Inflation Targeting Formally Begins in the U.S.

The Federal Reserve just announced its first formal inflation target.  They set a target of 2% interest as a long term target for inflation.  This is in step with Bernanke's academic work on monetary policy and with the recent Fed moves towards transparency and their attempts to create expectations rather than simply respond to them.  Many central banks have already practiced this for some time.

Brief Case Study: Sweden

Sweden Consumer Price Index

Sweden has been targeting inflation since recovering from a currency crisis in 1993.  This gives us a long period of time to examine inflation targeting's effectiveness.  The first graph (above) shows the monthly inflation rate of Sweden since their online data begins in 1980.  Their maximum inflation rate during the period has been 5.2%, and the minimum -1.9% with the average being 1.56%.  The standard deviation has been 1.42%, but while it has had a lot of variation, it has been pretty centered around 1.5% as shown by the histogram below.

The histogram shows the number of times that Sweden has hit a given percentage of inflation since they introduced inflation targeting in 1993.  I added a box from 1% to 3%, with a line down the middle at 2% showing the target and the acceptable range.  This shows that Sweden has been conservative in their approach to their intention, which has been a static 2% inflation target ±1%.  It looks more like that they've targeted 0-3% inflation rather than 1-3%, which ended up with a median 1.5%.  This policy has been largely successful in creating relatively stable growth for their economy, as shown in the graph below which begins in 1993.

Target Too Low?

Almost immediately after releasing the target, it was criticized.  This is probably to be expected, but not in the way that I expected it to be.  One of the first critics of the policy was Paul Krugman, who argued that 2% is too low.  Two percent is a pretty standard number in inflation targeting central bank circles.  It would be more shocking if they chose to formally inflation target and didn't choose 2%.

Olivier Blanchard was an early major economist to write of raising the inflation target in his paper (along with Giovanni Dell'Ariccia and Paolo Mauro) "Rethinking Macroeconomic Policy" which considered more than monetary policy, but also fiscal and tax policies as well.  Blanchard mainly asks if there would be substantially higher costs and benefits to targeting 4% compared to 2% inflation.

Stephanie Schmitt-Grohe and Martin Uribe wrote an interesting paper in 2010 titled, "The Optimal Rate of Inflation" where they attempt to formalize some aspects of the debate on inflation targeting.  "For a realistic model of the monetary transmission mechanism must incorporate both major sources of monetary nonneutrality, price stickiness and a transactional demand for fiat money. Indeed, in such a model the optimal rate of inflation falls in between the one called for by the money demand friction—deflation at the real rate of interest—and the one called for by the sticky price friction—zero inflation. The intuition behind this result is straightforward. The benevolent government faces a tradeoff between minimizing price adjustment costs and minimizing the opportunity cost of holding money. Quantitative analysis of this tradeoff, however, suggests that under plausible model parameterizations, this tradeoff is resolved in favor of price stability."

They bring up an incredible amount of ideas that I hadn't considered.  They examine ways in which the Friedman rule, or the optimal monetary policy that focuses on zero opportunity cost to holding money,  could break down.  All three of these ways are related to taxation, whose relation to monetary policy I had not considered.

While I'm not sure if I agree with them, all of these are important concepts to consider, especially when current monetary policy is constrained by the Zero Lower Bound due to our current liquidity trap.  Formally announcing a target seems to be a way of creating expectations both for better and for worse.  The better is that it signals to the market that the central bank is taking steps to create inflation, and the market can often help by making the claim a self-fulfilling prophecy.  Similarly for worse, inflation hawks can be cooled by the setting of a reasonable level of inflation target.

The latter of the two is important as the Federal Reserve will eventually have to perform a tricky dismount of these current monetary policies.  They have undoubtedly increased the monetary base in shocking amounts.  Much of this has been done with relatively normal operations using Treasury security repo's, but much of it has been done with alternative monetary policies.  This has been done to combat liquidity trap conditions, but as those conditions ease, longer term inflation problems will start.  The Fed has a large amount of sub-prime mortgages and it is unclear whether, even now, that there is a market for those assets.  The point being that many of the assets that the Fed purchased might not be incredibly easy to sell.

John B. Taylor has talked about crisis policies of the Fed being unprecedented and that there is a need for a clear exit strategy.  This is due to the fact that if or when inflation does creep above the target, all of the old devilish aspects of relatively high inflation will creep back into society.  The chief of those being: increases in the cost of capital to the user.  I recently wrote an article in praise of Chairman Bernanke, and I stand by that post, but to be clear... the most tricky part for Bernanke's Fed is still to come.

