… of whom I am one, are starting to growl again.
The cenral tenet of interest rate bearishness is that if interest rates are low enough to generate negative savings, as is the case in the US and Australia, they are too low to be sustained. The counterargument, put most forcefully by Ben Bernanke is that someone must be willing to lend at these low interest rates, and this lending must reflect a “global savings glut”. Bears respond that the supposed glut does not reflect savings by households or business, but is really a liquidity glut created by expansionary monetary policy around the world, which must eventually come to an end, or be dissipated in inflation.
Exhibit A for the bears is Japan where the central bank has not only held interest rates at zero for years, but has pumped vast amounts of money into the system. But Japan is now emerging from the long period of depressed activity that followed the collapse of the property and stock market bubble in 1991. Over the next year or two, we can expect to see liquidity being sucked out of the system and, eventually a return to positive interest rates.
Europe is similarly tightening policy. Again, there’s been a long period of macroeconomic depression, this time associated with the merger of East and West Germany also in the 1990s.
It’s probably premature to make too much of this, but over the last few weeks, the US 10-year bond rate seems finally to be drifting up towards 5 per cent. If the bears are right, it has a long way to go.
John Quiggin 
The central bank in Japan held nominal interest rates at zero for years. However the Yen was appreciating (ie deflation) so in real terms interest rates were still high. Eventually Japan figured out that it would only escape the deflation death cycle by printing Yen in sufficient quantity to stop the persistent appreciation of their currency. Simply targeting interest rates was not going to do this. Now that the deflation monster is basically defeated they can return to conventional interest rate targeting with a positive inflation bias. Of course in monetary policy terms they could do even better than this but they won’t. In any case we can expect Japan to start achieving strong economic growth again just as it did in the 1980s.
Both the USA and Australia are letting their currencies slide in value too much. Both need to lower currency liquidity to correct this problem (which in effect means higher interest rates). The USA more so than Australia at the moment.
Consumer prices continue to play the central accountability role in the formulation of monetary policy. Personally I don’t believe that we will see real stability in the global monetary arena until commodities prices once again play a central role.
I fall into the interest rate bear camp as well, but I am not certain that all the current “tightening” is what is driving yields upward and out of their trading range. In particular, if Japan’s move heralded the end of the Yen carry trade, we wouldn’t have to guess about it and you could count on more than 25 basis points on long bond yields. More like 25 basis points per second per second. Also notably, despite the internatioal bond market pull back, exchange rate moves, have been muted.
My opinion is that monetary policy is still extremely accommodative. Long yields are moving, but as a result of the increasingly hard charging economy, whose resilience and momentum truly portends inflation. In other words, liquidity conditions are not behind the conundrum of low long rates, but rather, expectations of nominal rates and anticipation of changes to regulations and preferences in the institutional ALM world. Long bond yields of course affect funding (although far less so than used to be the case. The degree of credit creation at the short end of the curve has grown exponentially- check CP growth- including in the residential mortgage market) and, as such, liquidity conditions. However, these are nominal funding costs. The better paper to look to for liquidity conditions is the index linked stuff where yields have changed very little.
As I say, I am a bond bear as well, but when the bond market goes, the jig is up. That certainly could come in the next year, but in any case, when it does, as with the multiplicative carry trades, there won’t be any wondering whether it has.
put me in the bear camp as well.
Keating had one 6% number for the CAD.
This present government has had 5 going on 6 when commodity prices are at their peak and may have started the decline they must have.
Given that there are more households with a mortgage and large ones at that, it is kryptonite to superman!
I think a big issue in keeping interest rates low is the recycling of Gulf oil money through European Banks. Official estimates see this as negligible but industry suggests that it could be as high as 45% of the US current account deficit. The Gulf states are investing a lot at home but still they have too much cake on the table – the glut spills over into lower interest rates. I have even read that the US might almost be a net gainer from the higher oil prices given the effects these have in lowering US interest rates.
Savings rates in Japan and particularly China are amazingly high. Its part of the story.
So can we just attribute the large CAD to developing economies like China? If I save money I want it to go into low-risk investments. That doesn’t include the Chinese stock market. So is it just that a large percentage of the savings in China are simply being invested offshore because right now their financial institutions and communist-controlled industries are too high risk? Given that China is growing rapidly, it is presumably generating a lot of excess savings.
I am also a bear. (Just in case I was not explicit enough earlier).
I raised this point about a month ago when the Aussie dollar hit a value of 42 gold milligrams (well below it’s ten year average).
This Bear terminology is a bit odd.
Interest Rate Bear = thinks interest rates will rise.
Stock Market Bear = thinks stock prices will fall.
“So is it just that a large percentage of the savings in China are simply being invested offshore because right now their financial institutions and communist-controlled industries are too high risk? Given that China is growing rapidly, it is presumably generating a lot of excess savings.”
I’d like some clarification on this.
Am I correct in presuming that the huge funds at the disposal of the Bank of China are largely composed of the accumulated savings of hundreds of millions of Chinese mums and dads?
To what extent are these compulsory savings?
To what extent are these savings subsidised by concessional interest rates or by tax benefits, or some other cross-subsidisation.
If none of the above applies, what is the state of Chinese financial services. Do Chinese mums and dads have access to investment trusts that may invest directly in overesas assets?
