Thursday, May 31, 2012

Chidem Kurdas - "free trade and markets matter much more than the euro"

Creating the euro was a different level of ambition from building a common European market. The latter had historical roots. There had been free flow of goods, capital and people across parts of Europe in the 19th century and earlier. Political barriers and wars disrupted those flows, but at times and in places free trade and free migration across national borders was a reality. Indeed, by mid-20th century older people remembered with nostalgia how easy travel had once been.
Hence by removing the barriers to the movement of goods, money and people, the European Union was not imposing a novel blueprint.  Had it stopped with free markets, tremendous economic and political benefits would have been achieved with little downside. I have to admit that I never understood the aggressive drive to impose a common currency.
Read it at ThinkMarkets
Euro Crisis from Long Perspective
By Chidem Kurdas

Many people appear to still hold hope that the current EU crisis will ultimately resolve itself in the creation of a United States of Europe. Kurdas contrasts the historical conditions of the US and Europe prior to accepting a common currency. His conclusion, similar to that of Peter Boone and Simon Johnson in The End Of The Euro: A Survivor’s Guide, is worth repeating:
what needs to be kept in mind is that free trade and markets matter much more than the euro. Preserving them should be the priority.

Related posts:
Ending the Euro Currency, Not the European Union

Spain's CDS Going Vertical

Spain's 5-year CDS spread is moving increasingly vertically. The Troika will need to act soon but it's anyone's guess which rabbit they will attempt to pull out of the hat. A supposedly "big" announcement over the weekend (Sunday night?) should not come as a shock. Regardless, further opportunities to kick this can down the road are becoming slim.

Related posts:
Crisis Events in Europe Speeding Up

Nouriel Roubini - Get Ready for the Spanish Bailout

(h/t Zero Hedge)

James Galbraith on the Federal Reserve

Short video but intriguing commentary. Galbraith offers support for the Fed's dual mandate, noting that it allows targeting inflation level other than zero. Separately, he comments on the non-independence of the Fed, a topic I mentioned earlier today in The Asymmetric Nature of Monetary Policy.


The Asymmetric Nature of Monetary Policy

Steve Roth, over at Angry Bear, recently had a good post on the future of monetary policy titled, The Fed Faces the End Game -- And Blinks? Roth elaborates on a game theory perspective outlined by Ryan Avent:
After three decades of taking away the (wage- and employment-)growth punchbowl when the party starts getting (“too”) hot, and after four years of subordinating their employment mandate to their cherished inflation-control credibility, the Fed has a serious shortage of “growth credibility.”
Which means that the Fed has created a game that is asymmetrical. It has great power to quash growth through open-mouth operations; we know they’ll sell bonds if they promise and need to, and that doing so will dampen inflation (and growth).
But on the expansionist side, we can’t believe their promises. They would need to make actual bond purchases to spur growth. And even if they do both promise and live up to the promise, we (with the exception of [market] monetarists, few of whom are running large businesses or managing large amounts of money) don’t have great or certain expectations for the results.
In Search for Austerity Continues as Central Banks Undermine Stimulus, I made a similar observation:
central banks ability to affect inflation, and to a lesser extent growth, is heavily skewed in favor of slowing either measure.
Whereas Roth suggests that asymmetric credibility stems from the Fed’s actions, I believe it is actually an inherent condition in our current monetary system. The Fed sets the base price for money and credit, but with private banks free to create credit, it holds relatively little control over the total amount outstanding at any time. As growth in the US has exceeded inflation for much of the past three decades, the conditions were ripe for borrowing and credit outstanding now greatly surpasses the sum of base money.

Even if the Fed promised indefinite QE, it’s hard to see the mechanism, aside from adjusting inflation expectations (wealth effects are minimal), by which this would spur real growth. Given the Fed’s skewed abilities and determination to maintain its credibility, it seems more obvious why inflation targeting remains prominent. Further, this may help explain why the Fed downplays its employment mandate (which should be removed anyways). Facing the endgame, the Fed knows it can reduce inflation (and growth) but remains unsure how successful it could be at achieving other targets.