References:

Blanchard, Olivier and Giovanni Dell'Ariccia and Paolo Mauro.  "Rethinking Macroeconomic Policy."  Washington DC: IMF.  2010. 

     Working Paper.

Cohen, Darrel, Kevin Hassett, and R. Glenn Hubbard.  ED: Martin Feldstein.  The Costs and Benefits of Price Stability.  "Inflation

     and the User Cost of Capital: Does Inflation Still Matter?"  Chicago: University of Chicago Press.  NBER Conference Report. 

     1999.  Print.

Krugman, Paul.  "Two Percent is Not Enough."  The New York Times.  New York: New York Times Publishing.  1/26/12.  Web. 

      http://krugman.blogs.nytimes.com/2012/01/26/two-percent-is-not-enough/

McCallum, Bennett.  "Should Central Banks Raise Their Inflation Targets?  Some Relevant Issues."  Economic Quarterly. 

     Richmond: Federal Reserve Bank of Richmond.  Vol. 97, No. 2.  2011.  Journal.

Schmitt-Grohe, Stephanie and Martin Uribe.  "The Optimal Rate of Inflation."  2010.  Working Paper.

Taylor, John B.  ED: John B. Taylor.  The Road Ahead for the Fed.  "The Need for a Clear and Credible Exit Strategy."  Stanford:

     Hoover Institution Press.  2009.  Print.

Federal Open Market Committee.  "Press Release."  Washington DC: Federal Reserve System.  1/25/12.  Web. 

     http://www.federalreserve.gov/newsevents/press/monetary/20120125c.htm

What to do When You're in a Liquidity Trap?

These are trying times in macroeconomy.  There have been several ways of dealing with severe drops in output.  The first is to lower interest rates, which creates the potential for a liquidity trap after they're lowered to zero.  At that point, we enter the liquidity trap and our knowledge of monetary economics becomes wholly incomplete.  There have been several ways that have been proposed to deal with this problem, and all of them deserve review.

A liquidity trap is defined specifically as the point when bonds and cash become perfect substitutes and traditional monetary policy is no longer effective.  The metaphor that economists use for this situation is that central bankers are "pushing on a string."  These are the situations that cause catastrophic recessions.



 The chart above shows the liquidity trap situation in an IS-LM chart.  Important things to note are that at the point of equilibrium, the LM's slope is flat (indicating the issues surrounding the lower boundary) and equilibrium is to the left of 'full employment' level GDP.

The liquidity trap is a phenomenon of monetary policy.  While the liquidity trap is a somewhat rare situation, it has become a major problem in the past few years for several major economies including the United States.  There has been quite a bit written about this phenomenom in the past ten years starting with essays confronting Japan's economic malaise.

Japan was one of the countries that people described as an 'economic miracle' much like Germany in the same era or China and India in the 2000's.  In the early 1990's, they began having a prolonged economic downturn that never returned to robust growth (yet).  The chart above includes Japan's annual growth rate.  It mostly describes growth around 0-1% with several downturns in 1994, 1998, 2002, and a particularly severe one in 2009.

This chart shows the base borrowing rate that the Bank of Japan uses to affect the economy.  It has been very low for a very long time.  During 2002 and 2009, we can observe liquidity trap, or near liquidity trap conditions.  In 2001, the Bank of Japan pursued a novel alternative monetary policy called Quantitative Easing."  The purpose of this program was to quickly inject more money into the economy under the zero limit boundary conditions.  Current Governor of the Bank of Japan, Masaaki Shirakawa writes about the experience in a working paper, "One Year Under Quantitative Easing."  Some issues that he brings up in the paper are that hoisting up asset prices becomes an act of fiscal policy rather than monetary policy, and that this lends itself to the debate on whether fiscal policy is helpful at all in stimulating an economy.

In the 2008 financial crisis and 2009 global recession, many countries were confronted with a similar situation.  Pronounced contractions while central bank interest rates are already low.  Many countries quickly found themselves in liquidity trap situations.  The ways that they addressed these issues varied.  Lars Svennson was deputy governor of the Riksbank in Sweden, and had already written extensively on such a scenario.  He was most famous for being a proponent of inflation targeting, but also for "The Zero Bound in an Open Economy: A Foolproof Way of Escaping from a Liquidity Trap."

