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.