The Return of American Savings...

This is something that I almost never see addressed in the media or practically anywhere else. And its a phenomena that bears mentioning, because it has tremendous implications for nearly every aspect of economic policy. I'm talking about the return of private savings in the United States. Take a look at the graph below; private saving as a share of gross domestic income is at a historic high since the late 1970s.

If this rate stays high, it will have tremendous benefits for the economy in the coming years.
1. Interest rates will remain low, regardless of international capital flows. This will keep interest costs on the Federal debt low as Medicare and SS costs continue to rise and alleviate pressure to raise taxes and run higher deficits.
2. Global imbalances will subside as domestic investment is funded out of domestic savings. This means a re-balancing of East Asian economies and even more net-factor payments to bolster American GNP.
3. Improved household net worth will take pressure off government social programs that make up 2/3 of Federal outlays. If individuals start accumulating savings at a faster clip, programs such as SS, Medicare, Pell Grants, ect. all become less critical for the median American, as retirement income, health spending, and college can be funded on an individual basis drawn on a private stock of savings.

My Wager with the OECD...

The OECD is now warning that US interest rates will rise if and when the Fed stops its latest round of bond-buying. Color me skeptical. First of all, there is no indication that the Fed intends to do any such thing- the warning itself pointed out that growth would slow and made no mention of inflation. But anyways, we have here another opportunity to evaluate the Fisher Rule in real time; I'd go so far as to say that if the Fed stopped its bond buying program, interest rates would be as likely to fall as to rise. I truly wish people would stop belly-aching about Fed policies as they related to interest rates. The Fed influences the price level and its attendant derivatives, nothing more and nothing less. If you want to know where interest rates are going, focus like a laser on capital inflows and inflation expectations. 

Bernanke Is Not to Blame for Low Rates #387

Thought I'd hammer away at this again because I hadn't in a while. But it bears repeating because of the enormous policy implications and the political lobbying power of people who don't like low rates. Anyways, with the knowledge that "the" real interest rate will adjust and remain at an equilibrium that balances savings and investment in an economy, we expect the interest rate to fall when saving increases relative to investment. Bear in mind, this is the natural operation of a secular market, with no policy interference; simply a price changing to clear a market. Well check out the graph:

Ben Bernanke needs to throw this graph right in Paul Ryan's face next time he starts complaining about the "financial repression" caused by "artificially" low rates. Serisouly, look at that: in 2010, the American economy funded ALL the private investment firms wanted to make out of domestic savings and had over a trillion dollars left over. Of course, that was more than absorbed by the Federal budget deficit, which is why we still ran a current account deficit. But with inflation expections running so low and the private sector flooding the economy with net savings, low rates are the result of the market system, not an act of policy or choice.

P.S. as luck would have it David Glasner just made a new post with exactly this theme, but of course a lot better. Here's an exerpt and a link:
"First, it can’t be emphasized too strongly that low real interest rates are not caused by Fed “intervention” in the market. The Fed can buy up all the Treasuries it wants to, but doing so could not force down interest rates if those low interest rates were inconsistent with expected rates of return on investment and the marginal rate of time preference of households."

A Very Discount Christmas Special: Mises and Hayek are Dead

Austrian economics dominates online amateur economics blogging and commentary. Their views go largely unchallenged because most people who read their stuff agree with it or have better things to do than worry about it. Yes, I have nothing better to do on Christmas Eve than try to start a war with libertarians.

This is actually a rather charming picture and makes the
headline seem morbid and untactful.

The Austrian business cycle theory posits that the business cylce is caused by the monetary authority. So far, so good. As I understand it, the theory is based around the analysis of the so called "boom and bust cycle," with booms preceding and causing the inevitable bust. The monetary authority increases the money supply which in short-order causes an increase in prices (inflation) and a fall in real interest rates. These artificially low interest rates are below the equilibrium real interest rate that would prevail in an "unmanipulated" market, and remain so for an extended period. Firms borrow funds at these interest rates and use the loans to invest in capital projects, which because they are financed at low interest rates are low-quality projects. Later, at some unspecified point in time, real interest rates are revised upward to their equilibrium value and the investment projects, which were undertaken to the point where their rates of return equalled the previous, low, interest rate, are now unprofitable. A recession ensues as firms cancel their "malinvestments," banks write off bad loans made with the initial increased money stock, and workers and capital are reallocated away from investment, which was made excessive, and toward consumption or other sectors. 

