Schizo-flation

An economy cannot experience both inflation and deflation, and yet that is exactly what seems to be happening. The Fed’s exertions have produced some consumer price inflation – though not enough for diehard Keynesians – and quite a bit of asset price inflation, and yet the economy “feels” deflationary. This would not be the first paradoxical price phenomenon. Inflation had been associated only with rapid growth – until stagflation was discovered in the 1970s.

One possibility is that prices are behaving differently in different segments of the market. Wolf Richter writes here about a bifurcated real estate market, with mortgages off but cash deals booming. We have mentioned Tiffany’s before, and this interview with John Mauldin touches on the market for fine art.

We need to characterize the economy’s condition, but we should not get hung up on price based definitions. For example, David Stockman describes the Great Moderation as an inflationary period, due to loose monetary policy, offset by cheap Asian imports. Frances Coppola says it would have been deflationary – except for the credit bubble. It all depends on your perspective.

Consider what deflation looks like, without reference to prices. Sellers struggle because demand is weak. They cut back on supplies, and they lay off staff. People are out of work. They don’t have much to spend, and debts become unsustainable. Sound familiar? This is the vicious cycle which characterized that earlier depression – and the current one. Wages and prices ratchet downward, but this is only a symptom.

Another way to look at price is not the value of goods, but the relative scarcity of money. The people unable to buy a house, get a mortgage, or put food on the table, are living in a deflationary world – they’re broke. The Fed doesn’t help by driving prices up all around them.

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Chinese Price Hike

Analysts are reading a lot into the PBOC’s recent reduction of its prime lending rate. Gordon Chang, for instance, sees desperation. Chang says lower rates are a reaction to slower growth, and also – in aiding state owned enterprises – a setback for reform.   Jeremiah takes a longer view, looking at growth trends and currency values among China’s trading partners.

Long term, China needs to rebalance its economy more toward domestic consumption. This will stabilize Chinese society by sharing the proceeds of economic success more broadly. It will also give Chinese producers a new market, free of export costs and currency risk.

The obvious way to do this is to allow the Yuan to appreciate, at a measured pace, exactly as China’s trading partners have requested. This will allow America to rebalance more toward production – although we will first have to end our obsession with consumerism. Here is a chart of the Yuan’s ongoing rise versus the dollar.

CNYUSD

In the shorter term, however, the Yuan is in the crossfire of a currency war. Try running that chart for the Euro, or the Yen. You may be sure the Yuan will continue to appreciate, but it may be in the relative sense of “less aggressively debauched.”

So, the PBOC cuts rates to keep up (down) with the neighbors. They are also liberalizing rates, allowing them to rise for ordinary savers. This stands in contrast to Europe’s lunatic policy of charging people to keep money in the bank. Lost in the news over China’s lending rate, is this rise in the deposit rate.

As Shaun Rein writes in The End of Cheap China, the impact of China’s rebalancing will be sharply inflationary for America. Not only will we not have cheap goods coming over here, but we will have to bid against a growing Chinese consumer class.

Jeremiah sees a nice symmetry here. In the 1970s, when America was struggling with inflation, we began importing cheap goods from Asia. Now, we will import inflation, which is just what the Keynesian doctors have ordered. Be careful what you wish for.

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QE Apologia

Now that the Fed has ended QE3, people are starting to evaluate the results. The economist has a roundup of academic studies. Positive findings about QE are generally the “could have been worse” variety. The various studies claim:

  • QE generated some inflation, but not enough
  • It did not generate hyperinflation
  • It did not contribute (much) to inequality
  • The “reach for yield” was justified

The quotation below pretty much sums up Jeremiah’s opinion. We cited hyperinflation as a risk, early on, but the real concern is trillions of new dollars sloshing around equity markets and not creating jobs. Applying the coefficient from a British study, the Fed’s $4 trillion intervention should have generated a roughly 6% gain in output. It didn’t.

QE’s detractors point out that central banks have expanded their balance-sheets by trillions of dollars, yet are still nurturing lackluster recoveries.

The results on inequality and low yields are equivocal at best. People holding financial assets have enjoyed 150% gains, thanks to QE (see chart). But, say the apologists, low yields have also helped people pay their debts. The reach for yield, which has pension funds investing in junk bonds, is justified if it prevents a “catastrophic” breakup of the Euro.

SPX

Overall, the collection of studies provides weak justification for such an extreme policy. The Fed has expanded its balance sheet fivefold, and the academics need a microscope to find the upside – plus, a raft of counterfactuals about how terrible sound money would have been.

We find The Economist’s title, “Early Retirement,” especially cynical. In the real world, our kids can’t find jobs, and the grandparents cannot retire. They will work until they die, because QE destroyed their savings.

See also: Of Flat Lines and Derp

Update: Here is a nice, impartial summary of the arguments for and against QE, with the current status. It is too basic for Jeremiah readers, but something to share with the kids. One editorial point – the author says “three problems,” and then lists four. The fifth would be that people with saving accounts are now enemies of the public good. German “strafzins” is best translated as penalty rate.

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Save Our Crude

Saudi Arabia has recently cut the price of crude oil exports to America, while holding the line in Asia. Oil experts are analyzing the latest price schedule relative to the price of domestic oil from fracking. Depending on your perspective, this is either simple capitalism, an attack on our oil industry, or proof that fracking is evil.

OilIt would make sense for the Saudis to undercut American producers, in a bid to put some of them out of business, while supporting their revenues with shipments elsewhere. Whether this is an “attack” or simply meeting the market price depends on the cost of production for each well. Below $85 a barrel, many producers will be shaken out.

