Asset Markets See the Light: No Fed Taper on the (near) Horizon

It seems that financial asset markets have lost the jitters they've been feeling for the last several weeks based on the misguided fear of an imminent Fed "taper." The jobs report which came out today had unemployment at 7%, a half a percentage point above the metric Bernanke laid out as a parameter for the current bond-buying regimen of $85 billion per month. This return to complacency following the recent hand- wringing means one of two things: either I'm highly influential and my message has gotten through, or bond and equities traders have actually decided to take the explicit policy pronouncements of the FOMC at face value. I know which option I'd like to believe.

Like I've said, short-term interest rates are going to stay low as long as unemployment remains above at least 6.5%. Bond investors have nothing to fear but a strong labor market. When the FOMC meets on Dec. 18, lets hope they give me an early Christmas present in the form of a vindicated prognostication.

Sumner, Krugman, Williamson, and My Two Cents

There's been a recent row in the economics blogosphere over the nature of quantitative easing, and its long-term effects on the price level. FOMC member John Williamson recently implied that quantitative easing, instead of causing inflation, instead will exert deflationary pressures on the economy in the long-run. Here's a quote: "The Fed is stuck. It is committed to a future path for policy, and going back on that policy would require that people at the top absorb some new ideas, and maybe eat some crow. Not likely to happen. The observation of continued low, or falling, inflation will only confirm the Fed's belief that it is not doing enough, not committed to doing that for a long enough time, or not being convincing enough."

Paul Krugman, Scott Sumner, and Nick Rowe, among others, have already jumped into the fray, with predictably intriguing discourse ensuing. 

Here's my two cents: Williamson mixed up the difference between real and nominal. Its really as simple as that. Quantitative easing, i.e. dramatically increasing the supply of base money in an economy, doesn't by definition induce asset owners to increase their real holdings of money, i.e. a great amount of purchasing power over goods and services in the form of currency or demand deposits; it by definition induces them to increase holdings of nominal balances.

Lets investigate this using some preliminary algebra. The real money supply is equal to the nominal money supply divided by the price level so that we write:

mD = MS/P

This means the real purchasing power of the money supply is equal to total amount of base dollars in the economy, i.e. paper money plus bank reserves at the Fed, divided by the price level, which is the "average" price of all output in the economy. Quantitative easing means an increase in the nominal money supply, the MS term in the above equation. Williamson has in effect postulated that for an increase in MS, mD must rise by the same amount, which implies that P must correspondingly fall to maintain the equality. What he overlooked is that just because a central bank decides to increase the supply of nominal money, asset holders do not necessarily want to hold more purchasing power in the form of money base. Instead, it is the level of prices that rises via inflation so that the newly issued money is held as real balances to keep purchasing power constant.

Memo to Skittish Bond Holders: Remember the Dual Mandate

The Federal Open Market Committee is not going to "taper," or slow the rate of its bond-purchases, in the short or medium term. The Federal Reserve Act ultimately governs the policy goals of the FOMC, and the Act contains a dual mandate to "maintain long run growth of the monetary and credit aggregates .... so as to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates."

Under Bernanke's leadership, the Committee has made an explicit commitment to maintain the bond-purchases of $85 billion per month until unemployment falls below 6.5% or inflation rises above 2.5%. Unemployment is currently running at 7.3% while headline inflation is approximating 1%.

Even the 7.3% unemployment rate is a misleading indicator of conditions in the labor market. Only Americans who are actively seeking employment are counted- the official number excludes those who have become discouraged and dropped out of the labor force due to lack of job opportunities. A more representative measure of the condition of the labor market is the civilian employment - population ratio, which peaked at 63.3% in the third quarter of fiscal year 2007 but which was 58.3% in October.

The current population of the United States is 313.9 million. If the same proportion of the population was employed today as in the third quarter of 2007, it would take the creation of another 15.695 million jobs; with that kind of employment gap and inflation average less than 1%, securities markets shouldn't expect a hike in rates nor a "taper" in quantitative easing in the near future.

Bond Markets and the Ever Elusive Taper

Bond market watchers have, in recent weeks, become mindful of what is widely perceived to be an possible game changer: If the Federal Reserve, as expected, announces an exit strategy from its $85 billion per month bond-purchasing program, known as QE3, investors can expect a rise in yields and a fall on bond prices, effectively ending the secular bull market in fixed-income securities that has prevailed since the inception of the Fed's zero-interest rate policy in December of 2008.

A concurrent and highly relevant development is notably absent from the recent discussion of the trajectory of the bond market: the imminent (it now seems) appointment of Janet Yellen as the new Federal Reserve chairmanwoman. Yellen's academic career as well as her previous contributions to the direction of monetary policy (she is the current Vice Chair at the Fed) indicate one thing for certain: her moral suasion as formal leader of of the Federal Open Market Committee will favor continued monetary expansion. As far as inflation "hawks" and "doves" are concerned, she is firmly the later. 

