remain well above NBR official inflation forecast in both 2008 and 2009. Expects key policy rate to be hiked to 11.0% over next 12 months
# NBR Governor Isarescu: Inflation rate will remain 'relatively high' in coming months, creating a risk of a price/wage spiral

Commenting on these points, Gabriel Mihalache has written,

For what it’s forth, inflation in Romania went from dizzying 14% in January 2004 to 4% throughout the first half of 2007 and then, after July 2007, it spiked into 8-9% territory.

This graph (courtesy of Economic Investigations) shows just how far Romanian monetary policy has gone astray over the past few years:

The dots are the end of year inflation targets, the dashed lines are the +/- 1% target band and the red line is actual inflation.

Wow! Look how that red line has taken off! As Milton Friedman used to say, and as my colleague David Laidler has often reminded us,

Persistent inflation is always and everywhere a monetary phenomenon.

The different regions of Canada are experiencing different rates of inflation along the lines one might reasonably expect. The provinces that produce lots of energy and food (especially the prairies) have had higher rates of inflation, while those emphasizing manufacturing and lumber products (notably Ontario, but also Quebec) have been experiencing lower rates of inflation. The RGE Monitor wonders if the disinflation in Canada has reached a turning point.

More on inflation from the RGE Monitor:

* Core CPI growth rose to 1.5% y/y in April, from 1.3% in March (1.5% in Feb) below the BoC's 2% target but the first rise in 10 months. Total inflation rose to 1.7% y/y from 1.5%. Gasoline prices the main contributor to acceleration of total inflation, followed by mortgage interest cost
* TD: March could have marked the bottom for Canadian inflation in the current cycle as Canadian dollar's downward pressure on retail prices cannot be counted on. Food inflation tripled in April to 1.2% and seems to be catching up to international trends. BoC might ‘ease the easing’ and cut only 25bps points rather than 50bps at its June meeting.
* BMO: domestic bakery and cereal prices up 9.9% y/y, the largest gain since 1981. the dampening impact of the strong C$ is starting to fade but it is still cushioning Canada from global food and fuel inflation.
* CIBC: w/out the GST cut, all-items inflation would be above 2%. In the last three months, core prices have been running at an annualized 2.9% clip, its quickest pace since April 2007. CPI
* Ontario had the slowest price increase.
* Consumer prices were slow to respond to increased purchasing power of loonie, as recently as September BMO noted average 25% higher prices on similar goods between in US and Canada. Consumer pressure (including increase in cross border shopping) convincing retailers to lower prices; moderating prices; trend likely continue in coming months

Note that as Canadians come to expect a higher rate of inflation, there will be two sources of upward pressure on interest rates. The short-term source will be that the Bank of Canada will eventually have to raise the overnight funds rate to try to hold the rate of inflation to a rate that is within the Bank's guidelines or target range. The second source is via the Fisher Equation: Increases in the expected rate of inflation lead borrowers to be willing to pay, and lenders to demand, higher nominal interest rates on loans.

Now or soon might be a good time to lock in a longer term mortgage rate.

Every time I look at the data, it seems pretty clear to me that if aggregate demand is pushed upward, then in the short run the economy will experience reduced unemployment rates and (often with a lag) higher rates of inflation. During such a period, the unemployment rate drops below the natural unemployment rate (or the NAIRU), and that seems pretty much like what the North American economies were experiencing during the past few years. We had unemployment rates lower than we had seen for the past 25-30 years. These numbers make it seem that our economies had been pumped up by the spending supported with loose credit conditions.

We learned in the late 70s and 80s that we cannot sustain these low unemployment rates by continuing to inflate aggregate demand. Eventually the unemployment rates rise back toward their natural rates. This process of having our unemployment rates rise as we slide along the short-run Phillips Curve is not the same thing as an inadequate-aggregate-demand-induced recession; rather, it is a reversion to long-run equilibrium. Furthermore, any attempts to head off this reversion to the long-run are likely to be highly inflationary. Both the Fed and the Bank of Canada will have to be very careful not to over-inflate our economies in a futile attempt to reduce or hold unemployment below the natural rates.

Making things worse, it is likely that the long-run vertical Phillips Curve is shifting to the right (increasing the natural unemployment rate), at least temporarily, as the economies suffer some short-run aggregate supply shocks:

1. The liquidity crisis is not just affecting aggregate demand; it is accompanied by a decline in the production of financial intermediation, a supply effect (cf Tyler Cowen, with thanks to Gabriel Mihalache).
2. Rapid growth in the developing economies has led to a tremendous increase in their demand for commodities. This, in turn, means the prices of these goods are higher for North Americans, which has the same effect as any other supply shock in the economy [h/t to BrianF for this one].

Both of these supply shocks will tend to raise the unemployment rate, at least temporarily (for several years?) above what would otherwise be the natural unemployment rate. And the sad thing is that the central banks will try to deal with them by increasing aggregate demand, but their doing so will not help the unemployment picture much, but will put more upward pressure on the rate of inflation.

According to Felix Salmon and Tyler Cowen, it is possible that the US Fed is trying to create a whole bunch of liquidity because of all the uncertainty in the financial markets. From Tyler,

Let's say the new common knowledge is "this asset class isn't as liquid as we used to think." Ideally price should fall but how much? If selling is only scattered the market never learns the shape or exact location of the new demand curve. Furthermore the selling you observe only tells you "how good is the market at responding to this knowledge shock" and not "what was the initial liquidity downgrading in the first place." Convergence, today, appears to be problematic.

Felix Salmon adds,

If the problem is that there are too few fools in the market, it might make perfect sense for the Fed to step in as a fool of last resort. With any luck, once the Fed starts acting foolishly, other market participants will follow suit.

This description of what the Fed might be doing sounds similar to the old interventionist, Keynesian view that a proper role for monetary policy is to lean against the wind by doing things that increase aggregate demand when it is slipping or reduce aggregate demand when the economy is overheating.

The trouble with this role for the Fed is that it is terribly short-run and myopic. The Fed creates liquidity because markets don't clear? Markets don't clear???

That is highly questionable at best. What is happening is that people who are trying to sell financial assets are finding it hard to sell the assets at prices they would like to receive because of buyer uncertainty... that much sounds quite plausible. But the Fed policy isn't really leaning against the wind; rather, it is bailing out investors who took some risk and don't want to accept the consequences of that risk [in this case, the risk is that we might want our money and try to sell an asset into a very thin market, thus receiving a very low price relative to our original expectations].

I just don't see why this is a "good thing" for the Fed to do. It seems more reasonable to me to ask investors to accept the consequences of the risk they take on. Otherwise they have an incentive to take on even more risk in the future, with the expectation the Fed will bail them out. In addition, the extra liquidity could easily lead to additional inflationary pressures in the near future.

This doesn't sound like "leaning against the wind" to me. It sounds more like spitting into the wind.

Totally unwarranted digression: Speaking of saliva, can someone get high off it?

In an effort to add the appearance of stability to the UK banking system, the British Treasury will require banks that issue currency to leave matching funds on deposit with The Bank of England longer, thus forcing Scottish and Irish banks to forego as much as £100m per year in interest income [from news.Scotsman.com, courtesy of Brian Ferguson]:

The future of Scottish bank-notes could be in doubt following proposed new measures to protect customers from failing financial institutions, it was claimed last night.

Clydesdale Bank, one of three banks allowed to print Scottish banknotes, has admitted it would have to consider whether to continue issuing notes north of the Border if the Treasury proposals get the go-ahead.

Alex Salmond, the First Minister, has also voiced fears over the move, claiming the changes posed the "biggest threat" to Scottish notes in more than 160 years. Under current laws, Clydesdale Bank, Royal Bank of Scotland and Bank of Scotland have to lodge funds with the Bank of England to cover the value of their notes, but only for three days of the week – the other four days they can be invested elsewhere, gaining millions of pounds in interest.

However, the new proposals, announced last week by Alistair Darling, the Chancellor, would require funds to be lodged with the Bank of England for the entire week.

A spokesman for Clydesdale Bank said it was "very concerned" about the potential impact of the proposals and was seeking a meeting with the Treasury. He added: "If this were to go ahead, it would force us to consider whether issuing bank-notes would be viable in the future, a position we do not want to be forced into."

So, in an attempt to add the semblance of stability to the banking system, the Treasury considers putting in place a policy which reduces the amount of lending the banks can do. By itself, this policy would surely reduce the money supply in the UK and put upward pressure on short-term interest rates.