Svennson advocated announcing upward sloping short term price levels coupled with small long term inflation targets.  Then announcing that the currency would be devalued and that the exchange rate would be pegged.  The Central Bank would make a commitment to buy and sell as much currency as they need to maintain the peg.  Once that short term price level target is reached, then the peg is abandoned.

When Sweden found itself in a liquidity trap, Svennson did something that most monetary economists said was impossible.  The Sveriges Riksbank became the first central bank to announce negative interest rates.

There have not been any academic papers about the Swedish experience yet, but it can be said that Sweden had the most growth (nearing 8% one quarter) of any European country coming out of the recession in 2010.  At first glance, it is was successful policy.

The chart above shows that the United States has had several episodes of near zero interest rates.  During the "Great Depression" of the 1930's, interest rates were very low.  These were also the times that John Maynard Keynes originally advocated for activist monetary policies, and even fiscal policies when those were ineffective.  He did not use the term liquidity trap, but The General Theory of Employment, Interest, and Money is basically written from that perspective.

In 1961, the Federal Reserve adopted "Operation Twist" during a period of low interest rates (not zero), as an alternative monetary policy to stimulate the economy.  Now, we have been confronted with near zero interest rates since 2009.  The general economy has recovered to modest growth, but unemployment has remained high due to structural changes in our economy.

This high rate of unemployment has led to a general sentiment that even though we are technically not in a recession, it still feels like recession-like conditions.  It harks back to the old expression that a recession is when your neighbor loses his job and a depression is when you lose yours.  Jobs play a critical part in any economy, and the current jobless recovery has left many Americans dissatisfied with economic policymakers' results.  Above shows that drastic uptick in unemployment, accompanied with relative price stability.  It shows that we did have a period of pronounced deflation despite the fact that the Federal Reserve cut rates, and pursued several rounds of Quantitative Easing.  The United States also engaged in fiscal stimulus.

 CONCLUSION

We still do not have a great idea of how to tackle the liquidity trap.  The typical policies of fiscal stimulus, and alternative monetary policies have (for the most part) been lackluster.  The liquidity trap is one of the most difficult and vexing situations in economics and deserves much more study.  Another issue that confronts policy makers is a large part of economics blames monetary policy for the problem in the first place and are wholly dissatisfied with the remedies.  One fact that they point to is the enormous growth in the monetary base and central bank assets.  They point to this as a sign of coming hyperinflation.  This makes it difficult for policy makers to pursuade the public that the inflation that they are pursuing is managable and desirable, rather than a prelude to hyperinflation.  There is also the problem of the lower boundary.  Bennett McCallum predicts that this might not be zero, but it likely still does exist, so there are still issues there even if it is not quite zero.

It is very possible that Europe may be facing this situation very soon, and perhaps other countries such as the United States would follow in that case.  For that reason, this will remain a critical issue to study in 2012.


REFERENCES:

Krugman, Paul.  "IS-LMentary"  The New York Times.  10-9-11.  Web.

Krugman, Paul, Kenneth Rogoff, and Kathryn Dominquez.  "It's Baaack: Japan's Slump and the return of the Liquidity Trap." 
     Washington DC: Brookings Papers on Economic Activity.  Vol. ? No. 2.  1998.  Journal.
McCallum, Bennett.  "Theoretical Analysis Regarding a Zero Lower Bound on Nominal Interest Rates."  Boston: NBER.  2000. 
     Working Paper.
Shirakawa, Masaaki.  "One Year Under 'Quantitative Easing'."  Tokyo: Bank of Japan.  No. E3.  2002.  Working Paper.
Svennson, Lars E.  "Escaping from a Liquidity Trap and Deflation: The Foolproof Way and Others."  The Journal of Economic
     Perspectives.  Vol. 17, No. 4.  Journal.
The Federal Reserve System Purposes and Functions.  Washington D.C.: Board of Governors of the Federal Reserve.  2002. 
     Print.


This article is based on a presentation by Joseph Ward, Hares Fakoor, and Olivia Gonzalez for an intermediate macroeconomics course.

Another Way to Cut Taxes

In the current economic climate, policy makers have dual fears of raising taxes, and cutting government spending for fear of corresponding changes in GDP.  At the same time, policy makers are concerned about large and growing national debt totals.  Clearly, both all of these are important priorities and somewhat in conflict with one another.  This is where reducing regulatory taxes can provide an important third way to promote growth even as the federal government begins reconciling deficits.