Continued expansion in the short-term is just what bond markets ought to expect regardless of changes in leadership. At the inception of QE3 in December of last year, Chairman Bernanke stated that the bond purchases would continue until inflation exceeded 2.5% or unemployment fell to 6.5%. Neither metric is near these parameters. The Federal Reserve, always wary of losing institutional credibility, is even more so in the last five years since its primary policy tool, adjusting the Federal funds rate, has failed to return the economy to full employment. Reneging on an explicit policy pronouncement is unlikely to be on the Fed's agenda.

On a longer time spectrum, and with the assumption that Yellen's tenure will result in a continued expansionary stance for monetary policy, longer-term bond yields are actually as likely to rise as to fall. If unemployment remains high and the economy continues to operate below potential, the "liquidity effect" caused by swapping monetary base for interest-bearing Treasury bonds will hold rates down all along the yield curve. If, on the other hand, a consistently expansionary stance of policy actually succeeds in boosting demand, creating jobs, and moving the economy toward full employment, inflation expectations will rise. At this stage the "Fisher Effect" will dominate, and nominal interest rates will rise as investors demand a premium to protect their real yield from erosion by inflation. In short, bond investors won't feel the heat unless it's generated by the labor market.

Calibrating the Volcker Rule: Better Get It Right

The Frank-Dodd Wall Street Reform and Consumer Protection Act celebrated its third birthday in July. Yet regulators are just now attempting to hash out the specs of one of the most potent weapons in the new arsenal appropriated to regulators: the Volcker Rule.

Put simply, the Volcker Rule prevents bank deposits that are insured by the FDIC from being used in "proprietary trading," essentially buying and selling securities with depositor's money for profit. The logic behind the rule is as follows: since the deposits are insured by the FDIC, banks have less incentive to invest them carefully, since any losses will be covered by insurance premiums they've already paid. Thus moral hazard induces banks to take more risk onto their balance sheets than they otherwise would ceterus paribus. Heads, the banks win; tails, the FDIC loses.

The treatment for this ailment plaguing the financial system seems straight-forward: ban speculation with depositor's money. As with any complicated medical procedure, however, complications have arisen. Regulators at the SEC and the CFTC are having difficulty formulating a coherent distinction between proprietary trading and its close cousin, "market making." Market making occurs when a bank buys a security with the intention of selling it in the near future and pocketing the spread between the bid and offer. If these two transactions sound eerily similar it's because they are. Market making, however, is done with the intention of being able to offer clients a variety of financial instruments as well as being able to sell instruments on their behalf. In proprietary trading, the bank earns income from solely from successful speculation; market making generates income through commissions paid by clients.

Another banking practice liable to fall as collateral damage should the gauge of the Volcker Rule be set too low is the practice of "hedging". Hedging allows banks to protect the total value of their assets relative to deposit liabilities and hence protect their capital position. Even if a bank were to hold only risk-free Treasury securities, an increase in interest rates would cause a decline in the market value those bonds. Loan default has the same effect. To protect against these types of risks, banks may purchase securities such as forward rate agreements that are expected to reverse correlate with changes in price of the original asset.

Regulators need to properly and clearly define the "Volcker Rule" as expediently as possible, and in doing so take care not to preclude banks from performing functions essential to their stability. Buying and selling securities on behalf of clients is not a clandestine or risky business practice; hedging against risk does not destabilize the financial system.

The fact that the Volcker Rule was included in the Frank-Dodd bill yet is only being defined three years later suggests that regulators expect to wield large discretionary power in deciding what sorts of banking transactions pass muster. This is a mistake.

Financial regulations must be concrete and communicated with clarity, with a minimum of discretion left to the individual regulators. The reason is simple: Regulators at agencies such as the SEC or CFTC or the newly created CFPA are overseen by the House Financial Services Committee and the Senate Banking Committee. These committees are comprised of Congressmen and Senators who rely on the largess of campaign donations to finance their political careers. If broad discretion is left to individual regulators, the whole operation is reduced to something akin to a magic show: impressive sounding regulatory legislation serves as misdirection to distract the public into thinking lawmakers have "reigned in the big banks;" Congress serves as a false wall between the regulators and the firms swapping campaign cash for influence. In the end, no one is held accountable when there's no rabbit in the hat.

Genesis at Geneva: Let's Begin the De-fissilization of Iran

The latest fracas to widen the gulf between competing factions in the Federal government has arrived, a mere month after partisan gridlock nearly laid the global financial system low. Its origins lie not with Federal debt or deficits, nor even with the recent road-bumps in the implementation of President Obama's signature achievement, the Affordable Care Act. In fact, its origins aren't even in North America. The newest casus belli springs from some 4,078.1 miles away in Geneva, Switzerland, where the P5+1 (Britain, France, Russia, China, the U.S., + Germany) are convening to discuss the latest specter to haunt the security community of the advanced world: the nuclear ambitions of the Islamic Republic of Iran.