To Review:

1. Money Supply Increases 2. Interest Rates Fall 3. Firms Borrow and Make "Malinvestments" 4. Rates Rise Again 4. Malinvestments are liquidated 5. A Reallocative Recession Ensues 6. Rinse Repeat

This all sounds reasonable enough; but as we'll see in part 2, there are fatal flaws that need to be addressed.

The Fed Takes Another Step in the Right Direction

How I love printing money.

But seriously, the Fed just announced a new set of actual RULES it intends to use as guidelines to set monetary policy for the next several years. Basically, its a committment to keep the Fed funds rate at zero and continue the $40 billion a month in asset purchases until unemployment falls below 6.5% or inflation rises above 2.5%. Its not targeting the TIPs spread, or NGDP, but its something- and a sign of good things to come. Check it.

"To support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the asset purchase program ends and the economic recovery strengthens. In particular, the Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored. The Committee views these thresholds as consistent with its earlier date-based guidance. In determining how long to maintain a highly accommodative stance of monetary policy, the Committee will also consider other information, including additional measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments."

From here: http://www.federalreserve.gov/newsevents/press/monetary/20121212a.htm

I've Performed and Invaluable Public Service

Behold, a time series illustrating one of the more elusive economic indicators, the real interest rate. The blue line is the real rate on corporate AAA bonds, the red on 10 year Treasuries. Useful stuff. FRED data transformations are the miracle of the age.

Bond Markets Predicting Inflation, Round Deaux

Can Bond Markets Predict Inflation?

One of the key pieces of evidence marshalled by inflation doves is that the bond market expected extremely low inflation for foreseeable future. We know this because the spread between non-indexed and indexed Treasury yields has collapsed since the financial crisis of 2009, as nominal income growth has slowed to a crawl and excess capacity is plentiful. But just because bond investors in the aggregate expect low inflation, does that mean inflation won't happen anyway?

First off, lets take a look at the relationship between nominal interest rates and inflation:

So far so good. It appears the old monetarist notion that inflation expectations drive nominal interest rates holds. In addition, heres the relationship between inflation expectations and actual inflation:

So it appears that the bond market is not a perfect predictor of inflation, but not in the direction inflation hawks might think. The bond market consistently OVERESTIMATES the rate of future inflation. Nominal bond investors are peevish when it comes to the value of their investments. And if they're not afraid of inflation, neither should you be.

Things You Won't See on Either Platform...

But probably should. If I were Tsar  running for President, some policies I'd advocate.

1. Re-finance the Federal debt to greatly extend its maturity. This would mean higher interest payments in the immeidate aftermath, but would mean we could lock in extremely low rates for decades, even after interest rates return to "normal." We could save hundreds of billions without changing/doing a thing.

2. Expand free trade and lower/ eliminate tariffs across the board. I was struck in the debate tonight when Obama said "we prevented China from exporting us cheap tires." I ran over two nails in one week and paid out the $%&# for two new tires. Obama directly lowered my real income with that tariff. Tariffs are taxes on American consumers, not foreign producers. Run for Premier of China if you want to get tough on the Chinese.

3. Eliminate farm subsidies. We pay billions of dollars a year in direct payments to agri-business so that they will produce less food. That's right, we collect a round of taxes literally for the privledge of constraining food output and raising prices. That's the intent not just the consequence of the policy. And when food (shock) is expensive, we collect another round of taxes (with the associated dead weight loss) to give people food stamps to buy the food we paid to make more expensive. Lets stop paying taxes to reduce our real incomes.