Philip Howard of Common Good recently wrote a terrific op-ed in the Wall Street Journal.  “How to Overhaul Regulation” is a very interesting take on what substantive regulatory reform could look like.  He identifies the key underlying problems inherent within most modern American regulations: their complexity and their universality.  Regulation overhauls should be seen as an incredible opportunity for the federal government to effectively offer businesses tax breaks without affecting government income.  Government income would likely increase due to increased efficiency and corresponding general reductions in price levels.

Regulations, at their best, help solve market problems.  These problems might ensure that producers are not damaging shared resources, or if they are that they are, these damages do not become externalities.  That is, that the producer is the one who pays for damages, and prices those damages into their products for consumers to ultimately pay.

All regulations add costs for firms.  The first cost is that of information.  Understanding a regulation’s impact on an individual firm must be borne out before substantial investments are made.  When information costs are high (as they are when regulations become complex), they become a substantial burden on firms.  Large firms are able to employ economies of scale to minimize these costs, but small firms are not.  This is why small firms are dramatically more impacted by this feature.  Howard’s idea of regulating small firms differently is an important idea.  Laws are meant to be evenly applied throughout society, but when regulations that come from those laws are universally used, they affect firms disproportionately.  Then they become unfair to small firms.

Heavily regulated industries can become dominated by large firms as smaller competitors drop out.  These regulations act as barriers to entry which reduces competition and causes consumers to be harmed twice by this regulation.  First the consumer is harmed by the regulatory costs, which are ultimately passed on to the consumer.  Then the consumer is harmed by decreased competition and potential monopolistic market conditions.

As Howard describes, “Regulators try to imagine every possible mistake and then dictate a solution.  The complexity is astounding.”  Regulations should be observed from an information economics perspective.  One way that the federal government could help American firms is by estimating how much time it would take a lawyer or an ordinary business person to read and implement a regulation.  Departments could issue guidelines about what an appropriate range of time for agencies to target, as these should be considered costs for the businesses and as they pass these costs on, consumers.  The reduction in information costs could be seen as a very real tax cut for American businesses and therefore consumers.  Regulations have often been seen in economics as taxes because they incur costs and are compulsory. (Posner)

The Obama administration has made regulatory changes including simplifications, especially through the Office of Information and Regulatory Affairs.  President Obama has made this a priority through Executive Order “Improving Regulations and Regulatory Review.”  This is an important mandate by the President at a time when American market flexibility is needed to meet increasing strong competition from global trade. 

The order stresses that agencies "facilitate the periodic review of existing significant regulations, agencies shall consider how best to promote retrospective analysis of rules that may be outmoded, ineffective, insufficient, or excessively burdensome, and to modify, streamline, expand, or repeal them in accordance with what has been learned." 

As stated earlier, regulations are useful to correct market failures or behaviors in which completely free markets produce inefficient results.  Many or most regulations are also more complex than they need be to resolve these inefficient results.  Many regulations also inject rules that do not solve market inefficiency, but rather add to it (perhaps where it didn't exist in the first place).  As President Obama pointed out in his executive order, analysing which regulations promote market efficiency, and which aspects merely add to the billable hours of compliance lawyers should be a regular activity in the federal government.

Regulatory tax cuts could be used in concert with either real tax increases or reductions in government services to moderate their impacts on GDP.  The purpose of this would be to attempt deficit reconciliation during a weak economy.  Hopefully 2011 will be a year of regulatory tax cuts for American firms that could become more efficient and therefore more competitive.

References

Dudley, Susan.  "Prospects for Regulatory Reform in 2011."  Washington D.C.: George Washington University. 
            April 5, 2011.  Working Paper.
Howard, Philip K.  “Starting Over With Regulation.”  The Wall Street Journal.  New York: Dow Jones &

Co.  3. December 2011.  Newspaper.

Posner, Richard.  “Taxation by Regulation,”  The Bell Journal of Economics and Management Science.

Santa Monica: The Rand Corporation.  Vol. 2, No. 1.  Spring 1971.  Journal.

Exec. Order No. 13563.  (January 18, 2011)

A Laissez-Faire Market for Lemons

I haven't written about the Occupy Wall Street movement, mostly because I've found the movement somewhat confusing.  I wonder if all protests have at least a somewhat fractured feel to them, and even if this protest had an especially fractured one, it is probably an impossible standard to ask them to have a consensus, coherent position.  I can remember protesting the Iraq war in 2002, and disagreeing with almost as many signs as I agreed with, but there I was.  In the video below, Keith Olbermann gives a statement that is something of a list of injustices.  It's a spaghetti soup of wrongs that is all over the place politically.