Therefore it seems I actually agree with Avent’s conclusion and Roth’s translation:

Ryan thinks that the Fed’s afraid that it:
…will need to roll out dramatic, unconventional actions—the fear being, of course, that such actions would leave it hopelessly politicised and powerless to fight inflation. … [They're] fighting to maintain their vulnerable independence.
Translation: They’re fighting to avoid the MMT-World end game, where the Fed becomes an irrelevant mechanical actor.

Related posts:
Political Fears May Keep ECB Easing On Hold
Fed's Treasury Purchases Now About Asset Prices, Not Interest Rates

Wednesday, May 30, 2012

Permanent Zero: Record Low Treasury Yields and Banking Instability

The Fed is squeezing interest rates down to levels where you see private portfolio preference shifts, a euphemism for the risk seeking return mentality that arises from artificially low real fixed income returns and that forces up risk assets. But this can only go one for so long.
See, eventually there will be another recession and the question should be what happens to all those toxic assets on bank balance sheets. What happens if new loans go sour too? If you recall, US FDIC-insured institutions recorded $35 billion in Q1 2012 accounting gains. But the quality of those accounting gains was dubious. Here’s the key line to note:
Lower provisions for loan losses and higher noninterest income were responsible for most of the year-over-year improvement in earnings.
Read it at Credit Writedowns
What record low 10-year rates tell us about the toxic effects of permanent zero
By Edward Harrison

Yields on 10-year Treasuries reached a new record low of 1.617% today.
Regarding the continuing decline, Harrison explains that Long-term interest rates are a series of future short-term rates. The Fed has already “promised” to hold rates near zero through 2014 and I suspect that target date will be extended further by year end. Separately, when the Fed altered policy to begin paying interest-on-reserves (IOR) it also changed the direct measure by which monetary policy is adjusted. Given the enormous size of the Fed’s balance sheet (and outstanding Treasury debt), going forward it may be easier to effectively raise interest rates by hiking the IOR rate rather than actually altering the Fed’s target rate. With these concepts in mind, it should come as no surprise that 10-year (and 30-year) yields continue to move lower in similar fashion to Japan (although I currently don’t expect Treasury rates to reach the JGB lows).

Over the past couple years I have also remained suspect of US banking profits (and by extension S&P 500 operating profits) for the reason highlighted above from the FDIC. Much of the gains appear to be merely accounting profits. When the next recession/crisis hits, those accounting profits can (and probably will) easily flip to large accounting losses. In my view, the risk of serious shortfalls in capital during the next downturn remains extremely present today. As Minsky often pointed out, complacency about risk is often a warning of building risks in the background.  

The next crisis/recession will probably occur with short-term rates still at zero and without many aspects of the Dodd-Frank Act or Basel III provisions in place. Given the public response to previous bailouts, the Treasury/Fed response will be a wild card. Any bets on what their initial actions will be?

Related posts:
Fed Stands in Own Way on Monetary Policy
Treasury Yields Low for Good Reason

Crisis Events in Europe Speeding Up

Following weak demand for 5 and 10-year Italian debt in today’s auctions, yields are once again spiking. Italy’s 5-year yield is over 5.5% and the 10-year breached 6% again. Meanwhile, Spanish yields are rising sharply as well. Spain’s 5-year yield is now over 6% and the 10-year is quickly moving towards 7%.
As the chart displays, the curves are becoming flatter outside of 3 years, where the LTRO wasn’t focused.

Yesterday, Sober Look offered the following chart showing the similarities between Spain and Portugal's 10-year yield spread to Germany. As the post notes:

On April 1st, 2011, Portugal's 10-year spread to Germany went above 5% for the first time. Two weeks later Portugal formalized its request for assistance from the EU/IMF.
Spain’s 10-year spread to Germany surpassed 5% for the first time on Monday and today reached 5.5%.

Without any imminent promise of further easing by the ECB or stimulus from the EU, it appears investors are not waiting to test the Troika’s limits. Even if the ECB were to attempt another LTRO, many of the European banks are already heavily underwater from their sovereign debt purchases in the first couple go a rounds. Will the banks be willing to triple down on the same risks?

