Guest post: Paul Kasriel on fiscal deficits and inflation

Today I had the pleasure of exchanging a few emails with Paul Kasriel, Chief Economist of Northern Trust. Paul is in my opinion one of the greatest economic forecasters around (you can read him here). I don't think he would disagree if I said he is a great student of Friedman and Hayek, and that he knows what is money and what is inflation. Here is what I asked him and his response:

RK - Some economists argue that money and government bonds are near-perfect substitutes in an investor portfolio. Thus, they conclude, large fiscal deficits will result in higher rates of inflation, whether or not the central bank lets the money supply grow very fast or not. What is your opinion of this theory?

PK - I do not understand the argument. If the government sells the public bonds and the banking system (including the central bank) does not create the credit for the purchase of these bonds, then the public is transferring purchasing power to the government. The public cuts back on its current spending and the government increases its current spending. In contrast, if the banking system creates the credit for the public to purchase government bonds, then the public does not have to cutback on its current spending and the government can increase its current spending. This would be inflationary. In the former case, the Austrian economists refer to this as "transfer" credit inasmuch as purchasing power is transferred from one entity to another. The Austrians refer to the latter case as "created" credit in that the banking system and central bank create credit, much like a counterfeiter, enabling one entity to increase its purchasing power while not necessitating any other entity to cut back on its purchasing power. Perhaps I am missing something in the argument of these economists who believe that government debt issuance is inflationary in and of itself.

Those economists I mention (they seem actually to be a majority of economics scholars), believe that a dollar is a dollar, is a dollar. But if you issue a bond, someone has to cut its spending in order to buy it. Also, why not extend the theory and include AAA rated private bonds to government bonds? And while you're at it, just throw in all investment grade bonds.

To conclude, Japan seems to provide a pretty convincing evidence for Paul's point of view. But as he says, maybe we're missing something?

Not much U.S. macro news today...

... much like every single Monday. Tella Opeyemi and I argued in a 2009 paper this might be a reason for the so-called Monday effect, which is a tendency for stocks to exhibit poor performance on average on Mondays.

Our hypothesis is supported by the fact that this effect is statistically significant for stocks but also for other risky asset classes and risk-free Treasury bonds. "Investors seem to decrease their exposure to all asset classes on average on Monday, and increase their cash holdings, maybe awaiting economic and financial reports released later in the week."

On the limitations of the yield curve as a recession predictor

The yield curve has an amazing track record at predicting U.S. recessions: it basically predicted all of them, giving only a few false signals which still turned out to foresee slowdowns. In the current environment however, its predictive ability may be seriously lowered : Wright's model B tells us we would need to see a yield of 0.7% or less on the ten-year T-Bond to have a recession probability of at least 50%... I would bet we could fall back in a recession without ever getting even close to that yield level. Ask the Japanese.

My GDP forecast...

... for last year, as computed by the model, called VAR(30), that I am presenting as a Master's Dissertation. Excerpt from the results section, followed by the forecast the model would have made back in December of 2007:

The annual pseudo out-of-sample forecasts (performed as of December of each year) were compared to the (December) Wall Street Journal Economic Forecasting Surveys since 2004. VAR(30) would have been the only one to predict a 2008 recession in December, 2007. Over the short, four year period (2005 through 2008) available for a benchmark, VAR(30) outperforms on average all of the private-sector forecasters polled by the Wall Street Journal. This figure is however skewed to the upside by the 2008 extreme outperformance: excluding the 2008 recession year, the rank falls to the 16th place, out of 42 (only forecasters who provided GDP growth estimates for all of the four years were included in this ranking, and thus there can be survivorship bias in the list). This illustrates the importance of Renshaw’s “right ballpark estimate”. Specifically, VAR(30) ranks 15th out of 59 for the 2005 GDP forecast, 41st out of 59 for 2006, 20th out of 63 for 2007, and 1st out of 54 for 2008.
Also presented are fan charts of each yearly pseudo out-of-sample forecasts made each December. Fan charts represent the 90%, 75% and 50% confidence bands around the central GDP forecast.


(click to enlarge)

Contradicting McCulley

It is not a great day for me as I am writing this post which is a rebutal to Paul McCulley, one of the persons from whom I have learned the most. He tends to be too keynesian sometimes, and his last month's commentary is one example:

To be sure, we are presently living in an unusual world, in that the Fed is pegging the Fed funds rate at effectively zero. But it is not stimulating robust demand for credit, or alternatively, it is not stimulating bankers to gin up demand for credit by loosening terms and conditions to prospective borrowers. Actually, reality is probably a bit of both: reluctant borrowers and reluctant lenders.