If so, why do Chinese savers accept relatively low returns that accrue from BoC investment in US government paper?
Katz,
The Chinese put their savings in the bank like the rest of us did not so long ago. What’s more, used to be it was illegal for them to invest abroad, but, as their ever juggling policy makers have realized they’re not in Kansas anymore, I think this has been relaxed. For clarification, the order of operations is something like- certain copious quantities of Chinese production directed at the American consumer is exchanged for USD, which is converted back into renminbi, which is offset by BoC forex intervention that is paid for (or sterilized by) by the sale of govt. liabilities. This leads to the piling up of reserves (nearly all dollars no mind what the ministry of truth would have us believe). Mas o menos. The currency is not tradable, so its a little bit more nuanced than that, but that’s effectively how it goes.
Speaking of “excess savings”, the (US) Council of Economic Advisors just released its annual report. It has a section on America’s CAD entitled, “The U.S. Capital Account Surplus”. Whew! And I was beginning to worry that we wouldn’t be able to euphamism the problem away. Next on the agenda is the double plus good climate change.
Terje,
It make sense when you translate the interest rates to what is actually traded on interest rates – bonds. Interest rates rise = bond prices fall. Interest rates fall = bond prices rise. So:
Interest Rate Bear = thinks bond prices will fall.
Stock Market Bear = thinks stock prices will fall.
BTW – I would also agree that interest rates are headed up, just not as much as I think the PrQ believes. With consumer price inflation under relative control, only a small upwards movement may be needed to control asset price inflation.
When I was taught economics there were two definitions of recession.
The US which was two successive quarters of negative growth and the German one of one year of negative growth.
Now we are being told Europe was in a depression.
I would have thought that would need a minimum of 10& negative growth and I didn’t spot that in Europe.
on Japan they haven’t had to worry about deficit financing because bond yields were so low. With interest rates returning to ground level has anyone a scenario on what may happen?
Andrew,
Consumer price inflation is always slow to take off. Consumer prices are quite forgiving of monetary errors. They are a useful measure for long term monetary accountability but not so good as an interum target.
The RBA could slash interest rates in half tomorrow and consumer prices would not tell you anything about this change for a long while. In essence bread and milk would cost the same a month after such a change as they did a month before. However commodity and currency prices movements would immediately tell you something about this monetary change.
The RBA could create inflation for six months and then backtrack with deflation for six months and consumer prices would stay flat and tell you the RBA were innocent of any mistake.
Thanks. That is actually a helpful way to look at it. And in hindsight it is kind of obvious.
Regards,
Terje.
Terje,
Actually, this is not so formulaic as you make it out to be. Where the canary in the coal mine can be found for an overly loose monetary policy is a matter of where the additional investment is directed and, in those sectors, what resource was most capacity constrained. Many sectors of the economy use commodities as raw materials, but not all. Commodities likewise are not always capacity constrained (and history is littered with the carcasses of commodity producing companies that didn’t grasp this salient little nugget). Take for example the case where additional investment is directed at services like, say, I don’t know- software and internet companies- and where the number of unemployed workers in that sector were low. In this case, the dead canary could be found in the wages of software developers mine. In short, as surely as an optimizer finds a specious input, monetary excess finds a bottleneck, (and, as an apropos aside, there is nothing a speculator likes more than a bottleneck).
Of course, back in the real world, were the RBA to halve intrabank rates, it would precipitate a hemorrhaging of foreign capital and concomitant tightening of monetary conditions.
Majorajam,
Your analysis includes some good thinking. However commodities are globally traded. If Australia loosens its monetary policy then commodity prices will rise (in Australian dollar terms) irrespective of whether commodities are capacity constrained or not.
Under the example I gave, a price response in commodies would not be due to a supply problem with commodities. It would be due to a supply problem with our currency (ie oversupply).
If we look at big monetary mistakes from the past we see commodities gave the game away before consumer prices did. In the early 1970s when the US dollar was loosened we saw the price of gold rise. Then the price of oil rose. Lastly came consumer prices and wages. There was no constraint in the production of gold beyond the natural ones of scarcity that have always existed.
If you look at any nation that starts out in a state of price stability and then goes to high inflation (lots of examples from history) the commodity prices (as denominated in the nations currency) are the first to move. Consumer prices and wages are typically the last cab off the rank.
Regards,
Terje.
“on Japan they haven’t had to worry about deficit financing because bond yields were so low. With interest rates returning to ground level has anyone a scenario on what may happen?”
Japan’s public debt is extremely high. Their ageing population means public spending is likely to rise even in a sustained recovery.
Mine concerns abotu the US CAD focus more on the capacity of the Asian lenders to manage their debt portfolios than on any risk of US default.
” … certain copious quantities of Chinese production directed at the American consumer is exchanged for USD, which is converted back into renminbi, which is offset by BoC forex intervention that is paid for (or sterilized by) by the sale of govt. liabilities. This leads to the piling up of reserves (nearly all dollars no mind what the ministry of truth would have us believe).”
If Majorajam’s characterisation of the financial relationship between the Bank of China and Chinese savers and depositors is correct, then he is describing a most remarkable component in international finance.