Apart from the severe costs of bailing out Spain, which may require more funds than previous bailouts combined, the decision also removes Spain from the group of countries promising capital to back the ESM/EFSF. Without Spain’s contributions, the burden of the bailout mechanisms will fall even more squarely on Germany. France and Italy will also see their shares increase, which the latter can ill afford at this moment.

It is unclear exactly what conditions must be met for a country to officially request a bailout from the Troika, however Spain seems to be moving rapidly in that direction. If two weeks is a reasonable estimate, than it appears highly unlikely the EU can come together on an alternative option in such a short time. The events of the European crisis are speeding up and have finally reached countries that are seemingly too big to fail and too big to bail out. Risks of a larger fallout are finally being priced into the US stock market, though it remains significantly detached from Treasuries, the dollar and commodities. Which direction the crisis will turn next is anyone’s guess, but either way it should be a bumpy ride.  
Related posts:
Pain in Spain is Only Beginning
Nouriel Roubini - Get Ready for the Spanish Bailout
Private Debt Continues to Drag Down Europe

John P. Hussman - The Reality of the Situation

Euro Hopium
Two main hopes have kept investors relatively complacent about the growing risks in Europe: the hope for Eurobonds, and the hope for large-scale ECB purchases of distressed sovereign debt (essentially money-printing).
With respect to Eurobonds, investors should understand that what is really being proposed is a system where all European countries share the collective credit risk of European member countries, allowing each country to issue debt on that collective credit standing, but leaving the more fiscally responsible ones - Germany and a handful of other European states - actually obligated to make good on the debt.
This is like 9 broke guys walking up to Warren Buffett and proposing that they all get together so each of them can issue "Warrenbonds." About 90% of the group would agree on the wisdom of that idea, and Warren would be criticized as a "holdout" to the success of the plan. You'd have 9 guys issuing press releases on their "general agreement" about the concept, and in his weaker moments, Buffett might even offer to "study" the proposal. But Buffett would never agree unless he could impose spending austerity and nearly complete authority over the budgets of those 9 guys. None of them would be willing to give up that much sovereignty, so the idea would never get off the ground. Without major steps toward fiscal union involving a substantial loss of national sovereignty, the same is true for Eurobonds.
Over the weekend, Jean Claude Trichet, the former ECB head, proposed a system to save the Euro, whereby European politicians could declare a sovereign country bankrupt and take over its fiscal policy. He also proposed a system whereby the Eurozone could produce its own domestic energy by placing a giant hamster on a wheel the size of the Eiffel Tower.
Moving to the European Central Bank, large scale ECB purchases of sovereign debt would simply be the money-printing version of Eurobond issuance. When the ECB purchases the bonds of a given country, and creates Euros for them, it has essentially printed money until the point in time that the bond is paid off. If that day never comes, as is the concern with distressed European debt, then the ECB has essentially printed permanent Euros in order to finance the spending of the country whose bonds it purchased. In order to guard against this sort of backdoor fiscal policy, the ECB only buys bonds after ensuring that it has a senior position to other bondholders. So if the ECB was to purchase distressed European debt on a grand scale, the result would be that theremaining bonds would be subordinated, making the prospective losses on those bonds evenhigher than they were previously.
Ultimately, what investors really want is for the debt of various countries to be wiped away by the ECB simply printing money to retire that debt, or by having Germany and stronger Euro-area members to make endless transfers to peripheral European countries. The whole system rides on this willingness to transfer fiscal resources, or to allow money printing (with no revenue to stronger members from that money printing) in order to finance heavily indebted members. The reason the recent elections in Greece and France matter is that they send a signal from the public to European governments: the people are unwilling to make any more "austerity bargains" that put the public behind bank and government bondholders. So Germany is now being asked to continue its transfers without any end in sight.
We can't rule out the chance that Europe will cobble together enough temporary liquidity for Greece and troubled banks to kick the can down the road another time or two, but these kicks will become increasingly weak and short-lived in the context of a new recession. Even in the event of various liquidity injections, there is virtually no chance of addressing the solvency of Europe - the ability of each government (much less the banking system) to sustainably pay their debts - within the constraints of the Euro. As long as the Euro exists as a single currency, individual countries can't inflate away the real value of their debt, or restore their trade competitiveness through exchange rate depreciation against other countries.
Under these strains, I expect that the Euro will fracture well beyond a Greek exit. Ultimately, the result might be a "strong Euro" that reflects the union of Europe's most fiscally responsible countries, or we might instead see a "weak Euro" that follows the departure of Germany from the currency union and leaves peripheral members free to inflate. So it's not clear which direction the value of any surviving Euro may take until it is clear which member countries will remain. In any event, however, what we are unlikely to see is a single Euro that combines fiscally responsible and fiscally irresponsible countries, and requires endless one-way transfers of sovereign public resources in order to hold the system together.
Read it at Hussman Funds
The Reality of the Situation
By John P. Hussman, Ph.D.