In my opinion this is completely wrong. The Fed's policies have indeed stimulated robust supply of (risk-free) credit from the bankers and robust demand for credit by the Treasury. I don't have a chart at hand showing of how much of the Treasury's recent borrowing has been financed by the U.S. financial system, but I trust that it's the bulk of it.

Thus, we can categorically say that the near-zero Fed funds rate is not, for the moment, fueling an inflationary pace of aggregate demand growth relative to the economy’s supply potential. And neither is the Fed’s Credit Easing, which is the proximate cause for the explosion of excess reserves in the system. Yes, in the fullness of time, zero Fed funds could conceptually re-ignite borrowers’ and lenders’ mojo. Indeed, that’s precisely the Fed’s objective. And if and when that objective is achieved, the Fed funds rate will need to be hiked to temper the re-ignited mojo, so as to prevent the economy from overheating.

This part is way too keynesian even for McCulley. Kasriel finds a correlation of 0.64 between M2 and inflation, and only 0.08 (!) between the output gap and inflation. Also, look at how inflation flamed up in 1934 while the unemployment rate was in the high teens.

Money Supply

This post is somewhat more edgy than usual. My readers (all three of them) will have to read carefully. Here is an excerpt of an email I sent to Paul Kasriel (Director of Econ research at Northern Trust):

I am writing to you with reference to the latest Econtrarian, in which you explain that a decrease in the amount of stocks that an individual buys as a proportion of its income does not lead to an increase in the money supply since "XYZ’s bank account is debited by the same amount that the employee’s bank account is credited. No new money is created in this process. All that has happened is that the ownership of money has changed".

I can try to extend the argument to the case where an individual sells previously owned stocks and decides to hold the proceeds in her bank account: since there has to be a seller for every buyer, the seller's bank account will decrease by the same amount as the increase in the buyer's account, and so no net new money has been created.

However, I am wondering what you think about the case where someone sells stocks to a foreign buyer (which is likely to have happened in the recent past, as holdings of foreign equities by U.S. investors have decreased significantly). Then, could it be that the U.S. money supply has increased in the process, while matched by an equal decrease in the money supply in the foreign buyers' countries? This could lend support to Asha Bangalore's February 19th argument that "Inflation adjusted money supply is advancing because currency, demand and saving deposits have risen sharply. At the same time, bank lending has contracted", which otherwise would be at odds with your view.

And here is his answer:

Unless the foreign buyer borrowed dollars to purchase the dollar-denominated stock or bond, there is no increase in the U.S. money supply. If no borrowing occurred, then the foreign buyer would have to purchase dollars in the forex market to pay for the stock/bond purchase, which, again, just changes the ownership of dollars but does not increase the supply. The foreign purchaser of stocks/bonds presumably purchases the dollars with her own currency, which changes the ownership of that currency.

I have to admit that I am perplexed as to why the U.S. money supply, excluding currency and retail money market shares, is increasing as rapidly as it is when bank credit and bank assets are declining. Assets equal liabilities plus net worth. With commercial bank assets declining in recent weeks (assets soared back in October due to JP Morgan's assumption of WAMU, a savings & loan), then liabilities plus net worth also must be declining. If net worth and other liabilities are declining, then it would be possible for deposits to be rising even though total assets are falling. The data indicate that this is what is happening. But I still do not understand the process by which this is occurring. I am skeptical that advances in the money supply are as "stimulative" as otherwise when bank assets and bank credit are contracting.

Paul

If anyone believes they can contribute to the discussion, feel free to do so.

Gross' keynesian framework starting to show its limits

Although I have an immense respect for Bill Gross (for both his accomplishments and his thinking), I have always thought he was a bit too keynesian for my taste. Now it looks like the model is being stretched (emphasis are mine):

Trillions will be required in the U.S. alone and it is critical that there be a high degree of policy coordination among all nations, which avoids protectionist measures reflective of failed policies in the 1930s. To date, PIMCO’s Mohamed El-Erian’s imperative of “shock and awe” has been more like “don’t bother us, we’re working on it.” Get moving. Risk being bold – Washington.