In expectation of this result, will interest rates start rising now? And even if they don't, will the Bank of England have to take off-setting measures, increasing banks' reserves and lowering overnight interest rates?

I have rarely come across such a good example as this one.

• From Greg Mankiw:
  

  When designing a tax system and evaluating tax proposals, policy analysts have at least four goals in mind:
  
  1. Efficiency: The tax system should distort incentives as little as possible (and, in the case of externalities and Pigovian taxes, correct incentives when necessary).
  2. Intergenerational equity: The tax system should raise enough revenue so current generations do not unduly burden future generations.
  3. Egalitarianism: The tax system should try to achieve a more equal distribution of after-tax incomes.
  4. Stabilization: The tax system should help maintain the economy at full employment.

• And in contrast from Gabriel Mihalache,
  

  Let me offer a different picture.
  
  When designing a tax system and evaluating tax proposals, policy analysts have at least four goals in mind:
  
  * Reelection of the incumbent party.
  * Nondecreasing interest groups’ income.
  * Having the burden fall on the least (politically) organized group possible.
  * Bullying the central bank into monetarizing the debt.
  
  Harsh, I know, but don’t come to me complaining when you’ll get European-style G shares of Y. (60%+) You have been warned.

It is left as an exercise to the reader to determine which is normative and which is positive (I know: there's a chance they're both positive, but I don't believe it.)

As the markets threaten to continue their downward trend, I keep wondering what took so long for the threats to emerge, and what is taking so long for the drop to materialize.

As Nouriel Roubini says, quoting himself,

The debate today is not any longer on whether we will experience a soft landing or a hard landing in the US; it is rather on how hard the hard landing will be. ... My view is that the recession will be protracted and painful as a shopped-out, saving-less and debt-burdened consumer is on the ropes and now faltering; while the financial system is on the verge of a systemic crisis that will cause a severe credit crunch...

Indeed the delinquencies and losses in the financial system are spreading from subprime to near prime and prime mortgages; to credit cards and auto loans; to commercial real estate loans; to leveraged loans that financed reckless LBOs; to the losses of the monolines that are effectively bankrupt and at risk of spreading further massive losses to money market funds and other financial institutions once they get properly downgraded; and soon enough to corporate defaults and junk bonds that will in turn trigger massive losses on credit default swaps; eventual losses in the financial system may add up to more than $1 trillion...

As for decoupling there is no way that the rest of the world can decouple from a US recession. ...

The Fed will ease aggressively but whatever it does now is too little to late; this easing will not prevent a recession as monetary policy can deal with illiquidity problems but it cannot resolve the deep credit and insolvency issues that plague the US economy; also when there is a glut of capital goods - in 2001 tech capital goods, today a glut of housing, consumer durables and autos the demand for these goods becomes relatively interest rate inelastic; it takes years to clean up this glut and monetary easing does not work as it is like pushing on a string...

Horrors! Is Nouriel Roubini asserting that the US economy is caught in a liquidity trap??

Last October these two guys saw things in the same perspective. The clips are quite amusing and roughly 8 minutes each. I recommend viewing them in this order.

Courtesy of the WSJ, via Brian Ferguson:

Yesterday, the San Francisco company that runs the popular fantasy game pulled the plug on about a dozen pretend financial institutions that were funded with actual money from some of the 12 million registered users of Second Life. Linden Lab said the move was triggered by complaints that some of the virtual banks had reneged on promises to pay high returns on customer deposits.

Second Life is an elaborate online world where players create new identities for themselves -- images called avatars. These avatars can own land, run businesses and build homes. And there's a link to the real economy: To buy things, players use credit cards or eBay Inc.'s alternative payment service PayPal to convert actual U.S. currency into "Linden dollars," which can be deposited using pretend ATMs into Second Life's virtual banks.

The banks of Second Life were operated by other players, who enticed deposits by offering interest rates. While some banks paid interest as promised, others used depositors' money for unsuccessful Second Life land and gambling deals. Under its new banking rules, Second Life says only chartered banks will be allowed -- though it isn't clear any real chartered banks will operate in the virtual play world.

The company now believes that (and I am translating very loosely here) transaction costs of the players to check out the banks' reliability, etc., are greater than the benefits from having no regulations of the banks.

I feel like Scrooge in opposing discretionary fiscal policy.

• It seems that politicians are eagre to implement stimulative fiscal policy all the time, but during periods of low unemployment and potentially rising inflation rates, we never seem to hear much about how we need to raise taxes or, more importantly, cut back on gubmnt spending (especially of the pork-barrel type) to slow down an over-heating economy. Where were all the fiscal Keynesians in 2005 - 2007?
  
  
• Are there any electable politicians who think the size of the gubmnt is too large? Are there any electable politicians who distrust placing authority and discretion in the hands of politicians and bureaucrats? And why is that so many people who distrust current politicians or bureaucrats think that replacing them or worse, adding to them, would make things better?
  
  
• I, for one, am a bit (but not entirely) skeptical of the Ricardian Equivalence (named for its discoverer, Professor Equivalence) argument against stimulative fiscal policy. Russ Roberts explains the concept clearly in this snippet from a fictitious dialogue,
  

  Well, if the government isn't going to cut spending (and they're not, because that would offset the stimulus of the tax cut, wouldn't it?), then it's going to have to borrow all the money to cover its spending for this year. The bonds the government sells are going to have to be repaid. We're going to have higher taxes next year and the year after. I think we better put that $16,000 aside to pay for those taxes.

  The idea is that any time the gubmnt increases its debt to stimulate the economy, there is an equivalent reduction in spending as people save more for the increased tax liability. Maybe. But I'm not so sure people think that way.
  
  Several years ago, a colleague asked me, "When the federal debt rises, don't you start saving more for the anticipated tax bill?" He was absolutely stunned when I said, "No, I start spending more so I won't have anything left to tax when I get older. You keep saving, though, so you can pay the taxes to help look after me."
  
  
• And what prompted this posting: I've been teaching for years that the lag in implementing discretionary policy is almost always far too long for such policy to be useful.
  
  The recognition lag (recognizing that recession is imminent) is often 6 - 12 months. We're often well into it before enough decision-makers agree that we are into it that anything that might be useful can be done.
  
  Then there is the decision lag, the time during which politicos and others argue/debate/logroll/negotiate about whether and what to do. This lag can be anywhere from 3 to 9 months, or longer. And sometimes the hodge-podge of results is downright disgusting (see Clinton's "Christmas Tree" of recommendations for fiscal stimulus).
  
  That's followed by the implementation lag ; this lag occurs because even once a policy is agreed upon, it takes awhile to implement it. The gubmnt cannot cut rebate cheques overnight. Tax cuts cannot be put into place overnight. And stimulative gubmnt spending usually takes much longer to implement. The lag is anywhere from a month or two up to maybe 6 - 8 months.
  
  And finally, there's the effect lag . Once implemented, the policies take awhile to have any stimulative effect. The Keynesian multiplier does not work overnight to its fullest extent (assuming you think the multiplier is anything other than zero anyway!). This lag can be anywhere from 3 months to a year!
  
  Overall and taken together, the combination of these lags can be so long that by the time the policy takes effect, we're well past the trough of the recession and possibly into a boom period, when we no longer need the stimulus (note that the lags are often much shorter for discretionary monetary policy, though even there as Milton Friedman once said, the lag is "long and variable".).
  
  For some confirmation of the problem of lags, check out this op-ed column in today's NYTimes:
  

  The history of anti-recession efforts is that they are almost always initiated too late to do any good. This chart [a graphic in the original article], based on recession timelines from the National Bureau of Economic Research, shows the enactment of stimulus plans is a fairly accurate indicator that we have hit the bottom of the business cycle, meaning the economy will improve even if the government does nothing.

The price of gold rose from about $650/ounce to nearly $900/ounce over the past few months and is still in the mid 800s. Why?

In the past, when the price of gold has raced upward, it has been because speculators were concerned about leaving their financial assets in any form that was denominated in currency, particularly US dollars. Whether they feared global political unrest, or they expected rampant US (and other) inflation, they took refuge in gold and waited out the storm. They earned no interest income on gold, but they expected greater capital gains (or smaller capital losses) from holding gold than from holding other assets.

In those instances (e.g., the late 1970s, early 1980s), speculators drove up the price of gold, expecting it to continue to rise, driven higher by a rising US rate of inflation. Once the US (and world) rate of inflation slowed down, gold no longer served as a hedge against rising inflation rates, and the price of gold plummeted from up around $900 to down under $400 in a comparatively short time.