This article moves over several important topics, but doesn't do as good of a job of blending them.  Clearly, I am not even as good as I would like the protesters to be in providing a clear and concise message.  Perhaps our problems are so complicated right now that clarity and brevity and not even possible.  The photos (somewhat) divide the topics.  The first one is our need for a greater degree of income inequality, and the second is a greater balance of transaction information in financial markets.

Dr. Nouriel Roubini recently wrote a very good article for Project Syndicate that is somewhat in step with an earlier article that I wrote on the Arab Spring and London riots.  Naturally, Dr. Roubini's article is much better written and more comprehensive than mine, but I was so worried about my own writings being too much of a pollyanna take on economics, that I almost didn't publish it.

To be earnest and honest, I think inequality is a difficult thing for economists to write about because inequalities are an inherent part of any market.  Any transaction ever happens because both parties have different valuations of each others goods.  When I buy tennis shoes, I'm judging those shoes to be more valuable to me than the $50 that I paid to get them.  On the same transaction, the person selling me those shoes values the $50 more than those same shoes.  Most economists aren't even particularly interested in ensuring equality in terms of income or wealth.  They would probably demand lawfulness, and argue that laws should attempt to ensure fair markets, but that all market participants have varying degrees of imperfect information all the time.  I've heard it said (I think in class) that markets were, in some ways, aggregates of imperfect information that led to the total (not perfect) amount of information.



(photo: Paul Stein)

Right now the Occupy Wall Street movement is continuing this Arab Spring.  The reasons for their protests are mostly but not completely different than the original Arab Spring in Tunisia and Egypt.  In Tunisia and Egypt, as in many other places in the world, long term dictators have ruled using power bases that bred inequality under corrupt shams of capitalism.  What Dr. Roubini argues is that Occupy Wall Street is not so different because all of these protests basically come from economic inequality.  He even goes so far as to call lobbying a form of legalized corruption.  This has to be considered a controversial statement, but perhaps it is not so far fetched.


He states that just as the European welfare state model has fallen on its face, the Anglo-Saxon laissez-faire model has fallen as well.  He concludes, "Any economic model that does not properly address inequality will eventually face a crisis of legitimacy.  Unless the relative economic roles of the market and the state are rebalanced, the protests of 2011 will become more severe, with social and political instability eventually harming long-term economic growth and welfare."

He said succinctly what I was trying to get at in August:

"Surely the American stimulus must be paid for, and it likely will not be worth it from a cost-benefit point of view.  What if these programs fail a cost-benefit analysis, but they maintain intangible, unobservable factors such as what is often called the "fabric of society"?  Nobody can really tell which factor exactly keeps the façade of civilization apparent to all of its citizens (or fabric of society), but surely that has a real benefit as well.

So what do these protests, riots, and demonstrations have in common?  Frustration with economic conditions is widely observed to be a contributing factor to all of these protests, demonstrations, and riots.  If we are to keep this "fabric of society" woven, we must have some degree of economic success.  Moreover, that success must be widespread throughout society.  As economists, we must address economic growth and equality in a way that is not a handout or a burden on future generations.  We must be serious about education both on a national and individual level, as skills disparity have been shown to be a main contributor to economic inequality.  If we are to institute programs of austerity, we must study to find a better way of promoting, establishing, and easing into them.  They will never be pain free, but simply making wholesale cuts is not the best answer either."

His version is not the same, rather it is much more audacious.  I'm not trying to say that I don't support a more laissez-faire or free market capitalism, but within our models of markets economists assume perfect information.  We also know that this is merely an assumption for the purposes of modelling, and that perfect information does not exist in real life markets.  I would assert that our real life markets need both parties to have more balanced amounts of information and to ensure that there is a bedrock amount of information for a transaction to be considered fair.

We will still (naturally) have different valuations, but both parties must be able to agree on what the exchange actually is.  When that threshold is not met, fraud can and will rule the day.  At the same time, we must not reduce individual responsibility to understand the exchange.  For example, if one party purchases derivative tranches that are AAA rated simply because of their AAA rating, that party cannot cry foul when the rating proves faulty.  Ratings agencies are good sources of information, but they cannot replace the purchasers responsibility to understand what they are purchasing because they are surely not purchasing a rating, but rather the asset.