In 2006, the International Atomic Energy Agency was "unable to verify" whether Iran was pursuing nuclear technology capabilities for purely civilian purposes as claimed, or whether it was in violation of the Nuclear Non-Proliferation Treaty. Iran was given a one-month deadline to "suspend all enrichment-related and reprocessing activities, including research and development" or face increased economic sanctions from the U.N. Security Council. The deadline was not met.

Since then, sanctions placed by the U.N. have resulted in the halving of potential oil revenues, the prime source of income for the Iranian government and broader economy. Despite possessing some 15% of the world's natural gas reserves, Iran has been largely unable to develop this resource. Export markets in Europe remain closed, as does sources of foreign investment funds and industry expertise. In addition, tens of billions of dollars in financial assets held abroad have been frozen due to the banking portion of the sanctions. Under intense fiscal pressure, the government of Iran has turned to fill the gap from lost revenues with inflationary finance, which has resulted in inflation running at 40% for the last two years. Faced with supply constraints on imports and a soaring cost of living, the Iranian economy has entered a full-fledged inflationary recession (the same phenomena dubbed "stagflation" when it occurred in the US in the 1970s).

These pressures have sufficed to bring Iran to the negotiating table in Geneva, and President Obama now has an opportunity to initiate the diffusion of Iran's fissile ambitions. The specific terms of the negotiation are being constructed as I write this, but they seem to hedge around two premises: Iran will agree to curtail enrichment of uranium, which it has been producing at an accelerating rate thus far, and limit it nuclear reactor capacity. In return, the West will agree to a limited reduction in sanctions, possibly allowing for limited foreign investment and technology to develop the liquified natural gas sector and unfreeze around $10 billion in frozen assets.

Not everyone is convinced. Benjamin Netanyahu, the Israeli Prime Minster, has called for demands that Iran immediately cease enrichment of uranium and the halting of a plutonium reactor in the eastern city of Arak. Failure to meet these demands, according to Netanyahu, should be met with increased sanctions and advised the P5+1 to "keep the pressure up." Economic sanctions were enough to bring Iran to the table. By extrapolation, it follows that increased and prolonged sanctions should suffice to bring Iran to its knees. But this is logic defied by historical experience. Fifty-one years of embargo on Cuba have not resulted in any concessions from our island neighbor to the south. Nor has the economic isolation of North Korea proved efficacious in limiting it's nuclear program. It turns out a nation can remain obstinately committed to a nuclear program on a GDP per capita of $1,800.

This hardline stance is also inconsistent with recent developments in the international geopolitical landscape. The United States no longer enjoys the near monopoly on soft-power it once did. The market for power-projection is becoming increasingly competitive, with a resurgent Russia and a newly- potent China offering nations that evoke ire of Washington an alternative to isolation. Vladimir Putin demonstrated his nation's ability to punch above its weight when he (at least appeared to) single-handedly remove the impetus of the planned American strike on Damascus by orchestrating the removal of Assad's chemical weapons arsenal. Now Syrian government forces are making headway against rebels who only recently thought their victory was at hand, courtesy of Uncle Sam.

The proposed lightening of sanctions on Iran will have a palpable effect on the material standard of living for Iranians. By lessening some (not all) of the pressure that is squeezing their incomes, in return for concrete reductions in their nuclear program, Obama will signal to the Iranian people that there truly is a tradeoff between the nuclear ambitions of their despotic government and the purchasing power of their take-home pay. Let's give them a taste of what compromise can bring. With any luck, they'll be back for seconds.

It's A Long Way to Al Andalus (But My Heart's Right There)

Once again, domestic political theater has proved an irritating distraction from events that, in a sane world, would come front and center in the mind's eye of the cognoscenti. While Congressional Republicans hold a kangaroo court to decide the fate of the credit of the United States and the short-term growth rate of the global economy, let us not entirely neglect the civil wars and endemic violence that has recently engulfed our good friends in the Near East.

I'd like to stake out a stance that may strike some as controversial but is in fact rooted in the deepest throws of sound reasoning and fact: The United States, and her international sovereign and institutional allies, must decisively oppose the rampant proliferation of Islamist political growth in Egypt and Syria. 

Obama and the broader international community simply refuse to acknowledge the conflicts in the Middle East for what they are: a resurgent and dangerous inflammation of politically-oriented, radical, Islam. Mohammed Morsi, who was ousted from his position as President of Egypt by the army at the behest of the Egyptian people, is a member of the Muslim Brotherhood, and had taken steps while in office to undermine Egypt as a secular state. In the aftermath, pro-Islamist forces have slaughtered both military and civilian targets, especially amongst Egypt's long- beleaguered Coptic minority, whom they wrongly blame for the broadly popular "coup." A sizable and growing portion of the resistance forces in Syria are Al-Qaeda or Al-Qaeda affiliates. How does the President of the United States react to these situations? He eliminates military aid to Egypt and proposes bombing and ousting the very head of state against which Al-Qaeda is fighting. I would state that in starker terms: He proposed that we enter into a civil war on the side of Al-Qaeda.