4. I've saved my favorite and most oft repeated mania policy for last. Yes, change the Federal Reserve Board's mandate from a dual mandate of price stability and low unemployment to a single mandate of a nominal GDP growth rate target. For explanation, click on nearly any prior post.

Rates Are Low in Spain and Italy...

By historical standards.

I finally managed to paint the picture I wanted to see  illustrate the absurdity of the claim that fiscal profligacy is causing rates in Italy and Spain to "spike." Here's rates for both in historical context.

I'll admitt I was taken aback when I saw this. I knew rates weren't incredibly high in historical context, but I had no idea how relatively low rates still were. So Spain and Italy had no trouble financing their debts at rates twice as high fifteen years ago. What's changed recently?

Notice the plung in nominal income growth right after 2009. The recession of the early 2000s doesn't even show up (Europe went into recession then too, right?) These "high" rates are unsustainable in a tight-money environment; if the ECB would play ball and stabilize nominal GDP in the Eurozone, it'd be smooth sailing.

Krugman, Low Rates, and Growth Expectations

One assertion frequently made by Paul Krugman is that low long-term interest rates in advanced economies reflect the expectation of continued economic weakness. Apparently, there's to be a debate in Britain's House of Commons featuring Krugman et. al. on the subject.

I figured I'd investigate this hypothesis with regard to the United States. If low rates imply weak expectations and rising rates rising expectation, I expect rates and the S&P to rise and fall together.

Krugman, as usual, is proved correct by the evidence.                  

Interest Rate Spreads (Again)

See how the U.S. Germany, and United Kingdom have all seen borrowing costs decline, roughly in the same proportion, despite vastly different public finance regimes, budget deficits, and stocks of debt, because they all have their own currencies (the euro being effectively Germany's currency.)

Here's the borrowing costs of Spain and Italy divering from the original three. No real point to this, but its sometimes helpful to have a picture to illustrate a phenomenon. 

The Agony and the Ecstasy, And the Government Debt

Whoow boy. A big hubub in the blogosphere about whether government debt imposes a burden on "future generations." Lots of input from high places. Check it:
http://krugman.blogs.nytimes.com/2012/10/12/on-the-non-burden-of-debt/
http://delong.typepad.com/sdj/2012/10/the-intergenerational-burden-of-the-debt-nick-rowe-tempts-fate-weblogging.html
http://worthwhile.typepad.com/worthwhile_canadian_initi/2012/10/the-burden-of-the-bad-monetary-policy-on-future-generations.html 
http://noahpinionblog.blogspot.com/

And now for some input from a low place, featuring my hat in the ring.
I've basically made this argument before, in my post about the stance of fiscal policy. Noah Smith spells it out well by framing the situation in terms of the effect on the capital stock, or the K term in the Cobb Douglas Production function.

Y = A(t) Ka Nb

The budget deficit affects the economy by absorbing funds that would otherwise have been invested in private capital. To the extent that the budget deficit "crowds out" this private investment, it does it by raising the real interest rate faced by borrowers. It makes sense that a larger budget deficit would raise the interest rate more than a small one, so that as the deficit grows, it increases the "burden" of future generations. Here's an ad hoc rule of thumb I just invented. It's basically an interest rate elasticitiy of the budget deficit:

(% change interest rate / % change in budget deficit)  < 1 no net "burden" on future generations

(% change interest rate / % change in budget deficit) > 1 net "burden" on future generations

Maybe I'll develop this further later. Perhaps something about future taxes.

Interest Rates and Monetary Policy (part 1, of many)

With the Fed's resumption of the task of trying to do it's job, I figured I'd get around to a piece on interest rates and monetary policy I've been putting off for a while. Here goes.