(photo: Xeni Jardin)

The general public has probably trusted ratings too much, and misunderstood the financial services industry.  In the past, it has generally been thought that our brokers had our interests in mind because we were constant customers and often their profits were actually percentages of ours.  When a financial services firm creates a financial "product", that role can change somewhat or totally depending on the size of the transaction towards a more adversarial role.  The market for financial products can become something of a market for lemons, where asymmetrical information rules the day.

In the past decade financial markets have often become the worst type of market for lemons... one where the purchaser does not realise that it is one.  In some cases, these transactions have been outright fraud, in other cases they have been (merely) deeply unethical.  Either way, they have led to market instability, which has had enormous negative effects on our economy.

The sign in the last photo is referring a real life transaction.  The Goldman Sach's "Abacus" deal that the SEC investigated and recently settled for a record setting $550 million.  The SEC has been investigating and issuing fines on many major banks and investment houses like this for becoming a market for lemons.  The question is will these actions restore public trust?  Perhaps the better question is... did public trust in these large banks ever leave?

In George Akerlof's amazing article "The Market for "Lemons": Quality Uncertainty and the Market Mechanism," (gated) he relates the common experience of used car shopping to the academic terms of quality, uncertainty, and asymmetric information.  In markets where there is asymmetric information and the value of the product is high (used cars, financial products) purchasers often confront the problem of identifying quality, but they are often met with problems of selection bias.  This happens because of a variation of Gresham's law where good automobiles or financial products are crowded out or priced out by lemons.  The result is an increase in market uncertainty which actually reduces the number of transactions and drives prices lower than they would be naturally.

This behavior actually happened when the derivatives market became what was called by pundits "toxic" and the Federal Reserve purchased assets that had practically no market value after the market for lemons effect took over to such an extreme degree.  These markets for lemons ultimately led to the financial crisis of 2008 and their eventual bailouts.

The woman in the final picture that is carrying the sign with the words, "It is wrong... " (written by The Atlantic's Conor Friedersdorf) is correct in a moral sense.  It most certainly is wrong, but continuing to ensure that this is also wrong in a legal sense is important as well.  The alternative is allowing laissez-faire capitalism to (often) become a market for lemons.  Then we will experience bad financial products driving out good ones, which will have negative effect on investment.  This is an appropriate and necessary role for government to ensure a basic foundation of information for both parties in a transaction.

Inequality is a trickier and longer term problem that probably stems from productivity inequalities more than anything else.  Widespread education that leads to productive skills is likely the only way to fix inequality issues in a long term sense.



Kenny Burrell - "Autumn in New York"

Washington's Frustration with China

Recently, the United States Senate passed the Currency Exchange Rate Oversight Reform Act of 2011.  This act follows allegations by the International Monetary Fund that China is still significantly undervaluing the Renminbi.

The Act states that the Treasury Department will monitor exchange rates between the U.S. and its major trading partners and report to Congress about it twice a year.  It also amends the Tariff Act of 1930 in regards to anti-dumping to establish export prices if a currency is considered fundamentally misaligned.  President Obama has not taken a public position on the legislation, and the House of Representatives' leadership have spoken out against it, so the legislation is unlikely to become law.  Indeed, some might say that a government that devalues its currency as much as the United States does passing legislation against another country that pegs its currency (in part) to the former's currency is a bit like the pot calling the kettle black.

A black pot and a black kettle (photo: Mark Corbin)

Most countries around the world engage in currency manipulation to varying degrees.  Almost all countries have fiat currencies, these are currencies that are controlled by central banks rather than being valued based on a commodity as was common in past times.  The Federal Reserve is an example of a central bank that has sought to weaken its currency in the past couple years.  Some countries that do not have reliable or credible governments or central banks use a system of fixed exchange rates.  China has had a system that tied their currency directly to the dollar.


(source: IMF)

The issue has quite a bit to do with the relative ascendancy of the Chinese economy to the rest of the world.  China has had significant growth in a time when the United States has struggled to maintain positive growth.  Much of their growth has been based on exports which have been helped by their currency's low and steady value.  The Peterson Institute for International Economics has released a working paper that China and Singapore have undervalued currencies, while the United States has an overvalued currency in terms of trade weight.



Shanghai (photo by ふみこ)



These allegations suggest that China has allowed its currency to depreciate, which has not been the case.  China's Renminbi has actually slightly appreciated relative to the dollar, and it has begun to have (slight) fluctuations because of the Renminbi's pegging to a basket of currencies rather than simply to the dollar.  As you can see in the chart below, these appreciations and fluctuations have been minor compared to the 8-14% annual growth that the Chinese economy has had overall.