The principals of the Bank of China are not subject to the normal disciplines of a commercial rate of return on their placement of invested funds.
This freedom of commercial discipline would allow the BoC to pursue a wider range of priorities, including long term objectives of grooming international financial conditions to achieve political-economic outcomes more or less regardless of commercial rates of return.
I’m unaware of any other instance of the availability of so much capital for any related extra-commercial venture.
If this is the case, has the BoC set itself a fool’s errand?
John, Terje, Majorajam, EP at LP,
I guess you bears have already stocked up on interest rate options. When your market-beating predictions come true, and you all become multi-millionaires, maybe you could spot a few dollars and buy me a beer sometime.
It seems we are back to the sustainability of the US CAD (and by inference, the Australian CAD) yet again. And the flip side of that, the Chinese CAsurplus, the oil states’ surplus liquidity.
There is a line of argument that says the US CAD is sustained by “dark matter”: unmeasured flows of services explicitly or implicitly provided by the US to the world. Liquidity (suitcases of $100 bills) insurance (low risk financial investment opportunities) and knowledge transfer (direct investment opportunities).
Raising interest rates might upset this particular apple-cart!
The last great unexplained economic puzzle while it was manifesting itself, was stagflation in the early 70s, at a time when a huge demographic bulge was intent on new household formation and the excessive demand that goes with it. Now that DINK demographic is busy socking away excess liquidity in all sorts of negatively geared, asset inflationary ways, rather than demanding a huge swathe of goods, albeit that those goods they are demanding now are held down in price by an indefatigable supply of cheap labour from places like India and China. My hunch is the low interest rate, high CAD scenario will continue for some time, until the beginning of the next decade. That’s when the eldest of the boomers hits the magic 65 yrs and the cashing out of assets begins in earnest. IMO that’s when we’ll properly understand where all the slack money went. At the moment a generation think they’re sitting on a healthy stockpile of future consumption for their unproductive years. Unfortunately that is only true if for every seller there is a willing buyer. Still if asset prices have another 8- 9% average compounding capital gain over say the next 4-5 years, you might be a little disappointed if you drop them now and turn them into interest bearing deposits on your high marginal tax rates.
Terje,
By what mechanism then will commodity prices levitate skyward? Telekinesis? This being a market economy, prices are set through the forces of supply and demand, as per the scenarios I alluded to. If you continue to cling to the belief that commodity prices are always the first to detect monetary excess, you ought to articulate that in terms of the effect of monetary excess on the real economy where those prices are determined.
Katz,
The BOC has gone to school on Japan’s experience of the 1980’s and taken away their own lessons- don’t be persuaded to strengthen your currency. Many economists support them on this. Clearly there is a substantial amount of institutional momentum built up, and very understandable concerns over the fragility of their banking system. No doubt the experience of the Asian crisis and its resulting political instabiltiy is fresh in the autocrats’ minds (and singular in their interests). However, the effect of their erstwhile policies is simply to put off the inevitable, and by so doing, to ensure that any adjustment will be that much more painful. It is also possible that they know all this and see it as a strategic plan to resettle the world order but very few outside the Bush administration have the requisite hubris for such a thing.
Joseph Clark,
I detect a tone of sarcasm. For a brief history lesson, many fund managers that judged the equity market overvalued in 1998 didn’t keep their jobs long enough to be proved correct. Many firms of the same belief, didn’t keep their assets. A guy I know who was adamant that the credit spreads on some of the toilet roll being promulgated through the system were bound to widen. He’s traveling now. All of this goes to show yet again that the quickest way to go broke is to bet against a speculative bubble. To quote Keynes, “the market can stay irrational longer than you can stay solvent”. To quote the Cube, “now let’s play big bank take little bank”.
Derick Cullen,
And if they told you that Wolverines made good house pets, would you believe ’em? The circumstances that “dark matter” is supposed to explain are mostly explicable by the coincidence of “exorbitant privilege”, the end of Bretton Woods, and the asset/liability shift in the NIIP over the last 30 years. Additionally, the latter doesn’t have the disadvantage of requiring massively increasing stocks of exported nebulousness, and does allow for a negative NII. This just in, we’re there to the tune of a few billion last quarter and it’s all downhill from here.
Majorajam,
Dark matter: There is a distinction between ‘measured’ and ‘measurable’. DC chose the word “unmeasured”. I assume DC’s choice of words is deliberate.
Asset bubbles: “All of this goes to show yet again that the quickest way to go broke is to bet against a speculative bubble. ” Not true in general (ie for everybody and all the time). Please provide conditions.
Strategy: To distinguish empirically between a ‘strategy’ and a ‘stuff up’ seems to me to be quite difficult; legislated lags in information access (classified information) compound the problem.
Central banks raise and lower short term interest rates when inflation and slump respectively threaten . Those are the only ‘fundamentals’ that effect rates. Long run rates are governed by fundamentals about as much as exchange rates are. Conventional wisdom and beauty contests are far more important. Notions about global savings gluts, recycling of gulf oil dollars, and so on, play an important part not because they make any sense, but because Trader A thinks Trader B thinks Trader C – and so on ad infinitum – believes them.
Ernestine Gross,
To distinguish between an ’argument’ and a ’piss take’ can also be difficult, I find empirically that is; the practice of deliberately erring on the side of the latter can be useful in this regard.