Is that what is happening now? Are speculators expecting a rising rate of inflation against which they are trying to hedge by buying gold? If so, I have some more questions:

1. If gold speculators are expecting rising inflation rates, will the Bush fiscal policy package plus the US Fed's easing up on the money supply confirm those expectations?
2. At the same time, if gold speculators are expecting rising inflation rates, why are nominal interest rates not rising via the Fisher Effect (named for its discoverer, Professor Effect), as pointed out by James Hamilton?
3. At the same time, if the US gubmnt fears a serious recession and is stimulating the smack out of the economy, what does that say about the US short-run and long-run Phillips Curves?
4. If the US gubmnt is expecting a recession, and if the speculators are expecting rising inflation rates, has the US short-run Phillips Curve shifted upward and to the right? If so, what could possibly have caused the shift? I don't know of any rising in the US social safety net that might cause the Phillips Curves to shift to the right, and does everyone else (beyond the gold buyers) have such rising inflationary expectations that the short-run Phillips Curve has shifted upward? That seems implausible to me.
5. So if there's no overwhelming reason for the Phillips Curves to have shifted, then to expect both rising unemployment rates and rising rates of inflation would have to be incorrect.

So why has the price of gold risen so much if so many people are expecting a recession that will spread to the rest of the world?

For more on inflation and the price of gold, see this in the Telegraph.

Actually the opening lines to this article are,

As global markets melt like a slab of butter on a hot frying pan, it's about time to figure out who cranked up the stove.

Where's Alan Greenspan, anyway?

Apparently, he anticipated our unwanted scrutiny.

The former U.S. Federal Reserve Board chief has taken great pains to shift blame for the mortgage crisis away from himself and the Fed's low-interest jet fuel of the 2001-04 period.

Beyond these pithy remarks, the article by Barrie McKenna is long on rhetoric and innuendo, but short on facts and data. However, it does raise one undeniable point which I shall attempt to rephrase here.

For more than three years, increasing numbers of economists have been raising yellow, then red, flags as we pointed out the dangers of the growth of credit, especially in the sub-prime mortgage markets. So, even if the Fed had high-powered money under control and even if the Fed had nominal measures of the core rate of inflation under control, surely they should have responded much earlier and more seriously to the run-up of credit that was funding the housing bubble. If they had seen these problems (and how could they miss them?), they should have slowed the rate of growth of high-powered money and they should have continued to inch the federal funds rate upward more than they did over that period. Doing so would have dampened the US housing demand and US housing bubble sooner and would have made things less of a crisis than they seem to be today.

When the velocity of money changes, it is the responsibility of the central banks to recognize the change and react accordingly. The Fed didn't.

Consumer sales either are down from what they were last year or else most pundits think they will be. Housing prices have fallen in most major US markets. Unemployment is inching upward. And new job creation is pretty small.

All these developments over the past few months have led far too many mediots and politicians to cry out for someone to do something to head off the coming recession.

I urge caution:

1. The bursting of the housing bubble is something that most economists have seen coming for quite some time; many of us were writing about it over two years ago. That, in and of itself, is not necessarily a sign of a coming recession.
2. Unemployment rates for the past two years or so have been too low! People were taking good jobs quickly because the economy was overheated, particularly in some sectors. As unemployment rates rise back up toward their natural rates (what? ~5 - 5.5%% in the US? ~6.5 - 7% in Canada?), that isn't what I would call a recession even if in the process we observe two consecutive quarters of negative real growth (which I doubt will happen).

We've been overheated in North America for several years. Our unemployment rates have been at or near historical lows, and that's not all because of welfare reform and a lowering of the social safety net.

As we adjust toward less of an over-heated economy, we will face disruptions, some pain, and some rising unemployment rates. But we should be very careful about trying to stimulate the economy to avoid the problems.

Remember what happened back in the late 70s and early 80s? If not, read on. Our economies faced sectoral dislocations and rising unemployment as we encouraged search via the provision of a higher social safety net. Trying to avoid and correct the rising unemployment rates, gubmnts provided additional stimulation to the economies, and mostly what we got was an upward spiral of stimulation, inflation, stimulation, inflation, etc.

Let's hope the gubmnts and central banks of today can do better. For sure, one thing they must do is avoid the temptations and pressure to over-stimulate aggregate demand.

Update: I fear Prime Minister Stephen Harper hasn't taken my advice. From today's Globe and Mail:

The premiers of Canada's two largest provinces will meet in Ottawa Thursday to develop a common front aimed at pressing Prime Minister Stephen Harper for help in dealing with turbulence facing the Canadian economy.

Note that these premiers would not be pressuring for a reduction in gubmnt spending or an increase in taxes if the "turbulence facing the Canadian economy" were primarily in the form of inflation!

To help blunt that concern, Mr. Harper is expected Thursday to funnel $1-billion to the provinces to help one-industry towns hit by slowdowns in forestry and other sectors.

Argh. This is exactly the wrong thing to do. An appropriate policy might, I said "might", be to facilitate factor mobility. But funneling money into one-company towns will mostly help the business owners and property owners, not the workers in those towns. Labour is a mobile factor of production; land and much capital are not.

Fortunately, following the comment to this posting by Tom Hanna, it looks as if much of the federal gubmnt assistance will be in the form of tax relief.

But sources say the aid, while helpful, will not dissuade Mr. McGuinty, Mr. Charest and others from arguing that Mr. Harper must consider providing economic help that goes further than simple tax breaks. “It has to go beyond tax cuts,” said a provincial official who asked to remain unidentified. “Tax cuts are good with a partner, but not so good on their own.”

And quite frankly, as much as I favour tax cuts (and attendant cuts in gubmnt spending), I fail to see how any reasonable tax cuts can be targeted to benefit only those in one-company towns without creating seriously inefficient incentives at the same time.

Tim Worstall summarizes it succinctly, saying "To Spend Is To Tax":

It’s not just the tax rises, it’s also the rise in borrowings: and, even more than that, the rise in promises of future spending (on pensions and the like) which are not being accrued.

Future taxes have gone up by vastly more than current ones have.

Last week, Sadistics Canada reported that the unemployment rate in Canada dropped below six percent for the first time in a zillion years (at 5.9%, it "reached its lowest point since 1974").

Canada's jobless rate unexpectedly fell to its lowest level since November, 1974, as the economy created triple the jobs that economists expected last month.

Employers added 51,100 jobs September, sending the rate to 5.9 per cent, Statistics Canada said Friday. ...

Economists had forecast 17,500 new jobs and an unchanged unemployment rate of 6 per cent.

Why is the unemployment rate so low now, and why has it not been this low for 33 years?

• Beginning in the early 1970s, Canada dramatically raised the height of its social safety net. As a result, people searched longer for jobs and the unemployment rate rose to new, nearly permanent higher levels.
• Over the past decade, though, the height of Canada's social safety has drifted downward slowly, inducing unemployed persons to take jobs more quickly, thus lowering the unemployment rate.
• Also over the past decade or so, the echo from the post-war baby boom has matured in age a bit... the demographics of the labour market are such that as more people have more education and work experience, couple with more family responsibilities than they did before, they tend to be unemployed less and to remain unemployed for shorter durations.

In other words, although the natural unemployment rate might very well have been up over 7% back in the late 1980s, it is probably much lower now.

But do long-term forces provide the entire explanation for the 5.9% unemployment rate? Probably not [see here for what I wrote last March about Canada's natural unemployment rate; I seem to adjust with a lag...]. The Canadian economy is booming even though the rising US price of the Canadian dollar is reducing the demand for manufactured goods. Elsewhere in the economy, the resource sector, the oil patch, and personal services are all booming.

Construction, utilities, professional and accommodation and food services have created the most jobs this year while factories have cut the most, shedding 71,300 jobs.

If the natural unemployment rate is still greater than 6%, then the current unemployment rate is further evidence that the Canadian economy is experiencing excess aggregate demand. This possibility causes expectations in the financial markets that the Bank of Canada will maintain a sizable interest-rate spread vis-a-vis the US (see this), and that expectation has sparked an even greater demand for the Canuck Buck:

The report sent the Canadian dollar soaring against its U.S. counterpart, trading at $1.0135 (U.S.) from [its previous] close of $1.0026.

Digression: We can tell when the jobless rate has dropped and labour markets have tightened: a concurrent indicator is that service at Tim Horton's and other fast-food outlets tends, on average, to get slower as the labour turnover with such employers quickens and as they dig deeper into the unskilled labour pool for employees, coming up with increasing numbers of employees who are less skilled and/or less motivated to provide quick, efficient, and friendly service.