The interest rate is a price like any other; it is the price of present consumption in terms of future consumption.  Say you start out with $200. You have the option of consuming the entire $200 today, or delaying consumption until a later date in order to consume more. The tradeoff is given by the equation:

Future Value of consumption  = Present Value of consumption * (1 + r) ^ t  where r is the real interest rate and t is the amount of time consumption is delayed. So $200 delayed at a real interest rate of 5% for 10 years would be: $200 * (1+0.05) ^ 10 = $325.78. The higher the interest rate and the longer the time defered, the greater the consumption to be had in the future. 

The point of this is that the real interest rate is an actual price, the kind settled by good ol' fashion supply-and demand, where supply and demand are the supply of deferred consumption and the demand for purchasing power immediately, as illuistrated by the following diagram to the right. 

The tradeoff  between consumption today and consumption tomorrow can be illustrated by the indifference curve to the left. Any point on the curve represents a combination of present and future consumption that maximizes utility for the individual, with the actual combination being point where the curve intersects the budget line.

The Fed Joins the Expansionist Choir

Good news come from both sides of the Atlantic! Last week it was Draghi announcing his open-ended debt-swaping operation to lower yields in Periphery debt, and today we have this from Bernanke:

"To support a stronger economic recovery and to help ensure that inflation, over time, is at the rate most consistent with its dual mandate, the Committee agreed today to increase policy accommodation by purchasing additional agency mortgage-backed securities at a pace of $40 billion per month.  The Committee also will continue through the end of the year its program to extend the average maturity of its holdings of securities as announced in June, and it is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities.  These actions, which together will increase the Committee’s holdings of longer-term securities by about $85 billion each month through the end of the year, should put downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative."

It's still not a committment to target Nominal GDP, but at least we're seeing expansion where it counts, from the ECB and the Fed. Its a step in the right direction. 

Who's Afraid of Inflationary Finance?

The Germans, of course. I'm a tad late to this party, but now's as good a time as any to jump in. It seems the German central bank (ReichsBundesbank ) has challenged the ECB's newest bond-buying scheme (which to my understanding consists of the ECB selling German bonds and using the proceeds to buy up Italian and Spanish debt to suppress yields) in the German Constitutional Court. Check it out:

http://www.independent.co.uk/voices/comment/the-bundesbank-is-calling-the-shots-now-8125952.html

Apparently, the head of the Bundesbank, Jen Weidsmann, has threatended to resign over what he calls "state financing via the money press." Of course, inflationary finance is a touchy subject for Germans, given its history with hyperinflation from 1921-1924 under the Weimar Republic. And of course, as everyone knows, it's that hyperinflation that lead to the collapse of democracy in Germany and the rise of Hitler!

Except that's not true. Hyperinflation in Germany ended in 1924, when Germany revalued and issued a new currency called the Rentenmark, at an exchange rate of 1,000,000,000,000 reichsmarks = 1 rentenmark.

Hitler was not elected as Chancellor of Germany until the 1932 elections, taking office on Jan. 30, 1933. That's a full nine years after the end of hyperinflation, in the middle of the deflationary Great Depression. Whats the connection between the election of 1933 and an inflation that occurred a decade earlier?

Lets get the history straight, shall we? Inflationary finance did not bring about the Nazis; mass unemployment did. Crushing debt burdens owed to foreigners did. Foreign mandates imposed in a beleagured population did. THAT'S the kind of environment that leads to radical leaders who's messages of spite and hatred can take root.

John Cochrane for Treasury Secretary

I remember seeing this a while back and wondering who would best replace Geithner at Treasury, should Obama win and Geithner decide to leave. Recently I came across an old blog post by John Cochrane in which he laid out a series of proposals to finance the Federal debt that I find absolutely compelling.

Lets take a listen:

"I don't know who in their right mind is lending the US government money for 10 years at 1.59% and for thirty years at 2.67%. You have to believe inflation will be lower than these values just to get your money back, let alone make any real return.  (The best I can do is to opine that these are not long-term investors, and they think they can get out before rates rise. I will admit that understanding such low rates is stretching my rational-investor efficient-market prejudices.)

Well, no matter. When offered a screaming good deal, you should take it!