Still Not Buying A Housing Recovery

Following yesterday’s Case-Shiller Home Prices report, which showed m/o/m gains but further y/o/y declines, many analysts were out once again touting the bottom in housing (e.g. House Prices: From "bold call" to consensus in four months). Despite the pervasive optimism, I remain in the camp that believes these calls will continue to be proven wrong, as they have been each of the past couple years. Steve Keen in a Correction to “What House Price Falls Really Look Like” offers the following chart on real US house prices over time:
Although prices, even nominally, have fallen pretty dramatically in the past several years, real prices remain 15% above their long-term average. Anyone who has studied the history of bubbles will recognize that prices practically always fall below the long-term average before rebounding (otherwise the long-term average would be far higher).

Based on estimates by the Cleveland Fed, expected inflation for the next 10 years is only 1.38%.

If such low values of inflation are realized, to simply reach the long-term real price average, nominal home prices must either stagnate for another decade or continue to drop for the next several years. While nominal housing prices may be bottoming, in my view, a real recovery still remains years away.

Related posts:
Dr. Housing Bubble - What if housing doesn't recover for another decade?
Don't Rush to Buy a Home!
Buy a House for the Experience, Not the Potential Gain

Tuesday, May 29, 2012

Noah Smith - Believe in yourself, for my benefit.

So there are theoretical reasons to believe that overconfident entrepreneurs are more likely to benefit society than they are to benefit themselves. If you try to be the next Mark Zuckerberg, chances are you're taking on a lot more risk than you would take if you weren't such an overconfident nut. But without overconfident nuts like you, our economy will be poorer and our society will be more stagnant.
So, by all means, young entrepreneur, believe in skill! Believe that you, not the person sitting next to you, will be the next tech billionaire. You're probably wrong. But the chance that you might be right is enough to make your quixotic madcap adventure worth it for the rest of us.
Read it at Noahpinion
Believe in yourself, for my benefit.
By Noah Smith

One of my college roommates always envisioned being a successful entrepreneur (and probably will be one day). His natural way of thinking led to frequent innovative ideas as potential business opportunities. My natural way of thinking is to focus on the operational aspects of any idea. What is the market? How costly is the product to produce? What are reasonable expectations for profit margins? This combination of personalities led to a constant back and forth of creative ideas versus practicality of actually running that business.

In my opinion (hopefully his too), our debates were ultimately very beneficial to both parties. He taught me not to get bogged down in the details and I helped him to probably avoid wasting time on profit-less ideas. The point is, between my roommate and I, he is far more likely to believe in his skill as an entrepreneur and take those risks. While there is certainly a role for the micro-thinkers, our society clearly benefits from those individuals willing to pursue out-of-the-box ideas. For all of our sakes, I hope that he and many others will give entrepreneurship a run (although I obviously hope my old roommate is the next Zuckerberg).