Majorajam,
I suppose you want me to apply your advice to your: “All of this goes to show yet again that the quickest way to go broke is to bet against a speculative bubble. �
Majorajam,
“It is also possible that they [principals of the Bank of China] know all this and see it as a strategic plan to resettle the world order but very few outside the Bush administration have the requisite hubris for such a thing.”
So I take it that you are sceptical about extra-commercial motives of the BofC, but you don’t rule it out as a possibility.
last time I heard the financial flows were showing households wee negative savers for the first time and the Corporate sector were net savers.
Is this still the case as it doesn’t back up Harry’s case.
As for China no-one with anyone brains would invest in the sharemarket because of corporate governance issues. These should be addressed in 5-10 years and then Chinese investors will invest domestically.
the largest investment goes into family companies at present
Katz,
The BOC’s motives are definitely extra-commercial. This is to say, they aren’t arbitrageurs and they aren’t engaging in standard commercial banking operations (with a negative asset liability carry, they’d be pretty poor bankers)- they are managing a currency peg. The nuance comes in because that currency peg is has allowed the US, European, etc. market share of Chinese companies to grow substantially. It has also, arguably, facilitated rapid growth in Chinese economy via that export growth (while it has less arguably stunted domestic demand). These are “commercial” considerations of a sort- but less so when you consider why breakneck economic growth is so important for the autocracy: keeping the people in the factories and away from the barricades.
Be that as it may, the currency peg untenable, and the BOC, the department of the Treasury and just about everyone else knows it. What that means is that the Chinese people collectively are likely to lose as much when their portfolio of reserves implodes (in the dollar debacle to come) as they could hope to profit from selling their wares in the interim. Hey, bum rap. So what gives? Who’s to say- maybe it’s the keeping people employed thing. Possibly they’ve deluded themselves into believing they can manage a dollar decline/renminbi increase. Then again, maybe they want to set the American roof on fire and watch the motherfker burn. Not that the collateral damage to the world economy wouldn’t cause a depression style bust in China. It’s Mutually Assured Destruction, monetary style.
To be perfectly honest, I don’t see that it’s possible that either the BOC or the Fed foresaw this situation and then moved to create it for some end game. This is just a case of wishful thinking, keeping your head down, putting one foot in front of the other and finding yourself at the end of a plank.
“This is just a case of wishful thinking, keeping your head down, putting one foot in front of the other and finding yourself at the end of a plank.”
Interesting.
Do your statements apply equally and contemporaneously to the BofC and the US Treasury Department? Or do ou detect some asymmetry. (Interestingly, as I type this Secretary of state Rice, currently in Sydney, is cautiously praising China for its adherence to commercial principles.)
Do you believe that this ” wishful thinking” involves hoping for a sustained commercial equilibrium or does it involve hoping for a circumstance which enables the pursuit of geo-political interests from an advantageous starting point?
In other words is this “wishful thinking” mostly characterised at any point by:
Negligence
Recklessness
Connivance (in the sense that both sides know that confrontation is inevitable, but neither side has yet detected an advantageous way forward that is also perceived to be prejudicial to the interests of the other side.)
Ernestine Gross: “Dark matter: There is a distinction between ‘measured’ and ‘measurable’. DC chose the word “unmeasuredâ€?. I assume DC’s choice of words is deliberate.”
I read a study a couple of weeks ago which set out to evaluate (and therefore measure the components of) the dark matter hypothesis. In general terms the evaluation found more questions and unmeasurables than answers and measures.
BUT it did put values on some components that currently are not included in conventional balance of payments/IIP stats.
I have yet to see a rebuttal of the evaluation by the dark matter proponents of the “unmeasurable” or a gripe about measurement estimates for the “unmeasured”.
Majorajam: “if they told you that Wolverines made good house pets, would you believe ‘em?”
It depends on what a Wolverine is, who “they” are, and whether I want a house pet!
In this case we seem to be searching for evidence for or against the sustainability of the status quo.
The evidence is playing the role of the housepet.
The Wolverine on offer is a hypothesis that the status quo is sustainable. Also on offer is the interest rate Bear, with the opposite view. Two wild north american animals about whose habits I know virtually nothing, and therefore can’t really say if the methaphors are apt or not (if they told you bears made good house pets, would you believe ’em?).
The “they” offering the wolverine as a housepet seem to be the commentators with vested interest in the status quo, not dispassionate observers. Interest rate rises are politically unacceptable both in the US and in Oz. Dark matter seems to be an ex post rationalisation of current policy settings, but does have some issues worth exploring.
The Bears need to confront the Wolverines on their own territory if they are to carry the day!
Katz,
I guess what I’m saying is that the point we have arrived at is one part providence and ten parts bad decisions, or better, decisions with unintended consequences. The US central bank has pursued its policy with a narrow mindedness that has led to the extremes of US profligacy we have seen. As JQ has said, monetary policy that leads to negative savings rates can’t be sound. Clearly incentives to save are nilch and incentives to borrow are legion (especially, incentives to borrow for the purposes of speculation). It’s only a slight simplification to say that their motivation for making the policy decisions they have made has been to rectify previous policy mistakes (like a gambler chasing bad bets). They are trying to rectify their having been too easy with credit in the 90s, by being still easier with credit (the Freud method of treating coke addiction- as with his, the biggest risk is patient mortality). This was called in 2001 by Paul McCulley of PIMCO, amongst others, “There is room for the Fed to create a bubble in housing prices, if necessary, to sustain American hedonism. And I think the Fed will do so, even though political correctness would demand that Mr. Greenspan would deny any such thing.”. How remedying to the fallout of an investment bubble? By creating still larger bubbles of course.