Call me a neo-con, call me right-wing intolerant ignoramus, but I have a strong anti- Al-Qaeda bias. I don't want to attend any party they're attending, I don't even want to RSVP. And as I oppose Al-Qaeda, the same logic forms the corollary for my disdain for the Muslim Brotherhood. The Egyptian chapter of the Brotherhood has called for the resumption of the jizya or head tax on Christians and Jews, as well as their exclusion from the upper levels of the civil service. The Brotherhood has also advocated outlawing any criticism of Islam by Muslims or non-Muslims, as well as banning alcohol and sun bathing at the beach- two pillars of the Egyptian tourism sector. Oh, and I saved the best for last: the Brotherhood does not believe women should be able to file rape charges against their husbands. Morsi drafted the Brotherhood-designed Constitution AFTER his own election- which, not surprisingly, contained no clause for impeachment. American apologists for the "Brotherhood" need to take a long look in the mirror and ask themselves why they support a party of misogynists that promotes discrimination and limits on free speech, all while paving the path to another dictatorship.

Furthermore, apologists for the presence of politicized Islam in the emerging "democracies" of the region are likely to conjure images of a civilization long passed. There was a time and a place (actually several) where Qu'ranic law formed the basis for the government and the results were far from disastrous. The Caliphate of Cordoba (711-1492) originated many pivotal figures such as Avicenna and Arrezzo, and was instrumental in reintroducing the scientific method, algebra, classical philosophy, medicine, and economics to the Western world. Beginning in the 15th century, the Ottoman Empire forged a multi-Continent, cosmopolitan society that, with notable exceptions, successfully coupled internal tolerance with impressive external expansion. A quick anecdote just for fun: Saladin's mentor's father, (Zengi, father of Nur-al Din) and Sultan of Aleppo, met his death at the hands of his own slave. His slave killed him out of fear of being executed for theft. Theft of his master's private stock of high-quality wine. No one thought it was weird for a Muslim Sultan to have a wine cellar in the 12th century. I categorically oppose political parties that want to retard their nations to standards that predate the Middle Ages. The burden of proof rests with my opponents.

The mere fact that a majority of voters in a nation may elect an Islamist party to power does NOT legitimize that actions of that subsequent government. The Jim-Crow state governments of the Deep South in the post-bellum period were elected and supported by the majority of voters. And, to blatantly violate Godwin's Law, You Know Who was likewise elected with a majority of his constituency's votes. Did the United States out step it's bounds when it helped to put an end to that nonsense?

Here in 2013, gone are the doctors, mathematicians, proto-economists, philosophers, and wine aficianados from the Islamist movements of yore. It's infinitely regrettable, because they were an interesting and, I can only presume, affable lot. But in their place has emerged a movement run by the most deplorable, intolerant, and despicable people on this side of reality. The Al-Nursa front in Syria has already instituted public stoning as a form of execution in some northern regions it has occupied, as well as cutting off the fingers of people caught smoking tobacco and forcing women to wear the veil. One telling video shows an Islamist militant who absentmindedly brushed aside a poster with the Muslim declaration of faith on it receiving 40 lashes. With a heavy steel pipe.

The question of whether or not these radical, politicized versions of Islam are a true or fair representation of the religion are irrelevant. I've known many faithful Muslims in my day, and think highly of almost all of them. I once worked a polling station on election day in a local mosque, and was stunned by the hospitality and cordiality of our hosts. Let's just say I spent more than the recommended hour feasting on lunch, to say nothing of the catered breakfast that awaited us when we arrived at 5:30 a.m. My criticisms lie not with the literally hundreds of millions of well meaning Muslims who merely want to live in peace and raise their families. Indeed, I would expect them to be amongst the staunchest opponents of those who would legislate violence and discrimination against their neighbors.

I aspire to a world of equal rights and equality between all people. Christian, Muslim, Jews, Hindus, whatever; man and woman; all citizens of every society, enjoying equal rights, protection, and opportunity under the law. Indeed, I believe this is the only proper aspiration for anyone of any moral conscience to hold. And the Islamist movements that have infected the public spheres of several of our planet's most vulnerable nations stand in stark contrast to this goal. We in the West are not the only ones who deserve equality and individual liberties under the law. Millions of religious minorities and women stand to live in a sub-standard Hell because they happen to have been born on the wrong side of the Atlantic Ocean and the Mediterranean Sea; that's not fair.