Are higher gold prices a sign that many investors are expecting the rate of inflation to rise rapidly?

Not necessarily, according James Pethokoukis, columnist with USNews. He summarizes strong evidence that inflation expectations are, if anything, dropping:

Since their peak on September 20, the difference between nominal and inflation-indexed Treasury yields from five to 10 years in the future has come down to 2.57 percent from more than 2.6 percent. This is probably still higher than Fed officials would like, but not in truly worrisome territory.

So if high gold prices are not the result of rising inflationary expectations, what is causing them?

I think the real message of gold today, as it has been since 2001, might just be that we live in a world of heightened risk, and gold has always been the ultimate safe-haven investment.

The most recent surge in gold prices comes at the same as time there's been more talk—particularly by the French—of taking military action again Iran if it doesn't abandon its efforts to build a nuke. (Interestingly, the last great gold surge happened during the Iranian revolution in 1979.) ...

After falling throughout the 1980s and 1990s, gold bottomed in 1999 and then began a steady march higher in early 2001. You could interpret that 20-year drop as a sign not only of diminishing inflation but also that the world was becoming a safer place, with less threat of a nuclear war. Likewise, the rise since 2001 and 9/11 is a sign that the world is becoming a dangerous place again.

The fear factor is also at play with stocks. The market's current price-to-earnings ratio is right at its historical average, a strangely subdued state given fat corporate profits and a lengthy economic expansion. Higher gold prices? Blame Ahmadinejad, not Bernanke.

I have not studied much accounting in the past 72 years, but my understanding of a liquidity crisis is that you're having one when you are short on funds although you expect to receive some in the future. As a result of this shortage, you borrow some to tide you over until your receivables come in or until your other assets become more liquid. You have enough wealth/assets to cover your outstanding liabilities, but only if you don't have to convert those assets into cash at distress-sale prices.

Isn't that what happened with Northern Rock?

If so, and if Northern Rock really is short on liquidity, what on earth is it doing declaring a dividend payable next month? Dividend payments are cash outflows, so where is Northern Rock expecting to get the cash for these dividend payments? Is it expecting to receive buckets of cash in the meantime? Is it now expecting that the Brit gubmnt will bail them out no matter what they do? Or is management looting the firm (and funds from the Bank of England) on behalf of current stockholders? Or is the firm maybe not just illiquid but also insolvent, and perhaps management is trying to hide this possibility?

From The Scotsman, courtesy of Brian Ferguson:

Crisis-hit Northern Rock sparked controversy yesterday by pledging to pay shareholders a 30 per cent higher dividend, following its bail-out by the Bank of England.

It said it would honour its 14.2p dividend announced in July - up from last year's 10.9p a share - that will cost the group nearly £60 million, or 7 per cent of the value of shares in the bank. ...

Moneysupermarket.com, said: "There will be a lot of people bemused by the whole process - how Northern Rock found themselves in the position they are in at the least.

"Now that they are effectively being backed by a government guarantee, most people will be astonished by the fact that shareholders are still receiving a significant dividend.

"It does seem inappropriate that shareholders should be getting a dividend at the same time the organisation is being underwritten by the Bank of England."

Is it possible that the current management is trying to reduce the firm's attractiveness as a takeover target even more than the recent liquidity crisis has already? What other plausible explanation is there for why rational maximizers might do this?

If I had much money in Northern Rock, this latest development would really encourage me to move it if I hadn't already done so.

Update: From the WSJ ($)[h/t to Brian Ferguson], it looks as if Northern Rock has decided not to pay the dividend after all. This makes sense. If it is looking for a buyer, it will be more attractive if it has some cash and hasn't had it's assets looted to pay off current stockholders.

The Newcastle bank said in a statement late yesterday that it was in preliminary discussions with potential buyers but any deal was far from certain.

Meantime, the lender, needing to stockpile cash and buy time to hash out a deal, said it has suspended its per-share dividend of 14.2 pence (29 cents) that was due Oct. 26, just days after insisting it would pay the dividend.

Remind me again. Why are they looking for a buyer if they are solvent but are merely facing a short-term liquidity crunch? These recent developments look like lots more than just a cash-flow problem to me.

King Banaian says that no matter what people say Alan Greenspan might have thought, sales of men's underwear are not a leading indicator of economic activity.

Northern Rock, a smallish bank in the UK, recently faced a potential liquidity shortage when it could no longer convert some of its assets [see Tim Worstall's comment for the correct details] into ready cash because nobody would buy those assets at any price other than a substantial discount until they had a better idea of the actual risk involved. For the most part the assets will pay off over time, and no one seriously questioned the solvency of Northern Rock. The bank just needed to borrow some funds to tide them over.

And the Bank of England stepped up to provide these funds. That's the way the banking system is supposed to work.

Meanwhile if depositors' accounts are insured (up to fairly high limits), they were in no danger of losing anything (other than their own short-term liquidity) even if Northern Rock had been insolvent. And if depositors' accounts are not fully insured, there is no good argument for asking all the taxpayers to bail them out ex post. It's like telling folks they don't need to pay their insurance premia because the gubmnt will provide the insurance for them anyway; under such a policy, only chumps and patsies buy insurance as everyone comes to rely on the gubmnt.

Why depositors decided to stage runs on Northern Rock escapes me. But maybe had I been there with all my money tied up in Northern Rock, I'd have been a bit panicky, too, as I saw others queuing up for their cash. (though I'd have probably tried to open an account at a different bank and then transfer the funds electronically via the internet rather than stand in the long queues). [for an interesting historical perspective, Tim Worstall has this. Also see this by Tim Worstall.]

If it turns out the bank is, indeed, insolvent, the officers of the bank will (or should!) likely lose their jobs, depositors will still get their money (up to the insurance cap, or lose their money if they didn't make sure their deposits were insured*) and the stockholders of the bank lose their money. That's the way a good banking system should operate.

But now the British gubmnt has buggered it all up. They've told bankers (this is a very loose paraphrase)(see Stephen Pollard)

Go ahead. Take big risks with your depositors' money. If the risks pay off, you will become fabulously rich and your depositors and stockholders will be happy. If your risks don't pay off, the nanny state will be here to bail you out (in the guise of bailing out the little-guy depositors). Taking more risk is a winning proposition for you and you'll never lose a cent.

I once asked David Laidler, colleague and world-class monetary theorist, if we could afford NOT to let a bank go under if it was indeed poorly managed to the point of insolvency. He fully understood the point I was making: The risks involved with a bank's lending, buying commercial paper, etc. are complex to the point that it would be inefficient to ask depositors to bear those risks indirectly. From that perspective, deposit insurance might be a good idea (and it surely would be if it were optional). But bailing out banks merely rewards inefficient risk-taking by managers, and the cost of bearing that risk is fobbed off onto the taxpayers.

But now that the Brit gubmnt has promised to bail out the banks, no matter what risks they take, watch for much more gubmnt regulation and intervention, telling them what risks they will be allowed to take. And then watch for entry from near banks (e.g. ING) and other institutions, in an attempt to circumvent the gubmnt interventions. I give 'em ten to fifteen years.

* In response to an e-mail question about deposit insurance, Tim Worstall tells me,

There is gubmint provided. 100% up to £2,000 and then 90% up to £34,000 (or thereabouts).

The fall out from this is likely to be that there'll be something very like FDIC: £100,000 financed from a levy upon the deposit taking institutions.

But the question of whether gubmnt provided deposit insurance is a slam-dunk efficiency-enhancing policy is far from settled. See this. What puzzles me is why private insurance hasn't become more common for institutions with many large deposits.