It’s not clear to the extent that this policy would have revived domestic demand without the massive injection of foreign savings. This is where China came in. If the world was not so keen to stockpile American paper then inflation and interest rates in the US would not have been so forgiving of this orgy of consumption. This could’ve meant a severe deflating downturn, or it could’ve meant a severe recession that eventually would work out all of the overinvestment and economic maladjustment of the 1990s. In any case, it would’ve meant that American demand was directed to a far greater extent at American production than is the case under a global monetary system in which dollar claims are “money”. That might’ve made things easier too.
In any case, the Chinese had different policy aims which I have stated previously- in particular managing their currency value and growing their economy. From 1998, and largely before then, their paranoia was with a speculative attack on the yuan (hence restrictions on locals investing abroad). It’s taken them some time to come around to the idea that they’ve actually got the reverse problem, a case study for which has been Japan. That example has led to the extreme degree of caution that characterizes current policy- that and the fact that their current policy has encouraged denial because of its allure. I mean, why rock the boat when you’re economy is going great guns, your exports are taking over the world, etc. etc.?
Wishful thinking means believing the apologists that delaying corrective action means never having to take it (or never having it forced upon you). “Dark matter”, “excess savings” baloney are quintessential examples. The Chinese bureaucracy is likewise probably furnishing all kinds of humdingers, replete with CYA exercises and clothes pinning their noses for passage up the channels.
The first two in the US. It’s like that part in a Cohen brothers movie where everything gets ratassed, except our guys are sitting on their hands while they tend to go off the deep end. As I say, I don’t have much insight into what’s going on in China, (although do note their moves to secure energy resources with their burgeoning purchasing power), but I wouldn’t be surprised if there were some strategizing around real outcomes, ie those that weren’t unrealistic about their illusory wealth (as the Chinese tend to fall under the “reality based community” category the Bush administration so derides).
DCatwork,
The challenges to “dark matter” (which by the way has no need for the snazzy title, save its marketing) that have been articulated to date are pretty damning. The passage of time and the coming to light of even less flattering data should finish it off. As to what has already been noted, dark matter, as it’s been “measured” (i.e. as a plug for an equation deficient in terms and parameters), it is highly unstable from period to period. Bounces around like a pogo stick. Are we to believe that the ‘expertise’ of American corporations or whatever is supposed to explain the existence of this return generating goo is so variable? It’s silly. Furthermore, the authors of the study neglect to incorporate asset liability mix issues as if all assets should yield the same amount regardless of their risk profile (convenient, considering the US assets are dispropotionately risky while most of its liabilities are parked in extremely low returning debt instruments).
The work does pass for serious academic work, because it has all the trappings and the authors are from Harvard. But a cursory peek beneath the veneer reveals it for what it is- a pretty sorry excuse (especially as compared to those serious studies that have actually gone through the trouble to examine the dynamics of the NIIP- in particular pre- and post-Bretton Woods).
PS Bears are not strictly the providence of North America- see Russian and Chinese national animals…
If you make a policy decision that devalues your currency it will be noticed in international spot markets first. That means currency markets and commodity markets. The supply and demand dynamics for your currency can not be quickly reflected in a domestic office lease that gets renegotiated only every few years, or in any number of other nominally fixed costs like salaries. Although in the domestic market it can create ultimate winners and losers amoungst the contract counter parties.
Commodities would not be a useful indicator if they were bound by 5 year supply contracts at a contracted price. And while sometimes they are there continues to be an active spot price that is more responsive to change.
So the answer is not Telekinesis. It is supply and demand.
The point is not that commodities are magical. It is that a lot of domestic prices are locked in at a nominal level by contracts and other institutional commercial forces. They are not free to change due to an unexpected shift in the value of the denominating currency. And such arrangments only endure because on aggregate the central bank manages to make enough mistakes in each direction such that the commercial system can absorb the shocks without fracturing.
When the central bank makes mistakes with a bias in one direction and with a magnitude that is not easily anticipated then you get the wage price spirals like we had in the 1970s. Painful ongoing commercial renogotiation of supply contracts that involve a lot of heartache and in themselves consume a lot of time and energy.
Terje,
The monetization of capital stock does not “devalue the currency”- central banks do not possess such magic wands. Central bank monetization of capital stock pumps money through the economy via lending institutions. These institutions lend to productive enterprises whose expantion or establisment creates demand for labor, land and commodities. These institutions likewise lend to individuals whose purchase of a home or a car create demand for finished goods, land and labor. To the extent the demand created from this lending activity overwhelms the supply of these various items, their price rises. To the extent this happens on an aggregate level, we call this inflation.
This is the action of the real economy where prices are determined. The nebulous mehanism you describe “devaluing the currency”, does not resemble the actual way in which monetary dynamics work.