Platinum is a President's Best Friend

It's day nine of the government shutdown, and the world has not ended. Sure, many services and programs that the desperately poor rely upon are not functioning, and the FDA is no longer able to properly monitor our food supply, but that's small potatoes- at least to hear folks in the media tell it. What's a little salmonella between friends?

But even if I could forgive the shutdown, and the lack of leadership on both sides of the aisle that preceded it (although its almost entirely the Republican's fault, I can't imagine why Obama did not craft some deft political strategy ahead of time), I'd like to call attention to the much bigger issue at hand: the debt ceiling that we are scheduled to hit on October 17.

On the 17th, the Federal government will be legally prohibited form issuing any new bonds to make up the difference between its revenues and expenditures. Currently the Federal government spends about $60 billion per day and collects about $30 billion in revenues. You see where this is going; almost immediately, the government becomes inoperable.

Let's leave aside the stupidity of a law that says Congress must set tax rates, spending commitments, and then have a third vote to allow the implications of the previous two. You can decide to buy three apples and four bananas, but whether or not you end up with seven pieces of fruit afterwards is not really up to you; numbers add up. Full stop.

And let's ignore the fact that there won't be enough money coming in to send out Social Security checks, Medicare payments, soldier's wages, and the budget for the TSA (okay, maybe it's not all bad). The truly terrifying prospect now looming on our collective horizon is that the Treasury may very well miss coupon payments due to holders of our national debt. And that, to understate things dramatically, would be not to our advantage.

The full faith and credit of the United States is the underpinning of not only our financial system but that of the world. If the Treasury department fails to service outstanding debt by remitting coupon payments as they come due, some $16 trillion in global financial assets will suddenly be relegated to junk-bond status, with a corresponding plunge in value and spike in yields. Financial institutions and investment funds the world over with take a massive capital hit, with many becoming insolvent. Think the crisis of 2008-2009 writ large.

Which brings me to the trillion dollar platinum coin. Obama should instruct Jack Lew, the Secretary of the Treasury, to mint the thing tomorrow. It would then be deposited with the Federal Reserve in Uncle Sam's account and presto, more than enough money appears to operate the Federal government. It really is as simple as that; Social Security checks go out, interest gets paid, the whole shebang.

I can here the protests now: "You can't do that; its illegal! Its immoral!" I beg to differ. Due to an arcane but nonetheless legal loophole, the Treasury can mint platinum coins of any denomination, and that includes $1 trillion. Some have argued that this infringes on the independence of the Federal Reserve to conduct monetary policy, and they're correct. But that is a small price to pay, and has legal precedent that predates the creation of the Fed in 1913. From 1862 to 1971 the Treasury issued United States notes directly, which circulated alongside the Federal Reserve notes we all know and (with notable exceptions) love today.

The real questions isn't whether or not the platinum coin is an awkward policy instrument, or whether or not it it will make for some unwanted political theater. It will. But the question facing President Obama and his advisers at the moment is this: Are you willing to save the financial integrity of the United States government, the credibility of the dollar, and our nation's preeminence in the global economy in return for some institutional hurt-feelings and a scathing review on Fox and Friends?

All global hegemons experience a moment when it becomes apparent that they are no longer the powers they once were. For Rome it was the moment Alaric and his Visigoths stormed the Eternal City in 410; for Great Britain the week in 1916 that the Royal Navy could not shake the Sultan's troops from the shores of Gallipoli. The global hegemony of the United States deserves a better end than a few hand-wringing politicians standing around afraid to try an unorthodox financial transaction.

Pennsylvannia Tea

So I've been tracking the development of the natural gas industry, and while Syria and Egypt have been hogging all the good press lately (bloody ingrates), these developments warrant interest. Since 2008, when large deposits of natural gas were discovered in the Marcellus and Utica shale deposits in the Midwest, unprecedented investment dollars have been plowed into their extraction. In recent months gas has finally begin flowing, and how. It turns out we have more gas then anticipated, and in fact it looks like investment overreached. And now prices have collapsed in the States. Cheap natural gas seems to be the new norm, and this is big news for the future of the economy, the environment, and the balance of trade.

Cheap natural gas is already spurring investment in steel, petrochemicals, and other industries that supply the sector and use it as an input. In addition, natural gas burns cleaner than coal and oil, and as such while result in reduced CO2 emissions and cleaner air at a lower, not higher, cost.

Our natural gas resources also herald in an export opportunity, albeit one that needs to be approached carefully. Natural gas is about twice as expensive in Europe as it is here and eight times as expensive in Japan. The Department of Energy is in the process of approving up to 20 applications by various firms to export their gas. Unfettered exports of gas would increase output and stimulate employment in the sector by allowing the domestic price to drift upward to the world equilibrium. But the increase in price would also reduce the quantity of natural gas demanded in the States and slow the transition from other fossil fuels and increase input costs to industry.