(...) Global willingness to accept American dollars is being tested. Granted, the U.S. currency has appreciated strongly against its counterparts during most of this crisis, but technical short covering as opposed to a flight to quality may have been the dominant consideration. Watch the dollar. If it falls hard, there may be nothing policymakers can do to restore the ensuing financial chaos.

http://www.pimco.com/LeftNav/Featured+Market+Commentary/IO/2009/Investment+Outlook+Bill+Gross+March+2009+Hairy+Lips+Sink+Ships.htm

Another outstanding piece by PIMCO. Shocker.

Koyo Ozeki | January 2009

Outlook for Global Finance: The Evolving Crisis and Japan’s Experience

Frankel: Is $800 Billion Too Big or Too Small? Yes.

http://content.ksg.harvard.edu/blog/jeff_frankels_weblog/2009/02/13/is-800-billion-too-big-or-too-small-yes/

Kasriel: The Great Depression – Just the Facts, Ma’am

As always the great Paul Kasriel has very interesting insights (emphasis is mine):

(...) the hurdles that today’s economy has to jump over to enter a recovery would appear to be much lower than the hurdles that were erected between 1930 and 1932.
In addition, the federal government is about to embark on a massive fiscal stimulus program. Will the Fed monetize much of the new debt issued to fund this program? We do not know yet. But if recent history is any guide, the answer is yes. Chart 7 shows that the growth in bank reserves in 2008 was almost 149% – an unprecedented increase. If the federal government embarks on a large spending spree and the Fed “prints” the money to fund the spending, then the pace of real economic activity is bound to increase. How long it will take for higher prices to begin to erode real activity is another question. But never underestimate the initial positive impact on aggregate demand of that powerful combination of increased federal government spending/tax cuts and a central bank running the monetary printing press at a high speed.

The economic data are likely to be abysmal through the first half of this year. The popular media will reinforce the gloom of the data. The same pundits who did not see this downturn coming will not see the recovery coming either. My advice to you is to keep your eye on the index of Leading Economic Indicators. If history is any guide, the LEI will signal a recovery well ahead of the pundits.

I plan on developing an enhanced version of the LEI for my Master's dissertation for a reason.

The Alternative Universe Newswire

The Alternative Universe Newswire

Thursday, January 29, 2009 at 9:21 AM Posted by Macro Man

There is a theory in particle physics, known as the many-worlds hypothesis, which posits that there are an inifinite number of universes, with a new one created whenever a particle's qunatum wave function "collapses." Readers of Philip Pullman's His Dark Materials trilogy will be familiar with one "practical" interpretation of the hypothesis, wherein similar but slightly different universes overlap each other.

Macro Man can confirm that this is in fact the case, as he possesses a rather unique newswire that feeds in from one of the alternative universes. He usually keeps it under wraps in the bottom of a drawer, but sometimes feels compelled to have a look at it when real-world news headlines leave him scratching his head. He finds that the alternative universe newswire sometimes offers a fresh, more truthful perspective on events than his everyday sources of news.

Recently, he's taken to looking at the alternative newswire with depressing frequency. Consider the following real-world headlines that have crossed his screen recently, and compare them with the alternative-universe newsfeed:

Our world newsfeed(OWN): Russia, China blame woes on capitalism

Alternative world newswire (AWN): Wen, Putin admit Martingale forex strategies "misguided".

In gambling, a Martingale strategy is one in which one's stake is doubled after every losing bet until he finally wins (or loses all his money.) If one possesses infinite wealth, this strategy will deliver a profit of the original stake when one finally wins; in the real world, however, its practitioners usually bust before finally winning.

In markets, the term refers to adding to a losing trade to "improve your average". Unsurprisingly, market punters usually achieve similar results to roulette players in using the strategy.

And in macroeconomics, it has come to mean an endless cycle of buying foreign exchange reserves to maintain an artificially weak exchange rate, regardless of the negative externalities of such a policy. To be sure, the US is culpable for a great deal of the current global economic stress, but this does not absolve either China or Russia for pursuing their own misguided policies which have generated a collosal misallocation of resources.

That the ongoing travails of the rouble has impaired the kleptocrats' financial standing in some small degree provides at least one small rainbow in an otherwise never-ending torrent of doom and gloom.


OWN: Brown says UK was right to sell gold in 1999, says UK bought euros by selling gold

AWN: Brown admits selling XAU/EUR below 300 was "collossally stupid"

The high print in XAU/EUR in 1999 was 270. It is now 632. Macro Man isn't sure what is worse: that Gordon Brown is too stupid to understand that that is a bad trade, or that he thinks that YOU are too stupid to understand that that is a bad trade.
OWN: "We foresaw economic downturn," Trichet says.