Nouriel Roubini explains why he thinks there is a very good chance the current financial situation is likely to get worse:

[T]oday any wealthy individual can take $1 million and go to a prime broker and leverage this amount three times; then the resulting $4 million ($1 equity and $3 debt) can be invested in a fund of funds that will in turn leverage these $4 millions three or four times and invest them in a hedge fund; then the hedge fund will take these funds and leverage them three or four times and buy some very junior tranche of a CDO that is itself levered nine or ten times. At the end of this credit chain, the initial $1 million of equity becomes a $100 million investment out of which $99 million is debt (leverage) and only $1 million is equity. So we got an overall leverage ratio of 100 to 1. Then, even a small 1% fall in the price of the final investment (CDO) wipes out the initial capital and creates a chain of margin calls that unravel this debt house of cards. This unraveling of a Minskian Ponzi credit scheme is exactly what is happening right now in financial markets. [emphasis added]

Furthermore, Roubini thinks the unraveling of this ponzi scheme will lead to a hard landing in the US economy:

So combine an opaque and unregulated global financial system where moderate levels of leverage by individual investors pile up into leverage ratios of 100 plus; and add to this toxic mix investments in the most uncertain, obscure, misrated, mispriced, complex, esoteric credit derivatives (CDOs of CDOs of CDOs and the entire other alphabet of credit instruments) that no investor can properly price; then you have created a financial monster that eventually leads to uncertainty, panic, market seizure, liquidity crunch, credit crunch, systemic risk and economic hard landing. The last two asset and credit bubbles in the US – the S&L real estate bubble and bust of the late 1980s and the tech stock bubble of the late 1990s – ended up in painful recessions. The latest credit and asset bubble was much bigger: housing, mortgages, credit, private equity and LBOs, credit derivatives, corporate re-leveraging. So, the current bust and de-leveraging of the financial system is likely to lead to another painful economic hard landing.

What puzzles me is this: if what Roubini says is right, why haven't others seen it, too? and if they saw it (and acted on it) then Roubini cannot be correct because the markets will already have taken it into consideration. I really don't see such a hard landing in the future. Slower growth? yes, almost certainly. A quarter or two of negative growth? quite possibly. Prolonged recession? Probably not. But I am still probably a bit more pessimistic than this:

The financial turmoil that began with the seemingly narrow meltdown in subprime mortgages is now forcing both policy makers and Wall Street analysts to scale back their expectations for growth in the overall economy.

Most economists still predict continued economic growth for the rest of the year and into 2008, but many are trimming their forecasts and warning that even their somewhat darker views could be too rosy.

For more, read the regular postings by the ever-insightful King Banaian and Bill Polley.

The opening in Tuesday's lead financial article in the NYTimes:

Wall Street thinks the Federal Reserve is running short of time.

After another day of restless anxiety in the world’s credit markets, most lenders and investors remained fearful of all but the very safest Treasury securities, and new figures showed that the rate of foreclosures in the housing market in July was almost double that of a year ago.

Analysts now say that the central bank’s move last Friday to restore confidence by encouraging banks to borrow directly from the Fed at a lower cost has had only limited impact so far and that the Fed will need to take more drastic action by cutting its benchmark interest rate soon if it fails to see more progress.

But it is clear from the article that many within the Fed see no reason to bail out those who persisted in taking risks in the sub-prime mortgage market long after many of the rest of us were pointing to the dangers lurking beneath the surface of that market.

I, for one, will be pretty concerned if the Fed does indeed prop up these markets by infusing extra liquidity into the markets and lowering interest rates. Doing so will send a signal that risks in these types are markets are asymmetrical: the investors get to keep the upside gains, but the gubmnt or central bank will be there to protect investors from the possibility of downside losses.

This kind of signal will encourage others in the future to take more risks, creating an even more fragile financial system in the future. Ben Bernanke and The Fed must resist this type of pressure and take the longer-run view. Otherwise the economy as a whole will see people taking inefficiently large amounts of risk, diverting financial capital away from less risky projects. That's fine so long as things go well, but should things not go so well, the required bail-outs will involve massive gubmnt interventions and less future reliance on markets. People will point and say, "See? Free-market capitalism doesn't work!" when in fact the crisis will have been caused by too much gubmnt intervention in the short run.

To avoid this scenario, The Fed and all those who have counted on its bailing them out, must bite the bullet now and not pump liquidity into the economy simply to bail out the risk takers. There might be other important reasons to keep the liquidity growing, but bailing out financial risk-takers now will only cause more problems in the longer run.

Here's an interesting view: it says that the "crisis" which has (finally -- many of us had been warning about it for at least the past two years!) hit the sub-prime mortgage market will not really be very serious and that the Fed really doesn't need to rush into cutting the Fed rate.

I'll give you 525 reasons why I am still upbeat on the economy—the 525 basis points Ben Bernanke has to play with. If it sees fit, the Fed can cut and cut a lot. (Already traders are betting that a rate cut is a sure thing before year's end and more likely than not within a month.) Core inflation is under 2 percent, and oil prices are dropping. I'll tell you one thing: If the Fed stands pat at this point, Bernanke will certainly have gone a long way toward creating a reputation as a hard-core inflation fighter. It's kind of like when a guy goes to prison and the first thing he does is sucker punch the biggest, baddest dude he can find. He makes his rep. Bernanke may now be making his rep.

That's James Pethokoukis, and I think he has a very good chance of being right. My interpretation is that with core inflation that low, watch for the Fed to cut the rate by at least 75 basis points (0.75%) before the end of the year.

Interestingly, the different banks in the UK issue their own paper currency. Here are some examples of the different 10-pound notes I came across during some of our recent travels.









Isn't that last note, the one from the Clydesdale Bank, interesting? Wait until you see the back of it:



I was concerned about receiving 10-pound notes from The Bank of Ireland, but that bank has a large presence in Belfast and Northern Ireland, with considerable dealings in pounds (vs. Euros in Ireland).

JZ had warned us that Bank of Ireland notes might not be universally accepted in SE England. She was right, and it was true for Scottish notes, as well.

We learned from experience that the tube-ticket machines in London do not take any but notes from the Bank of England. And my favourite football-watching pub refused to take my Clydesdale 10-pound notes saying,

We've had a few dodgy ones from up there.

Fortunately, the pub at the castle takes the Clydesdale notes.

I presume the note-issuing function of the various banks is seriously monitored and limited by The Bank of England. But it reminds me of all the various notes issued by the various regional banks in Canada or the US over a century ago.

And here, of course, is my favourite of all the bills I have seen: the Adam Smith 20-pound note. A Scotsman on a Bank of England note, which thrills many Scots. Having Adam Smith on the note also thrills many economists.

I have yet to see one of these in England, where the 20-pound notes I have seen have pictures of Charles Darwin or Edward Elgar. The ones I did see were, yes, in Scotland!

In a recent speech, David Dodge (Governor of the Bank of Canada) worried that because the world is awash with liquidity, it is becoming increasingly difficult to manage Canadian monetary policy.

There seems to be a lot more global liquidity out there than one might have anticipated," Mr. Dodge said. Spreads of high-risk investments are "pretty narrow" and don't properly reflect risk, he warned. In other words, issuers of high-risk debt can get away with paying historically low prices to get investors to carry their debt.

Because of the phenomenal growth in communication and technology, the supply of lendable funds to any one country, especially a small one, is highly elastic. A slight change in the interest rate, ceteris paribus, can cause massive tides of funds to leave or enter the country until interest rates and exchange rates adjust. These changes, including the rate adjustments, happen quickly, with the tendency for the supply of lendable funds to be horizontal, not vertical as we were all taught in our good old Keynesian models of the 1960s.

If the Capital-Asset Pricing Model has any validity (I think it's pretty good for most situations), it looks as if Dodge is concerned that the Security Market Line is shifting downward and becoming flatter. What he seems to be saying is that when returns drop as a whole, some people are willing to accept a bit more risk, which implicitly assumes "normal" shaped indifference curves in the risk-return trade-off, I guess.

...there is so much money chasing a limited number of investment opportunities, driving down aversion to risk - especially for high-risk debt issuers such as companies with junk bond status or emerging market economies. As a result, spreads (a proxy for the price that bond issuers pay investors to carry their debt) have eroded steadily and steeply over the past five years, leading many economists to warn that they are too narrow, and that investors have become complacent. "That is a real issue ... a very, very real problem and potentially a real concern," Mr. Dodge said...

He is worrying too much. Even if growing global liquidity might pose some problems, what's he gonna do about it? slap on exchange controls? I sure hope not!

Russ Roberts at Cafe Hayek has posted an excellent Global Warming Quiz:

It's a one question quiz:

Suppose we discovered that the earth was cooling rather than warming due to a natural cycle. Would you encourage people to drive more and use more carbon-based energy as a way of warming the earth?

I know, and you know, too, that most people who fret and wring their hands about global warming would do no such thing.

Instead they would argue that it's the particulate matter of our human-created pollution that is cooling the earth (with plenty of historical references to the effects that volcanoes had on global cooling) and therefore we need to have public policies in place to limit the amount that people drive, especially gas-guzzling SUVs. Global warming? Global cooling? It doesn't matter: we should drive less and burn less fuel; we should repent and sin no more, or maybe a bit less anyway (and heaven forbid relying on the market system to provide this guidance!).