Don't Bet Against Bunds

From Nomura’s European rates strategist Desmond Supple:
Were the market to price-in an imminent break-up of the EUR, in our view Bund yields could go negative out to 5yrs, while for the 10yr sector we would expect yields to move far below 1%.Given the value of the embedded FX option in the Bund, we think it is not impossible that yields will approach the cycle low in 10yr JGB yields in 2003 of 44bp…
We hope that this scenario does not materialise. We hope that we are incorrect in ruling out meaningful fiscal union or that we are incorrect in assuming that the ECB will only provide a policy response that is proportional to the crisis when its toes are dangling over the precipice. But history is not on our side. Hence, despite the low level of yields, we remain extremely bullish on Bunds.
Read it at FT Alphaville
Ten-year Bund yields below 1%? Wouldn’t faze Nomura
By Simon Hinrichsen

Sometimes the gambles that everyone else is unwilling to make are actually the best. Analysts predicting a rise in JGB yields have been wrong for the better part of two decades. Treasury yields have likewise continued to fall despite being a hated asset class for much of its 30-year bull run. For my money, 10-year Bund yields below 1% seems far more likely than a full European fiscal union.

EU Resolution May Hinder on Fairness Over Well-Being

The basic problem is that we care so much about fairness that we are often willing to sacrifice economic well-being to enforce it. Behavioral economists have shown that a sizable percentage of people are willing to pay real money to punish people who are taking from a common pot but not contributing to it. Just to insure that shirkers get what they deserve, we are prepared to make ourselves poorer. Similarly, a famous experiment known as the ultimatum game—one person offers another a cut of a sum of money and the second person decides whether or not to accept—shows that people will walk away from free money if they feel that an offer is unfair. Thus, even when there’s a solution that would leave everyone better off, a fixation on fairness can make agreement impossible.
Read more at The New Yorker
By James Surowiecki
(h/t Mark Thoma at Economist’s View)

This is why everyone betting on a peaceful/reasonable resolution may be proven incorrect. Similarly, economists that fail to incorporate lessons from other social sciences will continue to make poor predictions.

Facebook Stock at $10?

No one is going to invest in Facebook shares today if its price will be 30% lower in five years. So, in order to entice someone to invest in it today, Facebook needs to offer a handsome return. Assuming that its five-year return is equal to the stock market’s long-term average return of 11% annualized, Facebook shares currently would need to be trading at just $13.80.
Double ouch.
Don’t like that answer? Try focusing on earnings rather than sales, and you get only a marginally different result. Assuming its profit margin stays constant (instead of falling as it could very well do as it grows), assuming its P/E ratio in five years will be just as high as Google’s is today, and assuming that its stock will produce a five-year return of 11% annualized, Facebook’s stock today should be just $16.66.
How can Facebook investors wriggle out from underneath the awful picture these calculations paint? By assuming that its revenue and profitability will grow faster than the average IPO between 1996 and 2010 — and not just by a little bit, either, but a whole lot faster.
Read it at Market Watch
Facebook’s stock should trade for $13.80
By Mark Hulbert
(h/t Joshua Brown at The Reformed Broker)

Last week a friend texted me the following:

I wish we did a mandatory facebook short sale Friday. At what price would you buy?
My response:
If only it were so easy. Personally I’d stay away but maybe $10?
Looks as though my off-the-cuff response was not so crazy after all.

Monday, May 28, 2012

DC's Bubble Still Rising

How’s a country to make sense of a national capital whose day-to-day life is so much more upholstered than its own? Increasingly, it cannot. Recently Washington passed San Jose in Silicon Valley to become the richest metropolitan area in the U.S. Since the 1990s, says economist Stephen Fuller of George Mason University, the region has led the nation’s metropolitan areas in overall employment rate. The median household income in the metro area in 2010 was $84,523, according to calculations by Bloomberg News, nearly 70% over the national median household income of $50,046. Nine of the 15 richest counties in the country surround Washington, including Nos. 1, 3, 4 and 5. Per capita income in D.C. is more than twice that in Maine. All this explains why Gallup’s Well-Being Index rates D.C. as the most satisfied large metropolitan ­area in the U.S. The pollsters were especially ­impressed with the region’s low smoking rate (15%) and the 72% who visit the dentist annually for a checkup. Washingtonians are skinnier, exercise more, eat more vegetables and are more likely to have health insurance than the average American. They’re also more optimistic—about the economy and about the future in general.
Read it at Time
Bubble on the Potomac
By Andrew Ferguson
(h/t Tyler Cowen at Marginal Revolution)

As a resident of DC I feel both fortunate for my own opportunities and simultaneously worried about the long-term political implications.