PS Terje, as addendum to my rejoinder, there is also a spot market for finished goods, and these days with just-in-time inventory practices, a rather large one.
I read recently (in the economist?) that the world’s leading economies are all growing simultaneously and this is unprecedented. Is it overly pessimistic of my active imagination to picture a bubble of global proportions? (Start growing vegetables at home just in case and pickling the surplus?:)
Linked to this is the other unprecedented level of foreign currency purchases by developing countries (incl. domestic debt to secure international currencies) and it seems we have a situation of developed nation record debts and expansion linked to developing nation efforts to improve security/resilience. Some activists have said this is another case of developed country growth at developing country cost but this seems overly simplistic. Still, taken as a whole, it seems dangerously unstable to me.
The economist also wrote an interesting piece on the local circulation of money coming out of over-inflated real-estate prices in numerous cities fuelling over-inflated local economies, this being a wide-spread issue at present (explaining Germany’s slow growth as it real-estate prices were realistic).
Thanks for your detailed posts Majorajam.
This passage interested me:
“Clearly incentives to save are nilch and incentives to borrow are legion (especially, incentives to borrow for the purposes of speculation). It’s only a slight simplification to say that their motivation for making the policy decisions they have made has been to rectify previous policy mistakes (like a gambler chasing bad bets). They are trying to rectify their having been too easy with credit in the 90s …”
Some time ago on this blog there was some discussion about US pension funds:
https://johnquiggin.com/index.php/archives/2005/07/21/one-foot-on-the-platform/
” Katz Says:
July 22nd, 2005 at 3:57 pm
“This is mere speculation, but is it possible that the trust deeds of certain pension funds require investment of a proportion of the fund in government paper? If so, this my help to explain apparently counter-productive investment decisions of private investors.”
“stephen bartos Says:
July 22nd, 2005 at 4:16 pm
“Katz has a point – not only defined benefit and 401 (k) deeds or terms may specify this, but there is also federal legislation (see http://www.dol.gov/dol/topic/retirement/fiduciaryresp.htm ) requiring the trustees to be prudent and diversify their investments which in the past has always been taken to mean a mix of stocks, bonds and real property.
“There are also other reasons for apparently irrational behaviour in this case …”
“Given that we are talking about the Baby Boomers, proportionally the largest and most prosperous generation in history, the sum of their individual investment decisions are important for the shape and health of the whole sphere of investment (and public policy).
My questions:
1. How much wriggle room is there for tweaking 401 (k) regulations etc., in favour of greater incentives for compulsory savings?
2. How important are these regulations for underwriting public finance, perhaps at the expense of commercial returns for the pensions accounts of prospective retirees?
Katz,
There are ways to better incentivize savings, and 401(k) legislation could be one of them. I fear however the problem is far greater than that and has everything to do with the financial institutions that are, like drug dealers, cramming credit down consumers’ throats (a particular favorite of the credit card company is the commercial with the dollar bills wafting down from the sky- “the more you buy, the more you earn“). I applied for an increase on my credit card limit a while back, in passing- figured, why not? I certainly regret that decision, and so does my mailman. Piles of advertisements for new cards and loans now pile in daily. People lend for anything against everything here- lend against your paycheck, your tax return, your welfare check, your stock portfolio, your house. You can borrow to fund everything from $30K annual tuitions to breast implants. A growing lending business is set around consolidating people’s debt to ward off bankruptcy- going bankrupt? A loan ‘ll fix you right up! It’s the Alan Greenspan school of debt management.
The (requisite) compliment to all this hedonism are the capital markets where the resultant mountains of bog roll get distributed with ease (and plenty of fees). The institutional landscape there has become completely corrupted by the culture of greed and one of the casualties has been risk aversion. There are all manner of terrible lending practices going on, with the precarious receivables being set into securitizations, which all manner of investors (especially hedge funds) buy without a care in the world (usually with leverage and plenty of it). The market for “credit derivatives” which didn’t even exist ten years ago now has a notional amount outstanding of over 16 trillion USD(@!&*#!). This has led to the absurd situation where bankruptcies are triggering spikes in the prices of the bankrupted companies debts (and huge numbers of unsettled contracts because the thing is stuffed in some hedge fund manager’s desk). And for this, all these people are getting rich. Very rich. Goldman made nearly 3 billion dollars, last QUARTER!! All of the banks are coming out with record profits after record profits. This as the automotive and airline businesses are going out of business. A testament to the winners and losers of the finance game.
So, long story short, we’ve embraced risk, profligacy, and totally abdicated responsibility. 401(k) reform could be a part of some solution to this malfunctioning malevolence, but it is certainly not sufficient. Be that as it may, these things have gotten so bad precisely because we’ve become so criminally negligent. It stands to reason we won’t wake up on the wrong side of the bed some morning and take up the banner of responsibility. When all this ends, it will end badly.
Regarding your second question, I am not aware that pension funds or 401(k) plans have to devote certain monies to US treasuries or other governement paper. My personal 401(k) assets for one certainly aren’t.