In other words, their insistence that we cut back on our use of fossil fuels has little or nothing to do with global warming and has much more to do with some sort of elitist paternalism, wanting to insist that the rest of us live more austere lives. Digressive rant: and yet they would oppose a value-added tax as being regressive — they not only want us to cut back on our consumption, they want to control us and tell us what to do.

This question about global warming reminds me of the 1960s criticism of then-popular Keynesian economics and fiscal policy. We were all taught that it was a good idea to increase gubmnt spending and cut taxes to get the economy out of a recession. Rarely however, did politicians propose cutting gubmnt spending across the board to reduce inflationary pressures. So much for using fiscal policy to offset the swings of the business cycle. And so much for some of the rants about global warming.

Update: Also see this, sent to me by both BenS and Brian Ferguson:

The alleged solutions have more potential for catastrophe than the putative problem. The conclusion of the late climate scientist Roger Revelle—Al Gore's supposed mentor—is worth pondering: the evidence for global warming thus far doesn't warrant any action unless it is justifiable on grounds that have nothing to do with climate.

What would happen if the US halted its war on drugs? One effect would be the opposite of "currency drain" from the monetary system. There would be many fewer reasons for drug-dealers to hold and carry out their transactions using currency, and much of the outstanding currency would be deposited in financial institutions, setting off a multiple expansion of the money supply. Presumably the Fed would offset this effect. From this site (courtesy of Jack):

With any search process, intermediation can push the amount of information the searcher receives forward so much that a little search gets a lot of information at little cost, and it isn't worthwhile to do much searching beyond that. It appears that this effect has also occurred in labour markets; with the growth of job search via the internet, people remain unemployed shorter periods on average, and fewer people are unemployed as they change jobs. Here is the abstract from Betsey Stevenson's working paper:

The Internet has increased the ease and availability of employment information, but a question remains as to how, and if, this increased information has changed employment outcomes. This research examines the impact of the Internet on worker flows and job matching. While previous research found a negative impact of the Internet on unemployment duration, this research demonstrates the importance of including flows between employment to employment in an analysis of the impact of Internet. Over 80 percent of online job seekers are employed at the time of their job seeking and Internet users, conditional on observables, are more likely to change jobs and are less likely to transition to unemployment. Furthermore, those who use the Internet have greater wage growth when changing jobs. I use several approaches to attempt to isolate an exogenous source of Internet use in order to isolate the causal relationship between the Internet, job change, and wage growth. The first is to examine state-level aggregate data. As states’ Internet penetration rates rose differentially through the 1990’s so did employer-to-employer worker flows with a 10 percentage point rise in state-level internet penetration leading to a 5% increase in employer-to-employer flows. While it can be difficult to disentangle whether changes in state labor markets reflect Internet usage or drive Internet adoption, I find a useful instrument that isolates the causal mechanism: the Internet has diffused in much the same way as past innovations, and hence average state ownership rates of household appliances in 1960 describe Internet adoption patterns over the past decade.

I was prompted to look into this issue by Gabriel's comments earlier on my posting about natural unemployment rates, where he challenged my position that people's expectations might be out of line with reality, forcing the unemployment rate to differ from the natural rate. His position is that the monumental growth of the internet performs such effective intermediation that people's expectations should only rarely be out of line with reality by very much.

The results of Stevenson's work (which I accept for now, despite my general skepticism of "instrumental variables") suggests that with the intermediation of the internet, the optimal length of search has diminished considerably over the past two decades, and, as a result, so has the natural unemployment rate.

And these results are also consistent with Gabriel's view that with internet intermediation, divergences between the unemployment rate and the natural unemployment rate have probably diminished over time. If so, then perhaps Canada's natural unemployment rate is less than 6.5%. And to the extent that unemployment is search (what else can it be?), the internet should lead to reductions in both search and unemployment rates.

Nouriel Roubini writes about the sub-prime mortgage market meltdown and, with considerable justification, points out that he was warning about this problem long ago.

On my modest side last August, when I started to forecast a recession in the US in 2007 by Q2 that would be triggered by the housing bust, I also argued that this housing bust would soon also lead to serious risks and distress in the financial system. I pointed out that such stress and vulnerabilities would first be noticed in the subprime segment of the mortgage market as many (but not all of) of the excesses of the last few years in mortgage finance were concentrated in this market. I pointed out that the housing bubble and the credit bubble associated with it reckless lending practices and with regulator being asleep at the wheel while this unregulated gambling was taking place. I argued that the result would be financial distress and bankruptcy for many lenders and a systemic banking crisis similar to - or most likely worse than - the S&L crisis.

Here is what I wrote on this topic last August. And a year before that, I linked to a statement by Ed Leamer that a recession would follow the bursting of the housing bubble sometime this year.

And here was my own dismal forecast from last October.

I can readily imagine US GDP growth rates of less than an annualized rate of 1% a year from now, and I just hope the Fed has enough foresight and control to keep them from turning negative.

Update:Dave Altig has much more, with some illuminating graphs, about the mortgage markets.

Back in the late 1980s and early 1990s, most of us in Canada used to talk about the natural unemployment rate as being around 7 - 7.5% when the actual unemployment rates were 8% or higher. Economic conditions have changed since then. The social safety net is lower, reducing optimal search times for job-seekers. But how much has the natural unemployment rate fallen? Could it possibly have fallen to under 6.5%? Canada has been experiencing unemployment rates well under 6.5% for quite some time now (see this for an article about the most recent drop back down to 6.1%).

Job gains have registered the hottest start to the year in a quarter century, with more than 103,000 jobs created in the first two months of 2007, according to National Bank Financial.

February's jobless rate, meantime, unexpectedly fell to 6.1 per cent from 6.2 per cent, Statscan said. [emphasis added]

I know that the natural unemployment rate is pretty much a guess about what would result from job search if people's expectations were in line with reality, and it is still clear that people's expectations are not in line with reality, on average. But what is the reality, and what will it be when people's expectations are in line with reality and they adjust their job search accordingly?

Under today's economic conditions, 6.5% sounds about right to me. But I expect Gabriel Mihalache might not buy into this idea very readily.

A number of bloggers have written about the effects of price controls in Venezuela, including Phil Miller, Brian Ferguson, and Lynne Kiesling among others, all pointing out that price controls, in an attempt to put the lid on inflation, have created massive shortages.

Interestingly, I have not yet come across any blog postings that mention the rapid rate of growth of the money supply in Venezuela, and yet we all know that "Inflation is always and everywhere a monetary phenomenon [Milton Friedman]."

According to The Economist data, the Venezuelan money supply increased from 2,652 to 4,228 currency units over the past year. Given such a high rate of growth of the money supply, what surprises me is that nominal interest rates and the rate of inflation are not a lot higher. That makes me very suspicious that measured inflation is not picking up the rapid growth in prices in the underground and black markets.

In other words, the Chavez price controls are probably having some effect in keeping the lid on measured prices. But the resulting shortages are undoubtedly driving many markets underground, where, I'd venture, prices have been sky-rocketing.

The problem, of course, has been that Venezuela has a massive trade surplus because of the high price of oil and its huge oil exports, but the central bank has refused to sterilize the currency inflows, letting the money supply increase instead. And that's almost surely because Chavez has wanted to use those currency inflows for his give-away programmes.

For more thoughts along these lines, see The Emirates Economist and the comments there.

Consider a simple quantity-theory-of-money model with modest growth in the money supply and no change in the income velocity of money. In this economy, with moderate economic growth, there will be little-to-no inflation.

Now shock this economy with a massive increase in demand in one sector and one geographic region (say, a big increase in the demand for oil in Alberta). In that part of the economy, wages will go up because labour mobility is costly and the adjustments are not instantaneous. Also, in that part of the economy, prices of fixed inputs will sky-rocket (e.g. housing and land).

If those prices go up by considerably more than the rate of growth in the money supply minus the rate of growth in real output (still assuming velocity is constant), then prices somewhere else have to fall. Where?

The primary candidate is housing and land elsewhere in the economy, but that's a difficult political move and could trigger bankruptcies in those areas, especially if consumers have used home equity to support their consumption; it also helps explain why premiers in the Maritimes are trying to stem the emigration of their residents (e.g. see this in the Globe and Mail).

There might also be lower wages in construction (and other occupations) in those areas for workers who don't move so easily to the areas where there is a growth in the derived demand for labour. But longer-term contracts and other rigidities make it next-to-impossible for these wages to fall. So instead, unemployment might rise. Or more likely people will be inclined to say "I can't get work here, so I'm moving out west" in response to the market signals. And this has clearly been happening. From the same G&M piece:

“Probably 20 per cent of the parents on my son's hockey team, the fathers travel back and forth to Alberta and work in place like Fort McMurray,” he [Nova Scotia Premier, Rodney MacDonald] said.