Separately, I want to draw attention to the following quote from the article, less for the comment and more for the commenter:
“Happy hour is the most important hour of the day,” says Emily Schultheis, a Web editor and recent arrival. “It’s how you meet people, how you get jobs, how you find roommates, how you get tips for stories and how you get in trouble.”
Emily is a good friend of mine from college and Web editor at The Washington Free Beacon. Only a few months after its unveiling, the site is already making a name for itself under the guidance of its editor in chief, Matthew Continetti. Be sure to check it out!

Updated Blog List

You’ll notice a few stylistic changes on the blog today but I wanted to highlight the updated blog list. Apart from being able to now see the most recent posts for each site, I’ve added several blogs to the list that are well worth your time (in no particular order):

Sober Look
The New Arthurian Economics
Social Democracy for the 21st Century
Dr. Housing Bubble
Unlearning Economics
Conversable Economist
Uneasy Money
Patrick Chovanec
Yanis Varoufakis

Enjoy the rest of your Memorial Day Weekend!

Cost-Push vs. Demand-Pull Inflation: Monetary and Fiscal Policy Continue to Attack the Wrong Problem

What we spend, matters. If we spend money, there's no associated interest cost and we don't have to pay the money back. If we spend credit, we have the cost of interest to deal with. And the repayment of principal.
Our economic policies took money out of circulation and encouraged the reliance on credit. "What we spend" became more costly. The factor cost of money increased.
A factor cost is something like wages or profit, or something that competes with wages and profit. The cost of interest is a factor cost that competes with wages and profit.
The cost of interest is an "extra" cost, a largely unnecessary cost in our economy. Yes of course we need to use credit. But we don't need to use credit for everything. But we do. So, we have this extra cost to deal with, the factor cost of money. And it creates cost-push conditions. And cost-push conditions cause inflation. Inflation, or decline.
Read it at The New Arthurian Economics
The Cost-Push Economy
The Arthurian

An old post but a beauty. The difference between demand-pull and cost-push inflation is incredibly important for determining the correct policy response and has been largely misunderstood for several decades. Reliance of money-like instruments (credit) has dramatically changed the balance of “What we spend” and thereby altered the source of inflation. This change may also help explain why, since the 1980’s, The Economy Needs a Bubble! Until this distinction is better and more widely understood, monetary and fiscal policy may continue to attack the wrong problem.

Ending the Euro Currency, Not the European Union

For the last three years Europe’s politicians have promised to “do whatever it takes” to save the euro.  It is now clear that this promise is beyond their capacity to keep – because it requires steps that are unacceptable to their electorates.  No one knows for sure how long they can delay the complete collapse of the euro, perhaps months or even several more years, but we are moving steadily to an ugly end.
Whenever nations fail in a crisis, the blame game starts. Some in Europe and the IMF’s leadership are already covering their tracks, implying that corruption and those “Greeks not paying taxes” caused it all to fail.  This is wrong:  the euro system is generating miserable unemployment and deep recessions in Ireland, Italy, Greece, Portugal and Spain also.  Despite Troika-sponsored adjustment programs, conditions continue to worsen in the periphery.  We cannot blame corrupt Greek politicians for all that.
It is time for European and IMF officials, with support from the US and others, to work on how to dismantle the euro area.  While no dissolution will be truly orderly, there are means to reduce the chaos.  Many technical, legal, and financial market issues could be worked out in advance.  We need plans to deal with: the introduction of new currencies, multiple sovereign defaults, recapitalization of banks and insurance groups, and divvying up the assets and liabilities of the euro system.  Some nations will soon need foreign reserves to backstop their new currencies.  Most importantly, Europe needs to salvage its great achievements, including free trade and labor mobility across the continent, while extricating itself from this colossal error of a single currency.
Read it at The Baseline Scenario
The End Of The Euro: A Survivor’s Guide
By Peter Boone and Simon Johnson

The last sentence requires special attention. Much of the discussion today regarding a dissolution of the EMU seems to imply that free trade and labor mobility must rapidly decline. As frustrations between and within nations are allowed to grow, this outcome may prove true but it need not. The benefits from free trade and labor mobility in the EU are significant regardless of whether any single currency exists. If that were not the case, then why are some countries part of the EU but not the EMU?