AWN: Trichet reveals ECB forecast model (pictured, below.)
OWN: Brown defends economic record, blames global crisis for downturn

AWN: Brown admits that UK is buggered

OK, maybe it's not fair to pick on Gordon twice. But the gold headline above was literally unbelievable, and the graphic below (which amde the rounds yesterday) is too good not to share.

"Never sell America short"

That is what a friend of my father's told him in the late seventies, when many people were long-term bearish on the US. Today, even though the US has been disappointing to the perma-bulls for many years in a row, the consensus still seems to be that America will manage to put its house in order and reemerge as the leading economic powerhouse it has been for decades.

I have doubts. For several small reasons: the same as everyone else's (BRICs and the European Union for example) and my own (the 24 percent dropout rate in California highschools and the reticence of conservative politicians to engage the country more profoundly in biotech research because of religious views come to mind, but there are many others).

But my doubts arise mostly for the following reason: the still persistent triumphalism of some important circles of the country's elite, and most notably the Federal Reserve. Not just the FOMC, but just as importantly the research team (composed of some of the most talented economists in the world) which provides the basis for the Fed's analysis and policy, and also influences Congress, the White House, think tanks, you name it. When one of them tries to raise his voice, he is rarely listened to (think Poole on the GSEs many years ago).

The trigger for my posting this was reading a new paper by Carol C. Bertaut, Steven B. Kamin, and Charles P. Thomas (How Long Can the Unsustainable U.S. Current Account Deficit Be Sustained?). Their conclusion: "All told, it seems likely it would take many years for the U.S. debt to cumulate to a level that would test global investors’ willingness to extend financing." (Funny, the absolute level of the dollar and the fact that long-term Treasury rates relative to the past few years are still high despite the economic downturn would argue otherwise). Since I didn't really care for their model (it's a partial-equilibrium) or their conclusion for that matter, I jumped to the assumptions that they used to project the income balance. The income balance is the difference between the US foreign assets returns and the rest of the world's returns on their claims in the US (the net share of US production that is sent abroad as dividends or interest income).

I found exactly what I was expecting to find (p. 9): "(...) the rates of income on U.S. private portfolio assets and liabilities have been roughly similar in recent years and are projected to remain so, at a level close to the projected U.S. short-term rate of interest, going forward." It continues: "Historically, income rates on U.S. direct investment abroad have exceeded that on foreign direct investment in the United States. Although this gap has narrowed over the past decade, it remains large and we project it to remain large in the future." Why would that be? The answer is on footnote 6: "A number of explanations have been advanced for the asymmetry of rates of return on direct investment, including greater efficiency of U.S. firms, better project selection by U.S. firms, younger and thus less mature investments for foreign firms in the United States, greater competitive pressures in the U.S. market, or differences in tax treatment. (See Higgins, Klitgaard, and Tille, 2005.) None of these factors seem likely to disappear in the near term."

Naturally, none of these factors seem likely to disappear and I won't even try to argue why they probably will. The point is that none of these factors have actually been proved to be the reason of the persistently low income deficit of the US. As it has been argued by many authors, these factors are actually smoke and the true reasons behind the low income deficit are: poor balance of payment accounting and reconciliation, and/or statistical flukes, and/or temporary beneficial movements in rates, and/or difference in tax treatment of direct investment. This latter factor is actually cited by Bertaut et al. but the authors don't state, or take into account in their model, that this makes the income balance look better than it actually is! (For a review of the reasons behind the "mysteriously" low income deficit and net debt of the US, see my 2007 paper).

The point of this post is not to point out a misargument in Bertaut et al. paper. I just wanted to show, using a subject that I am familiar with (the US BoP), the wrong attitude of the governing elite of the US. In their analysis, these influent intellectuals very often use optimistic (sometimes overly so) assumptions. I will turn long-term bullish on the US once I can see that it does what the wise man advised: "prepare for the worst, hope for the best". What I see today would be more along the lines of "prepare for the best, if the worst comes... who could have known?"

My paper is online!

I set up this blog in order to provide a public link to my paper on the U.S. NIIP:

http://www.fileden.com/files/2007/5/12/1072901/On%20the
%20behaviour%20of%20U.S.%20foreign%20balances.pdf

If anyone knows a better way (more direct) to host files online, let me now.

I'll try to post a few comments on the markets and the economy from time to time.