... A report released last month said nearly 13,000 people migrated to Alberta from the Atlantic provinces over a one year period ending July 1.

What should monetary policy makers do in this case? If they maintain a low, steady rate of overall, measured inflation, the average of the high rate of inflation in one sector will have to be offset by deflation elsewhere. But the downward rigidities in the slow or shrinking sectors mean that prices cannot fall there, leaving them to suffer from increased unemployment among those who are less mobile and/or lower growth rates. At the same time, though, implementing policies trying to avoid slumps in the declining sectors and regions of the economy will add fuel to the inflationary pressures in Alberta and the oil patch.

To the extent that this simplified analysis has some validity, it is easy to see why policy makers might favour allowing a bit more inflation when there are large sectoral upheavals in the economy. So far, the Bank of Canada has been doing a decent job of balancing these concerns:

Prices in Alberta rose 4.7 per cent in December from a year earlier: A much higher inflation rate than the national average of 1.6 per cent, and well above any other province. (British Columbia takes second place at 2.1 per cent.) And Alberta's inflation rate has been consistently higher than the rest of the country for about three years.

My guess is that The Bank will let the Alberta rate go wherever it goes, but will try to avoid deflation in any geographic region of the economy. If so, there might be good reason to expect Canadian inflation to move into and remain in the upper regions of the targeted band national inflation rate of 1 - 3%. But if oil prices continue to decline, it'll be another story for another posting.

That's what the Province of Quebec is spending, explicitly and implicitly, to entice Alcan to build a smelting plant in the Saquenay-Lac St Jean region. That is one heck of a lot of money to spend on job creation, for jobs that probably would be created elsewhere in the economy anyway, especially if the province were to cut taxes instead.

I am skeptical, to say the least, of "job creation" statistics and arguments. If the long-run Phillips Curve and the long-run aggregate supply curves are vertical, we know that job-creation programmes do nothing more than rearrange jobs rather than create them.

As Stephen Gordon says, "Electric Boondoggle du jour".

During the housing boom, people were happy to buy high-priced houses with no money down and interest-only mortgages because they expected to gain some equity interest in the houses as house prices appreciated. At the same time, many mortgage lenders seemed to have agreed with them that housing prices would continue to rise. The result was that, in essence, the housing loans were collateralized with the expected capital gains on the house itself: borrowers were expected to be able to pay off their loans as housing prices rose, but even if they defaulted on the mortgage, the lender expected the house to have a repo value, after costs, that would more than cover the amount of the loan.

This massive expansion of credit based on expectations of rising prices is still likely to cause serious problems for the US economy over the next several years.

1. First, there will be a downturn in housing prices. It has already begun, in fact. [Update: see this in NYTimes]
2. Second, there will be mortgage defaults as borrowers simply walk away from houses in which they have negative equity (hint: when this happens, it's boom time for U-Haul; buy now and beat the rush!).
3. Third, consumers will spend less because of their reduced ability to cash in the equity in their homes.
4. Fourth, people employed in the housing industry will have reduced incomes.

All of these effects will have come about because the US Fed let the money supply grow too rapidly, made credit too easy, and indirectly promoted this phenomenal growth in borrowing.

The only thing the Fed can do now is try to ease off. It would be a mistake to crunch the money supply too much, for if the Fed put on a big crunch, aggregate demand would plummet and we would be in for some mighty serious recessionary pressures. Instead, the Fed has to slowly try to ease the inflationary pressures (that were its own doing with past easy-credit policies) while at the same time trying to keep the housing market from crashing too severely.

Dave Altig seems to think that is where the Fed is headed — a slow, soft landing in housing prices and not much of a crunch or crisis. Calculated Risk seems to think otherwise. Nouriel Roubini also seems to think a harder landing is more likely.

My own views are similar to the predictions made over a year ago by Ed Leamer (see here); they seem considerably more pessimistic than Dave Altig's forecast, but perhaps not quite as pessimistic as Calculated Risk. I can readily imagine US GDP growth rates of less than an annualized 1% a year from now, and I just hope the Fed has enough foresight and control to keep them from turning negative.

Also be sure to check out the related material at The Big Picture.

An indirect tip of the hat is due to The Emirates Economist here, who links to an article pointing out the problems of creating an asset-pricing bubble with too-rapid credit expansion in the United Arab Emirates.

David Laidler, once a champion of the 2% inflation target in Canada, is now revising his policy recommendation. In a recent report published by the C.D. Howe Institute, Laidler says,

... [T]he current 2 percent CPI inflation target was initially
conceived as a transitional step on the path to something called price stability, and has only by default acquired an aura of permanence. The current regime might embody the best way of running the country’s monetary policy, or at least close to it, but perhaps it does not, considering the corrosive effect of even 2 percent inflation on the purchasing power of money .... It would be wise to have some systematic and serious discussion of the question.

How much lower should the target be? Laidler hints at a 1% target, and discusses some of the problems with lowering the target that much.

Here is another problem he doesn't deal with: my own guess is that, given the known upward bias of between 1% and 1.5% to the CPI, the Bank of Canada would be well-advised to re-target the rate of inflation no lower than 1.5%. He seems to reject a non-integer percentage as an inflation targe, saying,

Given the practical need to work in round numbers to maintain policy transparency, 1 percent does seem to be the next feasible stopping point below 2 percent.

But I do not agree. The Bank of Canada could publicly and transparently announce an inflation target of "1.5% per year, not to exceed 2% and not to fall below 1% per year." Quickly the target would become a range (as, in fact, it is now), and the targetted range would be between two "whole numbers".

This nit-pick aside, Laidler is right. A 2% inflation target has worked but is too high. It should be eased downward.

I expect someone else would have. Old-time Keynesian economics was falling apart, and it was clear that something had to be done to fix up macro.

I'm not sure the latest Nobel prize winner in economics invented the concepts "natural rate of unemployment" and "expectations-augmented Phillips Curves", as seems to be the hype; furthermore, if those concepts hadn't been invented by him, my guess is that they would have been concocted by someone else and at about the same time. The microeconomics of job search is just too fundamental and became too important in the late 60s and early 70s, not to have led in the directions it did. And after it became clear in the early 70s that the short-run trade-off between unemployment and inflation was not stable, expectations-augmented Phillips Curves were being discussed by lots of people who never heard of his work.

But maybe I am just remembering things ex post, and my perspective is inappropriate.

As I noted yesterday at the end of my posting about the worries, fears, or concerns of three former central bankers, not everyone agrees with them. In particular, The Skeptical Optimist posts this [h/t to Craig Newmark]:

According to the fear-peddlers’ innuendo, we’re supposed to be preparing for foreign T-bond owners—especially the Chinese—to conspiratorially dump all their holdings at once, sending everyone (including themselves) into the poorhouse. (Sounds a lot like the global-finance version of a suicide bomber, doesn't it?)

This point is a good one. Foreign owners are not likely to dump their holdings of US T-bills or T-bonds all at once unless they think there is likely to be a massive failure and run on US economy; and even then, a holder of billions of dollars of US T-bills would find it very difficult to liquidate their position quickly. The Skeptical Optimist continues,

The official numbers say that, if we are to trust the Blue Dog Democrats' rhetoric, we should now be deathly afraid of the British, who have bought three times as much new debt than the Chinese have in the last twelve months.

This probably won’t surprise you: I don’t take the same stance as the Blue Dog Democrats. I do think the British, the Chinese, the Canadians, and many other foreigners know a good, safe, secure investment when they see one.

This is another good point, one to which most economists have referred at one point or another over the past two years or so. If foreigners are gladly buying up US debt at relatively low interest rates, they must not be as afraid of future risks as one might think. He concludes,

So my response to the Blue Dog Democrats fear-mongering about “foreign creditors” investing in United States Treasury securities is this:

“Mr. Blue Dog, you don’t even need a high school diploma to appreciate that the British are buying up our debt because they think it’s a safe, secure investment—and not because they’re planning to become T-bond suicide bombers.”

Cute. He certainly has a way with words. But as one reader so forcefully pointed out in a comment to yesterday's posting, many of the British purchases are just a reflection of the fact that many people in other countries do their purchasing through financial intermediaries in London. Furthermore, it is not just "blue dog democrats" who are concerned about the risk of recession in the near future. For just two notable examples, see the blog writings of Nouriel Roubini and Brad Setser.