In politics it often appears that planning for unthinkable outcomes is considered a sign of expected failure. Confidence, however, cannot solve all problems. Unthinkable outcomes still happen frequently enough and the repercussions are far greater than necessary. Even if the politicians will not make their contingency plans publicly known, one has to hope those plans are being thoroughly discussed in the background. An end to the Euro currency will be troublesome, but an end to the EU will be disastrous.

Francis Fukuyama - China’s ‘Bad Emperor’ Problem

So the apparent institutionalization of the Chinese authoritarian system is largely a mirage.  The Communist Party has not solved the Bad Emperor problem, nor will it until it develops something like a genuine rule of law with all of the transparency and formal institutionalization that entails.
Read it at The American Interest
China’s ‘Bad Emperor’ Problem
By Francis Fukuyama

Fukuyama offers perspective on the removal of Bo Xilai and the rewriting of history surrounding Mao Zedong’s rule.

Sunday, May 27, 2012

NGDP Targeting: Keeping An Open Mind

In a recent post on the topic of Nominal Spending & Output Growth – A long history,  Marcus Nunes at Historinhas, displays the following chart to show that
since the 1980s, and increasingly, nominal and real growth have become more tightly knit.
A few weeks ago, following some back and forth with Unlearning Economics On the Lousy Reasoning Behind NGDP Targeting I commented:
Woj - As long as the CB is reasonably successful at targeting low inflation, NGDP and RGDP will obviously be highly correlated over time. However, if the CB were to target quantity rather than price, I’d imagine that RGDP and NGDP might be less correlated. Is it possible that much of the correlation stems from current CB policy and that changing policy would also change the relationship?
Attempting to support this view, I expanded on the topic in a couple posts: NGDP Targeting: Changing Policy Changes Relationships and NGDP Targeting: Changing Policy Changes Relationships (Part 2).

Yesterday I posed the following question to Marcus:
Why will changing policy to promote higher inflation today not cause a breakdown in the correlation of the past 30 years, similar to the 1970’s?
Marcus was kind enough to not only reply, but also to direct me through email to his take on NGDP Targeting in The crisis from an AD perspective. The post is well constructed and a generally good read on the subject. The specific quote that struck comes near the end:
I wonder in what kind of world we would be living today if 20 years ago the group that argued for the stabilization of AD growth (level targeting) as the rule to be followed by MP had won the debate over those that proposed IT with the interest rate as the policy “instrument”. Quite likely we would be experiencing much less “fiscal stimulus” with all its attendant risks.
Although I remain a skeptic on NGDP Targeting and the impact of monetary policy more broadly, I entirely agree that fiscal policy holds far more “attendant risks.” In choosing between flawed monetary policies, the one that reduces the need for “fiscal stimulus” may very well be favorable.

As I noted in a reply to Marcus and Saturos, my hesitation on NGDP Targeting stems from a Minsky/MMR view under which private credit creation/lending (through banks) can and currently does significantly influence aggregate demand. The ability of monetary policy to control NGDP would therefore be weak and skewed towards reducing NGDP. Further, the amount of monetary stimulus necessary to try and meet targets may not be politically feasible.

All that being said, I’m not exactly a supporter of inflation targeting either, as discussed in Inflation Targeting Shifted Fed Focus to Constraining Aggregate Demand. Hopefully, in time, the lessons from NGDP supporters and the Minsky/MMR crowd can align to find common ground on monetary policy. Until then I remain open to and interested in new methods of monetary policy (including free banking) that offer improvements over inflation targeting.