A lot of this strain is caused by China's policy of continuing to peg its currency rather than let it float with the strength of its economy's.  It is often a positive thing for all countries involved when a developing or unstable country or currency pegs itself to a stronger currency.  It is another thing altogether for a relatively strong economy to do this.  A strong country pegging a currency can cause distortions throughout the international economy.  China is strong enough to stand on its own, and its currency is as well.  They should stop pegging their currency altogether and become an leader within the international economic community.

ED: Here is the People's Bank of China's response:

The xx - "VCR"

Trying to Have It Both Ways

The Federal Open Market Committee announced that it would do the twist.  In particular, they announced that they would sell $400,000,000,000 in short term (30 days to three years) U.S. treasury securities, and purchase the same amount of long term (6-30 years) U.S. treasury securities by next June.  This is meant to influence long term interest rates, as to stimulate investment in things such as mortgages.

What was very telling for me is that they left the federal funds rate target at 0-.25%.  The Federal Reserve performs open market operations to keep that rate at its target usually by entering into repurchase agreements on short term treasuries (usually 30 days) because that is what they consider to be the best way to remain flexibly sensitive to target fluctuations.  If they decide that the monetary base is likely to depreciate for a substantial amount of time, then they purchase bonds outright.  They've already been flat out buying bonds, and now they're buying longer term bonds, because they believe that they will need to keep the monetary base larger for a long period of time.


The Eccles Building (photo: Margit Myers)

The problem with 'the twist' is that long term treasury securities don't directly compete with federal funds.  They are different loans that attract buyers for different purposes.  So while these actions may directly increase the monetary base in the same way that the Fed is used to, they may have less of an impact on the federal funds target rate.  Essentially, the Fed is trying to have it both ways and influence both short and long term interest rates.  If the target rate changes because of all of this selling, what will the Fed do?  The Fed will likely buy more short term securities to put downward pressure on the Federal Funds target rate.

So while the Fed says that they are buying long term securities, and I certainly believe that they will buy 400 billion dollars worth.  I am not so sure that they will sell all of the 400 billion if those actions influence the Federal Funds rate to rise above the target.

I think all of the fanfare surrounding this 'twist' is actually a smoke screen to try and please two different constituencies.  On the one hand, they want to the markets to believe that they are performing stimulative measures, and on the other hand they want those wary of inflation to believe that they are not really performing stimulative measures.  Again, they are trying to have it both ways.

Another byproduct of these actions is that the Fed has made the job of quickly shrinking the monetary base a bit harder.  This will already be a difficult job if inflation ever gets out of hand.  Much of the assets that they've bought are those so-called toxic mortgage backed securities that will be very difficult to unload off of their balance sheet, and now they are loading up on longer term assets.  These treasuries will probably not be hard to sell to the market, but they won't be quite as easy as just letting them expire.  Of course, one also wonders how much the Fed needs to buy treasuries or how much the Treasury department needs the Fed to buy treasuries.

The Fiery Furnaces - "Benton Harbor Blues"

30% of Employers Likely to Drop Insurance After 2014

Before the Patient Protection and Affordable Care Act was signed into law by President Barack Obama, the Congressional Budget Office estimated that 7% of employers would stop offering health insurance to their employees.  A new survey by the consulting group McKinsey found a starkly different answer.

Photo: Jacob Windham

 
January 1st 2014 is when the majority of the act goes into effect.  The act expands Medicaid eligibility to 133% of the poverty line and subsidizes health insurance to 400% of the poverty line.  Tax credits are given to small businesses under 25 employees, and $2,000 penalties (per employee) are given to businesses over 50 employees for not insuring their workers.  Health insurance exchanges and other changes are introduced at that time as well.

McKinsey found that 30% of employers were likely to stop offering health insurance as part of their compensation package for their workers.  Among employers that had a high awareness of the reform, that number jumped to 50%.  McKinsey also surveyed employees to find that 85% of employees would stay at their job even if they lost their health insurance, although 60% of them expected increased compensation.  They also found that 30% of employers would gain economically if they eliminated their insurance even if they increased wages the same amount.

The gaming of Obamacare has not even begun yet, but it seems clear from this study that it will lead to a period of profound transformation.  Employer expectations of imminent change coupled with the likelihood of increased worker turnover and overall employment market volatility make it possible that employers have had an increased and increasing reluctance to hire until the rules take effect in 2014.  If this is true, it is not helped by the fact that the law may be thrown out by the Supreme Court before then.  Lower courts already have conflicting rulings, which virtually guarantees the Court's attention.

