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.

American "Competitiveness" In a Eurozone Context

For fun, I threw the unit labor costs for the United States onto the graph I made for the previous post, to see how American labor costs fare in comparison to the European situation. The results are pleasantly suprising: American labor costs are well below European labor costs.

Further evidence that the United States does not have a "competitiveness" problem, and that our labor and capital markets price inputs appropriatley to compete with the best exporters in the world.

In insolation, here's the US vs. Germany directly.

Labor Costs and the Eurozone Adjustment...

Here's Barry Eichengreen on the necessary adjustment process in the Eurozone: 

"Unless the increase in capital stock significantly raises labor productivity (which is unlikely insofar as much of the preceding period’s investment took the form of residential construction), the result is a loss of cost competitiveness.  The country then faces slow growth, chronic high unemployment and grinding deflation, as weak labor market conditions force wages to fall relative to those prevailing elsewhere in the euro area.  The temptation, then, is to leave the euro zone so that monetary policy can be used to reverse the erosion of competitiveness with a “healthy” dose of inflation."                                                                   

Now here's a chart I made showing unit labor costs in Italy and Spain, relative to Germany. It gives an idea of what adjustment the periphery countries need to make to bring themselves into line with Germany and regain competitiveness. It's for the manufacturing sector only because thats what most tradeable output consists of (not a lot of Italian haircuts sold in Germany). 

Unit Labor Costs = Labor Compensation /  Total Output 

Either real labor compensation in Italy and Spain needs to fall or output needs to expand, because labor costs obviously became seriously out of line during the "boom" following the creation of the euro in 2002.

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."

Observations on Tampa...

A few things I noticed from the RNC, before we get into the DNC this week.

1. There seems to be a definite trend toward protectionsim in the Republican party; both Sen. Rob Portman and Romney made strong allusions toward starting a trade war with China. Its important to remember that the Federal government can't tax or penalize Chinese producers, only American consumers.

2. It remains unclear what exactly the Obama Administration has done to supposedly hurt the economy in the eyes of Republicans. The Feds bailed out the auto-industry, which plays well in swing states like Michigan and Ohio. All the money given out to banks in TARP and successive give aways has been paid back with interest. The Bush taxcuts have been extended. Obama lifted the ban on offshore oil drilling put in place by Bush 41. So where is the impetus for this rhetoric about killing business initiative or driving gas prices higher?

Meanwhile, Obamacare doesn't go into effect until 2014, and the deficits we've run haven't driving up the cost of borrowing for investment; real interest rates, both short-term and long, remain at historic lows.

So at the end of the day, with regard to most Republican complaints, there's no "there" there.