Majorajam, Katz,
The phenomenon Majorajam describes started with the financial market deregulations in the 1980s. There are historical precedents but lets put these aside for the moment. Financial market deregulation was part of ‘micro-economic reform’. The one underlying assumption of this reform process, which struck me at the time, was that theoretical results, which hold for models of ‘competitive private ownership economies’ without financial markets, extend to models of economies with financial markets. But, in contrast to earlier episodes (ie prior to 1950s), there was new theoretical knowledge available at the time of ‘micro-economic reform’, which gave a clear message that this is not so. The paper I have in mind is Roy Radner (1972) theoretical model of a sequence economy. The model is identical to the Arrow-Debreu model (‘competitive’, ‘private ownership’) except that the market structure is different. Radner assumed there is a sequence of spot and future markets of commodities and financial contracts. The system turned out to be ‘unbounded’ because there is no natural limit on the shortselling of securities. That is, there is no natural limit on borrowing. ‘Rational expectations’, as defined by Radner, didn’t solve this problem either. Radner’s paper was published in Econometrica – a journal which surely cannot be described as ‘obscure’.
Wishful thinking seems to have driven the policy changes rather than ‘hard work’ to think through implications of the Radner paper (and subsequent papers) for institutional changes. Is this ‘negligible’ and if so on whose part?
I can’t answer this question, but I believe the dissemination of knowledge and the cross-fertilisation of empirical, theoretical and historical knowledge was hampered by the creation of Commerce Faculties and the creation of Finance departments within Commerce Faculties instead of Finance departments in Faculties of Economics. Cross-fertilisation as indicated is, I believe, essential to gain ‘insights’ from the rather abstract models I am referring to. These models do not lead to prescriptive conclusions. They are said to provide ‘insights’. It seems to me such events can only occur within the context of other information.
The micro-economic reform was a structural reform, albeit resulting in a structure that differed from that some might have ‘wished for’. IMHO, it is meaningless to compare aggregate savings ratios from national accounts before the ‘big bang’ with those since then. Changes in the ‘commitment to future savings’ (ie debt obligations) might make more sense.
That’s the easy bit. The difficult question is, how do commitments to future savings relate to ‘freedom’ – a term which pops up quite regularly on this blog-site. Moreover, did the populations know enough about the nature of the structural changes such that their consent could be said to be ‘voluntary’?
Correction: Please replace ‘negligible’ with ‘negligence’
Actually Ernestine, liberalization of the financial markets goes back well before the 1980s. Hedge funds have been around since the 50s. Mortgage passthroughs, money market mutual funds, certificates of deposit, etc. were all introduced in the 70s. Of these, the first two are notable for their role in the evolution of the unwieldy financial system that has followed (while the latter two largely laid the groundwork for some of the banking reforms of the early 1980s).
The point is not that anyone could have or should have foreseen what the results of liberalizing legislation was, but that they should’ve understood the massive scope for unintended consequences, (and understood that there was no reason to believe such consequences would manifest themselves over a calendar year), and on that basis, they/we ought to have been vigilant. Financial history has provided many a story from which lessons could be gleaned and worrying developments signposted. By inference of policy failure, all of this sad history has been forgotten. Largely as a result, we are doomed to repeat it.
PS your point about savings rates pre- and post- “Big Bang” (a historical event pertaining to the UK) is lost on me. Any shortfall in production relative to consumption plus investment must be met by external financing activity, and all financing activity leads to “commitments to future savings”, no matter its structure (equity or debt). So the distinction you are trying to make regarding national savings rates, whatever that may be, is highly unclear.
PPS Links to cited papers, where available, are always appreciated.
Ernestine
I found very interesting your discussion of the apparent disconnect between “new theoretical knowledge” (Radner, 1972) and the major microeconomic reforms in the US during the 1980s. As you tell it, Radner had a very cautionary tale to tell proponents of secondary financial markets. I also appreciate Majorajam’s caveat that these markets were emerging before the 1980s, a point which Ernestine did concede.
I take Ernestine’s comment:
“Wishful thinking seems to have driven the policy changes rather than ‘hard work’ to think through implications of the Radner paper (and subsequent papers) for institutional changes. Is this ‘negligible’ and if so on whose part?
“I can’t answer this question, but I believe the dissemination of knowledge and the cross-fertilisation of empirical, theoretical and historical knowledge was hampered by the creation of Commerce Faculties and the creation of Finance departments within Commerce Faculties instead of Finance departments in Faculties of Economics…”
To mean that, at least in the case of Reaganite microeconomic reform in the 1980s, the battle for the intellectual high ground (won in this case by Commerce factulties over economics faculties) was, if not determinitive, at least very important, in swinging the Reagan administration in favour of the reforms you are discussing.
The comments which follow may not apply to these discussions. If not, I’d be pleased to be corrected. My area of expertise relates to Reaganite taxation policies and their budgetary consequences (growing deficits). Director of the Office of Management and Budget David Stockman attempted to rein in Federal expenditures but found himself utterly outmanoeuvred by Defense Secretary Casper Weinberger who used trivial arguments designed to pander to Reagan’s predelictions. In other words, technical argumentation had little to do with the resulting mismatch between revenue and expeniture.
Now clearly at some level there is often a concordance between administrations and current theoretical and academic thinking. But often only distant echoes of the academic or theoretical imputs are heard when a proposal is thrashed out at the executive or cabinet level.