Abdalla El-Badri, secretary-general of Opec, said he expected a reduction in higher cost oil production such as US shale if Brent remained around $85 a barrel.

Readers may be forgiven for assuming that there is a single, world price for oil. Opponents of fracking argue that American oil will flow to the world market, diluting the advantage of domestic production. In fact, American oil producers are not allowed to export. It’s a form of protectionism.

Jeremiah is generally against protectionism, but on a case-by-case basis (see On Protectionism). You have to look at who is being protected. In the case of prescription drugs, for example, trade restrictions benefit pharmaceutical companies at the expense of consumers and taxpayers.

In this case, American oil producers are harmed because they cannot sell in higher priced markets. The benefits accrue to American consumers, in the form of lower factor prices – and cheaper gas at the pump. That seems like a good deal, but it makes us vulnerable to dumping by the big, global producers.

Jeremiah would place this one in the “shortsighted” category and call for liberalization, except for one thing – the curse of oil. Ours is not meant to be an extractive economy.   Those countries have some nasty tendencies, which ours has lately come to emulate. The last thing America needs is an economy that resembles Venezuela.

See also: The Case for Allowing U.S. Crude Oil Exports

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Le Cliché de Proust

ClicheJeremiah hates literary references. We read recently about a zoologist studying tigers, “in the forests of the night.” No kidding. This was in Intelligent Life, the aspirational magazine for rich people who want to be smart.

The stilted reference to Blake reads like someone who has reached intermediate proficiency in French, and is suddenly full of je ne sais quoi – or the sophomore philosopher who knows a little of existentialism and not much about existence.

A liberal education should supply material for a career of original thinking, not ornaments for the banal.

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Of Flat Lines and Derp

Paul Krugman is here again with his favorite straw man argument. Krugman is smart and everyone else is stupid because QE has not resulted in hyperinflation. He doesn’t say “stupid,” though. He says “derp,” which means “I have statistics which seem to support my prejudices and you don’t.”

InflationApparently, hyperinflation is the only negative outcome recognized by the good doctor. He presents a lovely FRED chart proving his point. CPI has been flattish for six years, while money supply has grown. Can you think of any negative outcomes, other than inflation? Here is one hint, from FT, and another from Jeremiah. The quote below is from an ECB study.

An increase in the monetary base tends to … benefit primarily those on higher incomes, who hold a larger amount of overall savings in equities, and thus benefit from greater capital income.

Krugman’s chart shows only that his prescribed policy has avoided one particular negative outcome. It does not prove that the policy has actually worked, nor does it address the many other negative outcomes. Krugman’s acolytes are nonetheless hailing this one chart as the decisive defense of QE.

So, has the policy achieved its stated goal of increasing employment? Let’s look at another FRED chart. It looks a lot like the CPI chart, doesn’t it? Based only on these two variables, you would conclude that QE has had no effect at all.

EmploymentAt this point, we are obliged to point out that both these charts are bunk because the fivefold increase in money supply is obscuring smaller changes in the dependent variables. Accordingly, we drop it and display only employment and inflation. We already know what the history of QE has been over the period, and now we can see that inflation has indeed risen while employment has remained flat.

Both

Finally, we observe that Krugman, a college professor and an economist of some note, is here coining a childish new term of abuse for his opponents – while engaging in exactly the sort of factless advocacy he presumes to criticize.

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Fixing the Euro

Everybody knows what’s wrong with Euro. It’s not even worth posting a link. Okay, here’s one link to FT. Everybody knows what’s wrong with the Euro, and how to fix it. The problem is that the fix is totally unrealistic. Here, we look outside the box for a different solution.

The problem with the Euro is that a common monetary policy does not suit all participants. France could use looser money as stimulus and to monetize some debt. Germany and the northern countries have much less debt and lower bond yields. They don’t need their currency devalued.

Common monetary policy only works if the participants have similar fiscal policy. This is why the Maastricht treaty set limits (which were ignored) on national debt and deficits. France is a deficit country, with debt at 94% of GDP. Germany, at 78%, is a fiscal discipline country.

The popular solution is “ever closer union,” which means taking fiscal policy away from the nation states, with the European Parliament setting the budget for all. There would even be a Europe tax, levied over the heads of national governments, to pay interest on Euro bonds.

This is a swell idea, if you’re the kind of person who prefers giant federal governments to quaint national ones. Unfortunately, about 500 million people suspect an undemocratic plot to disenfranchise them and abridge their national identity.

Furthermore, everyone knew in 1992 that the Euro would not hold together unless the nation states surrendered to European fiscal authority. One could even say that the common currency was a Trojan horse for “ever closer union,” lying in wait for a crisis like 2008.

I am sure the euro will oblige us to introduce a new set of economic policy instruments. It is politically impossible to propose that now. But some day there will be a crisis and new instruments will be created – Romano Prodi

So, we wondered why the revolutionary governments of Virginia, Georgia, et al., would surrender their monetary independence to the new federal government of the United States in 1787. Surely, the democratic impulse was at least as strong in early America as in modern Europe.

Indeed, the currency trap has operated in America exactly as it is operating in Europe, with the states subordinated to federal policy. It took almost two hundred years, though, for monetary policy to be invented.

This brings us to our iconoclastic solution for the Euro. Peg it to gold, or – since gold is a barbarous relic – palladium. Instead of a Euro budget to mesh with monetary policy, take the power entirely out of federal hands. Think of the management effort that would be saved.

No one could whine about fiscal discipline dictated by Germany. Once the peg were set, discipline would come from the bond market. National leaders would have full responsibility for their own budgets, and no excuses.

See also: Why EU superstate conspiracy theories are nonsense

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