In light of this tradeoff, I'd recommend the resurrection of a policy tool we haven't seen in a long time: the export tariff. In the ante-bellum period, the Federal government was almost entirely funded bu export tariffs from Southern cotton (brings the importance of preserving the integrity of the Union into context, doesn't it?). In recent years, of course, we've been more interested in increasing exports than taxing them. But levying a modest export tax on America's recent find would allow the industry to make a profit from exports while limiting the extent of domestic price increase, all while adding a new revenue stream to the public coffers. Hell, we could even use some of the money to research alternative energy.

Tax Reform Proposal, or: The Closest Shave in Fiscal History

A break from the endless droning of monetary economics. Lately I've been enraptured by the subject of tax reform. For years we've been told by Democrats that we need to raise tax rates on the wealthy (over $250,000 by their estimates) and by Republicans that we need to lower rates on everyone (especially people who earn their living from investment income; less so for that vulgar income stream known as wages). I've never been entirely sure about how I feel about this, until now: I hate taxes, and think even a top marginal rate of 39% is a little absurd. And don't get me started on how high corporate rates are. On the other hand I hardly like the imagery of slashing tax rates on the opulent and benefits for the indigent. But lately I've concocted a reconciliation for the two.

It starts with an idea that no one likes and only a few brave politicians ever suggest, but I'll take it a step further: eliminate all Federal tax expenditures. To a man. Dead in the water. Take away all the goodies, and piss off everyone in America. I'd eliminate the tax deduction for employer-funded health insurance, charitable contributions, accelerated depreciation, tax deductions for dependents, mortgage interest deduction, and deductions on corporate bond interest and Treasury interest, to name a few. I'd also remove the lower rate paid on realized capital gains. Income is income, and it's all game, no exemptions.

And then I'd slash all the rates. By how much I'm not sure, because it depends on how much can be raised by eliminating these tax expenditures. I've heard that we "spend" about $1.2 trillion on these types of deductions, so that implies we could collect about 37.5% less in direct taxes. That's intense. Even if we reduced everyone's taxes by 37.5%, that's dramatic. Now imagine if we lower rates on everyone, but by 50% on the lowest income earners and only 24% on the highest earners. That's a budget neutral tax cut both parties could get behind.

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. 

Another Ugly Regression, Plus Inflation and Interest Rates or Something

Another nail the coffin of of the myth that loose monetary policy means low interest rates. Either monetary expansion means higher nominal interest rates or lower inflation, because these two variables are definitely correlated. And I'm pretty sure printing money does not cause deflation. This is the 10 year rate on Treasuries run against annual inflation.

It's (Probably) Not Inflation Expectations...

That are driving up interest rates in Spain and Italy. As a card-carrying monetarist, one of my maxims is that nominal interest rates are driven by inflation expectations. This presents a quandry as far as the eurozone goes, because nominal interest rates are high and inflation low. Presumably, bond investors in Spain and Italy should not be expected substantial inflation anytime soon, unless they are anticipating a departure from the euro and a subsequent devaluation.
Either that is the case, or the equilibrium real cost of borrowing the these two major European economies has gone up. And whereas in the past I have demonstrated that interest rates on U.S. debt mostly rise and fall with inflation, it may not be the case with Spain and Italy.

Austerity Might be Expansionary in the Eurozone

Or at least not contractionary. I've been thinking about the fiscal situation in Europe, and how Keynesian critics of Eurozone policies advocate that government swear off austerity in favor of spending to boost the economy. According to standard Keynesian theory, when interest rates are up against the zero lower bound, monetary policy has no traction and fiscal policy has no opportunity cost because interest rates don't rise to crowd out private investment spending. As a result, countries like Spain and Italy should keep running budget deficits despite fiscal concerns, to support the fledgeling economy. Here's the problem:

That's the real interest rare on government bonds for Italy and Spain. Real interest rates are very much not zero, at least not in Spain and Italy, the two biggest economies presently in crisis. Nor are interest rates very high. But at an interest rate at anything above zero, public borrowing DOES crowd out private borrowing euro-for-euro. Krugman makes this point all the time, saying that deficit spending for the US economy is only appropriate in a liquidity trap with zero interest rates. But I guess the rules are different in Europe.