Saturday, May 26, 2012

Political Fears May Keep ECB Easing On Hold

In a post this past week noting that Greece Continues to Run Up Liabilities at the ECB, I mentioned:
Although the ECB cannot run out of Euros (go bankrupt), incurring actual losses blurs the line between monetary and fiscal policy. This result [a Grexit], which seems increasingly probable, will likely hinder support for further expansions of the ECB’s balance sheet.
Yesterday FT Alphaville ran a more expansive post On the ECB’s attempts to ring-fence its balance sheet, quoting a note from Standard Chartered analysts Thomas Costerg and Sarah Hewin:
It is worth noting that a key feature of the TARGET2 mechanism is that while liquidity flows from the north to the periphery, the collateral remains with the peripheral NCB – it is not transferred to the north. In theory, should a peripheral bank default on its repayment obligation to the ECB, the ECB would require the collateral from the NCB. However, it remains to be seen whether, in the fluid circumstances of a Greek exit, the NCB would indeed pass on the collateral; furthermore, the value of the collateral could have diminished significantly, potentially to a fraction of its original value (for instance, if it were a Greek government bond). As a result, in many circumstances, the collateral pledge would not entirely offset the loss of ECB funds.
Also from the post

Here’s a chart that shows the ECB funding to the periphery and marginal increase from ELA lending recently (via StanChart):

So apart from running up liabilities at the ECB, Greece also gets to retain the collateral at its own National Central Bank (NCB). This suggests that as time continues to pass, the Greek bargaining position should become even stronger. The ECB, similar to most other “independent” central banks, will not want to venture into the political realm by accepting losses that amount to de-facto fiscal policy. This fear may force the ECB to be more cautious in its actions, even as troubles appear to be rising in the periphery banking and sovereign sectors. With the Fed also potentially on hold due to political hesitations, markets may find they have farther to fall this time around before central banks are willing to intervene. The big question is, will central banks intervene in a timely enough fashion and with sufficient force to prevent another round of bank runs similar to 2008-2009?   

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Read it at Zero Hedge
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Friday, May 25, 2012

No More QE in June?!?!

Bottom Line:  The data flow is soft, but Dudley indicates it is not soft enough to ease.  And while some are pointing to falling TIPS-derived inflation as  given the Fed room to move, they have traditionally delayed until conditions are more dire (they are not exactly prone to overshooting in the first place).  The Fed doesn't think they will ease further; they think their next move will be to tighten.  Which means that financial conditions will need to deteriorate dramatically to prompt action in June.  So if you are looking for the Fed to ease in just four weeks, you are looking for financial markets to turn very, very ugly.  Lehman ugly.  And I wish that I could say that it won't happen, but European policymakers are hell-bent to push their economies to the wall while worshipping at the alter of moral hazard.
Read it at Tim Duy’s Fed Watch
Is QE3 Just Around the Corner?
By Tim Duy

I think Tim is correct in noting that market participants are expecting too much if they believe another round of QE is coming in June, absent some large disruption. However, a couple points seem off the mark. At the open Tim quotes
From the Wall Street Journal today: In "QE," the Fed pumps money into the financial system through asset purchases.
Depending on one’s definition of the “financial system” this may be correct, but the wording seems to imply inflationary money printing, which QE is not. As I wrote last year in Deflationary Monetary Policy:
Common conception is that quantitative easing is inflationary money printing. However, as noted earlier, quantitative easing (as practiced) is strictly an asset swap between the Federal Reserve and banks. Operationally, QE2 simply involved the Fed exchanging interest-bearing Federal Reserve notes for treasury notes. [Private] Net financial assets were not actually increased during this process. Quantitative easing therefore involves no money printing, simply swapping assets.
Separately, as Tim’s title implies, most people are calling the next round of quantitative easing QE3. Shouldn’t any further QE be considered QE4? Currently the Fed is engaging in Operation Twist, which apparently is not QE3. However, the next round, if it happens, is rumored to be sterilized QE. Since Operation Twist Doubles as Sterilized QE, applying the same logic implies that the next round should either not be considered QE or should be QE4. (I recognize this is nitpicky but think it’s important to keep track of all the Fed’s efforts)

Unfortunately for investors the market direction in coming months likely hinges, to a large degree, on the Fed’s actions. The Fed's Treasury purchases are now about asset prices, having accomplished little for economic growth since the first QE. With a Presidential election approaching, the Fed will likely err on the side of caution to avoid the perception of taking sides. Therefore, if the Fed doesn’t act in June, absent a collapse, it may not act at all in 2012.