Restructuring US debt to longer maturities has all sorts of advantages. (Restructuring. I am not advocating stimulus!) It buys lots of insurance, very cheaply.

Think about what happens with very long term debt vs. rolling over one or two year debt, which is what the US does now.  Sooner or later, interest rates will surely rise to normal, 5-6%. If we are rolling over debt, that means the US Treasury has to come up with an extra 4-5% times the outstanding stock of debt, each year, to pay interest. 5% of $15 trillion is $750 billion, more than half our current (and already unsustainable) deficit. Oh, and by then the debt will be a lot more than $15 trillion by then. 

And that's just the "return to normal" scenario. What if the exploding euro leads bond investors to wake up that all debt of highly-indebted, sclerotic-growth, perpetual-deficit, can't-cure-runaway-entitlement governments is dubious?  Greece didn't get in trouble trying to borrow for one year -- it got in trouble trying to roll over debt. If that moment comes and the US has lots of long-term debt outstanding, it just means a mark-to-market loss for bondholders. If we are rolling over short term debt, then the debt crisis comes to the US. And there is no Germany to bail us out.

Notice how the 30 year rate plummets in 2011 and remains low. And this is on indexed debt, not just reflecting low inflation expectations! Cochrane's refinancing ideas would allow taxpayers to pay these low coupon rates for 30 years into the future, potentially saving trillions in interest costs. 

Todd goes beyond the usual 30 year Treasuries, and advocates 50 or 100 year Treasuries. Good idea! I have wilder ideas. We should think about bonds with no principal repayment at all. 30 years of coupons, or even perpetuities. These bonds never have to be rolled over -- you never have to issue new debt to pay off the principal of the old debt. Or, if we want to maximize the duration of the bonds, issue the opposite: zero-coupon 50 year bonds.  At least that puts off any problems for 50 years!  If restructuring physical debt is hard, do what the private sector does: Massive fixed-for-floating swaps could lengthen the US maturity structure very quickly without unsettling somewhat illiquid markets for seasoned bonds. 

Lots of smart money is locking in absurdly low rates. Why not the US?"

Nick Rowe on NGDP and Interest Rates, Theory Edition

Enlightening new post over at Worthwhile Canadian Initiative that clarifies how to think about monetary policy in a non-interest rate paradigm. Check it out here:  http://worthwhile.typepad.com/worthwhile_canadian_initi/2012/09/goldpunk-strategy-space-and-michael-woodford.html#more

This is my favorite excerpt:

"If in that alternate history we had thought nominal interest rates were too near zero, and we wanted to loosen monetary policy, and we wanted to cause nominal interest rates to increase above zero, the central bank would just start raising the price of gold. It would be obvious to everyone. Raising the price of gold is how central banks loosen monetary policy. There's nothing special about the price of gold, of course. Except history. But the price of gold does have the right units, because it's got $ in the units. There's no $ sign in the units for an interest rate. And what central banks really really ultimately do is determine the value of that $ unit."

Tight Money and Fast Growth...

I'm back, and harping on the same strain again.

Today I thought I'd run Nominal GDP percent change per year against the Fed funds rate, expecting to see a negative correlation (lower Ffr = higher NGDP growth). What I saw instead suprised me:

A near-perfect positive correlation. I guess this means we should be raising rates to spur recovery, right? But in all seriousness, it's major evidence that high rates = loose money and fast growth, tight money = low rates and slow growth. Now I've made charts demonstrating that will both M2 AND the Ffr.

Nobel please.

P.S. here's the same thing but percent change from a year ago for Ffr. Similiar picture, same point.

Treasury Rates Falling on My Head, In Real Time

Not just theory. Real rates are low, and continue to fall. This has implicaitons for fiscal and monetary policy; but the relevant instituions (the US Congress and the Federal Reserve) continue to sit on their hands, and should be held responsbile for doing so.

http://www.businessweek.com/news/2012-07-11/treasuries-rise-after-record-low-yield-at-10-year-note-sale