In Which I Apologize to Lord Palmerston and the Parliament of 1839: Terms of Trade Edition

I've been on a bit of a China kick lately, so here's another one but in a more historical vein. The century (+10) of 1839-1949 is referred to by the Chinese as "the century of humiliation," in which their country was systematically cut up into concessions and spheres of influence by the Western powers, Japan, and Russia. 1839 marks the beginning of that century because it was in that year that China was invaded for the first time by, who else, the British (those guys were nothing if not well traveled).
The curious thing about the episode is WHY the British invaded, and the tale is one of history's less savory. For many decades, the East India Company had been operating what amounted to a warehouse and a living compound in a small portion of Canton, one of the only places the Chinese allowed foreigners to do business. The Confucian regime deplored commerce and hated "foreign devils," but permitted limited trade because they were able to levy such heavy taxes and duties on Western merchants. The EIC exported Chinese silk, tea, jade, and other luxury goods to Britain, where they were in great demand. The Chinese, in turn, had no interest in British manufactures, so they were paid by the company in silver. John Company (as it was known) got clever and found something that Chinese consumers did demand: opium, or, in modern parlance, heroine. When the Chinese administration objected to the large-scale poisoning of its population (opium left whole regiments of the imperial army practically skeletons) and seized opium shipments coming into Canton, the British company Jardine and Matheson, which had replaced the EIC as the main dealer in opium, lobbied Parliament for intervention. The intervention was not long in coming, the results were swift, and not to China's advantage.
This story has always fascinated me, but I always regarded the British position not only as ethically dubious (the crypts and bloods have nothing on Lord Palmerston), I also found it economically pointless. If the Chinese wanted to be paid in silver, there was no theoretical reason for the British to seek a substitute to export. Per the price-specie flow model, silver would flow from Britain to China,  and goods from China to Britain. This fall in the British money supply would result in British deflation, lowering the silver price of British exports relative to other markets such as the Continent or the Americas; Britain would end up paying for it's Chinese silk by selling Sheffield flatware to Boston households. The war to avoid the silver-silk transaction with China was an expensive waste, so I thought, because the British made the classical mistake of viewing an outflow of bullion as an outflow of wealth.
I was thinking it over today, (how lame) and I realized I had missed a critical point, in fact several. I had simply thought of the situation in terms of balance of payments and the purchasing power parity theory of the real exchange rate; I had entirely neglected to consider the terms of trade that is determined by reciprocal demand. While the long run real exchange rate between any two countries is unity, meaning that output in one country is not inherently more expensive in real terms than another, the terms of trade between trading partners is an index value of how much exports one country needs to give up to pay for its imports. It has nothing to do with exchange rates or financial flows, merely product prices. Take silver out of the equation, and it becomes clear the Chinese really were eating Britain's (boiled) lunch, because while the British were willing to pay through the nose for Chinese commodities, the Chinese had extremely low demand for British goods, causing the price of British exports to be low in terms of Chinese exports. This is known as reciprocal demand, and its a big part of the terms of trade.  So the British basically went searching for, and found, the ultimate export good: a highly addictive drug! Now, instead of having to sell x quantity of flatware to France to get y quantity of silver to get z quantity of silk from China, they could sell x quantity of opium to China for z quantity of silk, with opium (x) having less silver value than flatware(x) and the Brits pocketing the difference!
I only bring this up because the Opium Wars started the process that led to the Chinese revolution in 1911 and the subsequent fall of China to the Communists in 1949, which is increasingly relevant. And it's reassuring to know the whole thing was at least not predicated on faulty economic logic.

China and the U.S. Continued

A while back I had a post illustrating the difference between savings rates in the United States and China. Recall that China saves upward of 50% of its gross domestic income while the United States saves about 12%. Recently, I found a fascinating chart illustrating the difference between the capital stocks in both countries, and the results surprised me. I had no idea that China was so capital deficient, even in 2010. Also, I had no idea the USA was so capital rich even compared to countries like Japan.

This serves to illustrate how very different the US and China remain, with the former holding an incomparable advantage in wealth and prosperity. It also serves to demonstrate the wrong- headedness of those who say China is saving and investing too much and needs to shift its economic emphasis to consumption.

Monetary Policy and Zero Rates, A Thought Experiment

As always when I think about money and interest rates, I'd like to start with the Fisher equation, which says the nominal interest rate is equal to the real interest rate plus expected inflation. Lets imagine that in a closed economy, the market for loanable funds clears at a 5% real rate of interest, and the money supply is expected to grow 5% while real output grows 3%, giving 2% inflation. The nominal interest rate observed in credit markets would then be 7%. Simple enough. At a 7% nominal interest rate no one would argue that the monetary authority could "cut" interest rates by buying bonds, hence raising their price and lowering their yields. That's because the expansionary stance of policy (5% money growth) has kept them decisively positive, thus giving the impression that their is room to be "more" expansionary. At the margin, the central bank can exchange non-interest bearing  base money for interest bearing bills, altering the portfolio structutre of the economy and temporarily lowering short-term rates (before the increased money supply pushes up nominal spending and prices and financial markets price in the increase in inflation.)

But let's imagine a scenario where the stance of policy is not expansionary, but contractionary. Let's say the money supply is growing at 2% per year, real output at 1%, but the income elasticity of demand for base money is more than unity so that it rises 2% for a 1% rise in income. This gives us a -1% rate of inflation, or a 1% rate of deflation even though the money supply is growing at 2%. Now let's say weak growth has depressed the demand for loanable funds and households and businesses are saving more so the equilibrium real interest rate has collapsed to one percent. Going back to the Fisher equation, this means the nominal interest rate in the short-term money market is...zero. By standard Keynesian monetary theory, we are in a liquidity trap, and the central bank is out of ammo. On the margin, bonds and money are perfect substitutes, so expanding the money supply will do nothing.