Thus, in the case of Radner, at what administrative level of public administration in the US, if anywhere, was there a concordance between scholarship and public policy formulation?
If Radner were seriously considered at all, at what points in the policy formulating process did his voice diminish from one considered worth heeding to a mere whisper in the wilderness?
Or are you saying that the battle was lost in the internal turf wars of academia, long before public officials began formulating policy?
Katz, Majorajam, I find this discussion very interesting and I’d like to reply over the week-end when I have a little more time.
Btw, just came across a quotation I have no choice but to share:
“Several things can go wrong in a [CDO] deal and it will still be AAA [rated]. But then you get one more event and boom!” -Terri Duhon, B&B Structured Finance
as reported in Tuesday’s FT, US edition. It’s the most succinct description of modern credit creation I have come across. Priceless.
Katz,
Thank you for your considerate reply.
Perhaps there is a similarity between the example you gave from your area of expertise – Reaganite taxation policies and their budgetary consequences, involving David Stockman and Casper Weinberger – I can’t be sure. I can’t be sure because I don’t know Stockman’s arguments and, perhaps more importantly, your example seems to me to relate to macro-economic policy that involves values of parameters, assumed to be under the control of the government (eg revenue and expenditure) of a given system of equations that represent a particular macro-economic theory, while my example refers to the financial markets aspects of ‘micro-economic reform’. Micro-economic reform involves changes ‘in the rules of the game’ as a result of legislative changes on who is allowed to do what, when, and under which conditions. Changes in ‘the rules of the game’ amount to more than changing parameter values of a given system of equations. It amounts to different ‘structural relationships’ – a different set of equations, if you like, and different variables. While the analogy to a ‘system of equations’ isn’t quite satisfactory, it may suffice here to illustrate the difference.
“Now clearly at some level there is often a concordance between administrations and current theoretical and academic thinking.� I would agree that both, macro-economic policy and ‘micro-economic reform’ are influenced by ‘current theoretical and academic thinking’. The question is, what do we mean by ‘current theoretical and academic thinking’. Do we mean that which is most widely promoted and hence influential or that which exists and can be shown to constitute something new but it is not widely known? As for ‘micro-economic reform’, I would argue that the ‘current thinking’ in the 1980s (a little earlier in the USA) was a rehash of 19th century thinking, which, to an important extent, had been made precise by the Arrow-Debreu (McKenzie) model, published in the 1950s. The matching macro-economic policy prescription would be some version of the gold-standard.
Professor Roy Radner’s (1972) work belongs to general equilibrium theory that is concerned with ‘competitive private ownership economies’. I should think it would be considered basic research in Economics. The methodology used is analytical and non-prescriptive.
Perhaps I did not make clear what I mean by Radner’s model contained a clear message. I am not saying that Professor Radner was not heard. I don’t know whether Professor Radner and others who work in this area voiced opinions on ‘micro-economic reform’ or not. I don’t believe I need to know whether Professor Radner was consulted and what his advice was. It is the sequence of theoretical models which contain the message.
“Or are you saying that the battle was lost in the internal turf wars of academia, long before public officials began formulating policy?� You may appreciate that I don’t have enough information to answer this question to any satisfactory extent. However, I can offer the following observations.
i) Separation of Finance from Economics. There are a few texts which treat the theoretical content of Finance within the context of Economics and these books were published in the late 1980s, about 10 to 15 years after Finance developed into an applied discipline in the USA. In my experience, these books are not widely read. About two years ago, I went through a pile of recently published Finance texts that are widely used. None of them contained the important results since Radner (1972). On the contrary, one text, which became quite popular, went the other way. That is, the applicability of theoretical results, which are conditional, to ‘the real world’ was ‘sold’ (I can’t think of a better word) by finding an empirical example for which the numbers turned out to match the reduced form equations.
ii) My comment on ‘micro-economic reform’ was not restricted to the US. I mention the ‘big bang’, which Majorajam correctly related to regulatory changes in the U.K. (in 1981). But the term ‘big bang in finance’ has since gained currency. There is talk about ‘big bang in Tokyo’ and in Germany. But, when following the ‘big bangs in finance’ around the globe, the evidence is that the assumption, underlying the ‘big bangs’ (self-interest and competition is a ‘good thing’ in the markets for physical consumer goods, such as sausages, cars and shoes, it therefore must be a good thing for financial markets) has led to a series of ‘unanticipated consequences’.
iii) The site http://www.cfr.org/publication/3515/germanys_big_bangtranscript.html contains a ‘nice’ record of the promotion of changes in the rules of the game in financial markets in Germany. The site http://www.businessweek.com/2001/01_02/b3714251.htm reports on growing concerns. And, the site http://www.manager-magazin.de/geld/artikel/0,2828,186368,00.html announces the end of a dream of riches for many (This article is so plain that the translation function is likely to result in comprehensible stuff.)
iv) Dissemination of knowledge. Campbell Inquiry followed by the Martin Inquiry into the Financial System in Australia (1981) http://www.rba.gov.au/Education/FinancialSystem/regulation_of_financial_system.html.
So, I suppose you are right, history tells the story.
Majorajam,
Thanks for your reply. You asked for a web-site reference. The journal Econometrica is available electronically but not free of charge.