And even if his points are correct, try out a slightly different scenario — one in which foreign holders of US debt don't try to dump it all at once but begin to "rebalance" their portfolios, even slightly, away from US gubmnt paper and toward other assets. They do not have to dump US paper to do this; all they have to do is roll over less and less US debt as it comes due, as it appears has been happening in Japan, where holdings of US gubmnt debt have declined by more than $32b over the past 12 months. A little more rebalancing in the rest of the world, and watch for one of the two following reactions:

1. US interest rates will be driven skyward by the near insatiable demand for lendable funds by the US gubmnt combined with a declining supply of lendable funds from the rest of the world. The international supply of liquidity to the US is not infinitely interest-rate elastic; nor is it infinitely risk-inelastic. Or
2. The US Fed will monetize the debt by buying up more and more of the debt itself. Were this to happen, the concerns that inflation might take off again in the near future, mentioned by Volcker and Corrigan in yesterday's posting, could materialize.

Perhaps there are small (but growing!?) risks that this scenario will play out, but either way, the US Fed and the US economy face more risk than the Skeptical Optimist acknowedges in his posting.

An excerpt from the Prudent Bear [h/t to JJ], who provided a transcription of a roundtable Q&A session:

The Women’s Economic Round Table sponsored a panel discussion Tuesday in New York that featured New York Federal Reserve Bank President Timothy Geithner, former NY Fed President and FOMC Chairman Paul Volcker, former NY Fed chief and FOMC vice-chairman Gerald Corrigan, and former NY Fed President William McDonough. The discussion of monetary policymaking amongst some of our most seasoned central bankers ran the gamut from inflation, to asset bubbles, to communications, to LTCM and supervision. ...

Question (Terri Thompson): ... [W]hat are the two or three things that worry you most today?”

William McDonough: “The thing that worries me most, in fact, the only thing that worries me a great deal - are what are popularly called the global imbalances. The United States of America last year needed to import $800 billion of other people’s savings; six and a half percent of gross domestic product. Unlike the days of yore when it was rich countries that were exporting savings to poor countries, it is now emerging market countries - China, Brazil - which are not investing enough in their own societies and sending money to the United States. It seems to be a good deal. We are the importer of last resort. They want to export things. We have very well developed financial markets - very creative financial services companies. And, so we are the place to invest of last resort.

In my view, this is not in the interest of the United States. We are a country that has a very serious problem with our aging population, of which I’m part. The Social Security system and the Medicare system on an actuarial basis are both in deep bankruptcy. Therefore, it is not appropriate for us as a society to be living higher than we should on other people’s savings from poor countries. China has 400 million people living below the poverty line; 800 million people living in poor rural areas. It makes no sense that they have a trillion dollars in reserves and that we, the people of the United States, are living better as a result of it. We have to do a better job. They have to do a better job in managing their economies. This is a situation which, left to its own devices, is one that will hit a brick wall. The only question is when.”

Gerald Corrigan: “The first point I would make is related somewhat to the one Bill just made – its kind of the other side of it. That is that the United States savings rate is virtually zero. The household saving rate is negative. And for the reasons that Bill mentioned and a whole bunch of other reasons as well, this is a potentially very dangerous situation, not only in terms of economic and financial terms, but it brings with it, I think, some potentially very serious problems down the road in terms of the well being of our own citizens. You know, as I said, that’s very closely related to Bill’s point about imbalances.

The second thing that I would mention is I think there is what I will describe as a small risk that the old inflation genie could sneak out of a bottle on us again. I emphasize that I think that is a very small risk, but if there’s one thing I think I’ve learned in the 40 years it is now in the financial fights that is once the genie is out of the bottle, it’s very, very difficult and expensive to put it back in the bottle.

I would just add to both of those points, whether it’s inflation or imbalances or savings, the other thing you have to be very cognizant of is that these kinds of problems clearly have potential to generate potential elements of financial instability. And the fact of the matter is that no matter how smart we think we are, we are virtually incapable - individually and collectively - of being able to anticipate the specific timing and triggers associated with financial shocks. So if you put that variable into the equation, it seems to me that it just reinforces in spades how important it is to get the fundamentals right.”

Paul Volcker: “Well, what I immediately thought, Terri, when you asked the question, I should resist the temptation to say what worries me the most is that I’m not in Washington. That’s not quite true because I take great confidence in the people in the Federal Reserve and elsewhere, particularly Tim Geithner. But both of my associates here have already touched upon the issues that I would put front and center economically.

I do worry about a lot of things in the economy these days, because I do think an awful lot is going wrong in the world generally that are even more important than monetary policy. But I don’t think I’ll get into those too deeply and just underscore what my two friends just said. I am a little bit more worried about inflation than Mr. Corrigan – although he expressed a worry. Not that it’s high, not that it’s going to go running away, but it’s kind of creeping up.

And I am impressed by the degree of pressure - if that’s the right word - psychological pressure, political pressure there is not to do anything about it. A lot of people out there on Wall Street and on Main Street are operating on the assumption that nothing very startling will happen in terms of restraint. And that’s reflected in attitudes pretty broadly. But once people are convinced that that’s the case, it can creep up on you. And the more it creeps up on you, the more difficult it becomes to do something about it.”

For a very different view, however, see The Skeptical Optimist (link via Newmark's Door)

David Altig, at Macroblog, presents some pretty compelling evidence that the US Fed has pursued monetary for the past 20 or so years that pretty much followed the predictions of the Taylor Rule:

Below is a picture I've shown before. It compares actual federal funds rate decisions (through the first quarter of this year) with those of an estimated "Taylor rule", which assumes that the FOMC responds gradually to deviations of GDP from potential (as measured by Congressional Budget Office "output gaps") and deviations of inflation from an implicit target:



If you can detect a substantial change in behavior from that record, you are doing better than I.

What intrigues me about the graph is how clear it is that the Fed over-expanded with its monetary policy between 2001 and 2005. This excess liquidity found its way into the housing markets which are now turning downward and which will lead, according to at least some reputable economists, to a recession within a year.

The more I see things like this, the more I think that perhaps Milton Friedman's recommendation for a stable monetary growth rate (but how should the money supply be measured? M1? M2? M4? M16? the monetary base?) would be better for the economy in the long run than these attempts at fine-tuning.

As I understand it, the received doctine is that Samuelson and Solow were the ones who convinced JFK to initiate tax-cut legislation in the early 1960s. I recently heard, however, that there may or may not be some reliable evidence, that Bob Mundell was really the one who convinced him. Was this position first put forward by Eugene Birnbaum? If you have any information about this, please let me know.

I do recall attending a Mundell seminar in 1971 in which he recommended use of fiscal policy to address real economic variables and monetary policy to address price goals. But I do not recall his having said anything in any of the seminars of his that I attended then or earlier in which he took credit for having convinced JFK to cut taxes.

(I posted this a year ago this coming weekend):

That [headline is] the prognostication of economist Ed Leamer:

In Leamer’s view, the housing market appears to have peaked “in California and elsewhere. It will take more than a year for this weakness to turn into job losses and to affect the economy in general.” [emphasis added]

And, yes, he’s using the “R” word. As in “recession.”

Leamer lays the blame squarely on the Federal Reserve for leaving interest rates too low for too long. Now, he says, we’re not only heading for trouble in the housing sector, but in the auto industry — another market that got drunk on historically low rates.

Low borrowing costs accelerated future sales by enticing consumers to trade up to bigger homes and new vehicles sooner than they might have done otherwise. Instead of waiting to buy a new family car in a couple of years, folks said, “Oh, what the heck. Financing is so cheap we might as well get it today.” As a result, car dealers lose the sale they would have gotten two years from now.

As rates creep higher, consumers happily driving their new cars or living in their larger homes have no motivation to purchase additional ones. Since consumer spending drives two-thirds of our economy, when consumers close their wallets, the impact is far-reaching.

---

Update in 2006: With growing doubts and concerns about what will happen in the US economy over the next year or so, it looks as if Leamer may have called it pretty well.

For more on the housing slowdown and possible recession, see the postings at Calculated Risk and Econbrowser.

And for a really bleak outlook, see the charts reproduced at The Big Picture, where Barry Ritholtz contrasts what most people think of as a "housing bubble" with what he and Lon Witter call a lending bubble. Interestingly, these concerns were being raised a year and a half ago (and brought to my attention by MA and Sean), but only now are the predictions being realized. Ed Leamer seemed to have the timing right, too.