If it does stand, it is possible that the Affordable Care Act may actually lead to lower total compensation for U.S. workers.  If the the employment situation hasn't recovered to pre-recession levels, employers may use it as a method of fighting the wage-price stickiness issue.  This will have to be one of worst unintended consequences in the history of Congress, if it does happen.

Tracking Fear

As you may have noticed, I like Google Trends.  What's not to like?  It's a cheap and easy way to find out what people are interested in!  With the recent recession and fears of a double dip, I thought it might be a good way to track interest or fear of recessions.  Directly below is a chart from the somewhere in 2003 to the present for global searches of the word "recession."

As you might predict it jumps almost out of nowhere in what was still the peak of business cycle in 2007.  Then about a year later it jumps again in the winter of 2008 to its highest level.  This is before Bear Stearns collapsed, but right about when the stock market began collapsing around the week of January 21st.  The financial panic of 2008 can also be observed in September during the Lehman Brothers, A.I.G., etc crisis and in October when TARP almost didn't pass the U.S. Congress and stock market was pushing considerably lower amid heavy volatility.  Since then it has more or less tapered off until a jump in the past couple weeks.  Also note that the chart is divided in half by the initial stock collapse.  Before that, the chart is at very low levels, and after that it is always higher.  The searches to news correlate well (which is typical) but the initial January 2008 searches clearly overwhelm the news items.  This shows that the public was proportionately much more interested in news about a recession than the media was able to report.  Because recessions are an example of negative news and involve elements of expectations, this can be considered a way of tracking Google users' fears of a recession.  To the extent that Google is used, this can be considered a measure of the general public's fear as well.

Another feature of Google Trends is that you can break it up by country.  So I thought it might be interesting to see how the word "debt" tracks in countries with ongoing sovereign debt problems.

GREECE

Greece, shows (at first glance) that the Greeks only started looking for debt in 2011, which would be suprising because they had an earlier bailout in 2010.  Upon closer inspection, the chart shows that the Greeks were spiked their searches off the chart in the past couple months, and that is likely why early amounts do not show very well.  This is due to the way that Google trends displays its data.  It scales the data based on the average of the time period selected, so in the Greek chart the only part displayed is such an outlier that it blows out almost the entire chart.

PORTUGAL

SPAIN

ITALY

GERMANY

FRANCE

UNITED STATES

In most of the other European countries, the charts show a defined peak around the times of the first Greek bailout in May 2010, and the most recent Greek bailout and other recent uncertainties.  Portugal has a slightly different schedule and peaks around the Fall of 2010.  I'm not certain as to why, there isn't a corresponding news jump.  Both Spain and Italy are peaking right now, which makes sense because Italy just introduced another round of austerity measures and both their news cycles are showing jumps as well.  Germany is a bit of an odd ball in this group in that they seem to have a low level of interest in debt, with some pronounced peaks during this crisis, but low levels at all times.  France shows recent volatility, that would coincide with recent rumors of a debt downgrade.  The United States also shows low levels that spike with their recent debt downgrades.

Economics Debate: #1 Krugman v. #30 Rogoff

Paul Krugman of Princeton debated Kenneth Rogoff of Harvard this morning.  These professors both ranked on my Economist Rankings, with Krugman at #1 and Rogoff tied for #30.  They debated on Fareed Zakaria's Global Public Square (GPS) program.  They debated primarily on the recent S & P U. S. debt downgrade, general economic conditions, and whether we should have another stimulus.  The debate begins at the 3:55 mark.

I think it was a pretty good debate.  I'm not sure I could say who won.  I didn't appreciate Krugman interrupting Rogoff at the end, but both sides were in good form.  Krugman was his typical Keynesian self, and I'm not exactly sure how to peg Rogoff.  According to Wikipedia, he's labeled a New Keynesian (just like Krugman), but there were clear differences between the two.  I'm not sure who decides that on Wikipedia, and I'm sure it doesn't matter, but it would be interesting to see them put a Keynesian versus another school.

Kenneth Rogoff is the author of several books, most recently This Time is Different: Eight Centuries of Financial Folly.  Paul Krugman is the author of many many books as well, but won his Nobel Prize for Scale Economies, Product Differentiation, and the Pattern of Trade.