The implication of this is that all the hemming and hawing about how monetary policy is ineffective when nominal rates are zero has bizarre implications. When money has been loose, the thinking goes, more expansion will have traction. When money has been tight and the economy is weak, expansionary policy will do nothing. I don't buy it. 

I Did Not Know This, Fun Fact Edition

This was something of which I was not previously aware. Americans probably think (as I did before today) that the American flag is a unique design, or at most derived or inspired from something else. But no.  Its pretty much the same flag that has been around since 1599 (on the left).

In case you did not recognize it, thats the flag of theBritish English East India Company, chartered by Queen Liz in 1599. This was the design from that date until 1707, when Scotland and England merged to become the Kingdom of Great Britain. Henceforth, the Company flag looked like the one on the right.  (okay not entirely true, that one includes the cross of St. Patrick, included after 1801). 
If you like counting, feel free to count how many stripes are on that bad boy. Thats right. 13. So much for the "13 stripes for 13 colonies" thing. More like a big convenient coincidence. And yes, this is the same East India Company that was granted the monopoly on tea in the colonies that was the impetus for the famous Boston Tea Party. The early patriots not only stole the Company's tea, they also stole the flag. Burn.                          
"I pledge alliegence to the flag, of the Company of Merchants Trading into the East Indies, and to the Corporation, for which it stands, one entity, by charter of Her Majesty, indivisible, with tea, indigo, and opium for all."

Cartoon Time, Economics Edition

Paul Krugman on Monetary Policy at the ZLB

"The standard answer goes like this: interest rates are already very low, so the Bank of Japan has done all it can. Meanwhile, the government has a severe fiscal problem, so it cannot increase spending or cut taxes. There is, in short, nothing to be done except pursue structural reforms and hope for an eventual turnaround. This answer sounds hard-headed and responsible. In fact, however, it is based on a completely false premise - the idea that the Bank of Japan has reached the limits of what it can do.
The simple fact is that there is no limit on how much a central bank can increase the supply of money. Could the Bank of Japan, for example, double the amount of monetary base - that is, bank reserves plus cash in circulation - over the next year? Sure: just buy that amount of Japanese government debt. True, even such a large increase in the money supply might not drive down interest rates very much, since they are already so low. But an increase in Japan's money supply could ease the economic problem in ways other than lower interest rates. It is possible that putting more cash in circulation will stimulate spending directly - that the extra money will simply "burn holes in peoples' pockets". Or banks, awash in reserves, might become more willing to lend; or individuals, with all that cash on hand, will bypass the banks and find other ways of investing."

But this was written in the mid 1990s. And about Japan. So I guess the rules are different or something.

China vs. U.S. Savings Rates

I was going to include an extensive write-up with this. But I think the charts pretty much do the talking. And what they say is not encouraging. That's savings as a percent of GDP for the United States and China. Guess which is which.

The Big CON, Healthcare Edition

That is to say, "certificates of need." I recently learned about these, among other things, from reading an old John Cochrane blog post, and I am now inspired. I have seen the light. Seen the light in the sense that pretty much all of our national conversation on healthcare misses the point entirely, and by focusing on health insurance and the government pays-what-for-whom-when (Medicare for all! No, Medicare for none!) we're missing the mark by focusing on shifting the demand-curve for healthcare, when all the bodies are (literally in some cases) buried on the supply side.

Which brings me to the Certificates Of Need. A CON is a certificate that hospitals must submit for approval by the state government before they can purchase large-scale new equipment or expand physical operations, or build a new hospital at all. To be approved to expand operations, the hospital must demonstrate that its expansion will not impede the profitabilty of existing hospitals in the area or infringe on their market share.

Think about that, and imagine if that kind of rule were put in place in any other industry. Imagine if Verizon had to submit a form to the Federal government before developing a new cellphone and prove that it would not reduce AT&T's profits. Or Ford was prevented from building a new plant because it would harm GM's market share. We'd have a limited supply of cars and cellphones at higher prices. When you prohibit the expansion of production, that shifts the supply curve to the left. When you shift the supply curve to the left you get less output at higher prices. That's healthcare. It's not cellphones and cars because firms that provide these products are not LEGALLY PREVENTED from expanding plant and equipment; indeed it's encouraged. So prices continaully come down as quality and quantity grow. But not so with healthcare, so we instead get an endless series of schemes to expand "coverage" and reduce costs, when healthcare firms are legally prohibited from organically doing both on their own.

"Whoa, CONS are COOL."  

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."