Recently in money, interest, prices Category

A common theme in much of the political rhetoric during both this election cycle and the last four years has been complaining about China as a "currency manipulator." The truth is that China has kept the value of its currency artificially low, thereby increasing the cost of U.S. exports to China and decreasing the costs of U.S. imports from China. Just like a coin has two sides, it is clear that changes in value of the Chinese currency simultaneously helps some groups while it hurts others. The novelty is that much of the media and political focus has been on the U.S. groups that get hurt by this policy, while stories about the benefits are neglected. And it is likely that the benefits outweigh the costs--possible by a landslide.

Time to repost the most recent Deseret News article from yesterday.

As many observers expected the U.S. Federal Reserve began a new round of quantitative easing this fall in an attempt to stimulate the economy by increasing the supply of available money.  As I discussed at the beginning of August, there is no fundamental difference between quantitative easing and the Fed's normal open market operations.  In the latter case the Fed buys U.S. Treasury securities on the bond market and in the former case it buys other non-traditional financial assets.  In both cases, however, it pays for these purchases by creating money.

This article was published in the Deseret News on Tuesday, September 6th.

Money in most countries in the world is issued by a central bank that is granted the monopoly right to issue the nation's currency.  In the United States the central bank is actually a system of 12 regional banks that are controlled by the Federal Reserve Board of Governors in Washington, D.C.  The Federal Reserve System, or Fed, is legally a private enterprise and is owned by member commercial banks.  Effectively, however, the Fed is 4th branch of the government.

The members of the Fed's Board of Governors are all appointed by the President of the U.S.   One of these is selected every four years to serve as the Chairman of the Fed.  Currently the Chairman is Ben Bernanke, who served as a member of the Board under the previous Chairman, Alan Greenspan.  While the Fed is legally owned by the member commercial banks, these banks have little direct input into the governance of the Fed these days.  Member banks elect six of the nine members of each of the 12 regional Federal Reserve Banks board of directors.  This board of directors, in turn, selects a president to run the regional Fed.  In practice, the members of the board and the presidents are chosen in Washington by the Board of Governors.

The Federal Reserve has a great many duties.  It was created in 1914 primarily to serve as a lender of last resort and address a longstanding problem the U.S. had been experiencing with bank runs.  Prior to 1914 the U.S. had no central bank.  There was a brief period early in U.S. history where the First and Second Banks of the United States were chartered and then disbanded, but these banks served mainly as depository and lending institutions for the U.S. government and not as modern central banks.  During most of the 19th century and up through 1913, the U.S. had no central monetary authority that would step in and loan funds to banks that were hit with bank runs.  As a result the nation experienced periodic bank panics where runs would occur on several banks simultaneously and led to nationwide financial crises.  The Federal Reserve System was set up to help alleviate this problem.

The Fed has many other duties as well, including regulatory control over banking, facilitation of check clearing and interbank transfers, and maintaining accounts for many U.S. government agencies.  The most important role the Fed plays, however, is as a creator and controller of the U.S. money supply.

One of the reasons the Fed is structured as it is, is to insulate it from political pressure.  The Fed is largely independent of the Federal government.  Day-to-day operational control is in the hands of the Board of Governors and the governors are appointed to very long terms of 14 years.   If the Fed were more susceptible to political pressure from the president or congress they would be more likely to use monetary policy to finance government spending.

Over the years since 1914 there have been period calls by people to disband the Fed.  The main reason that this has never been done is because the alternative is undesirable.  If you are one of those who is not pleased with the way congress has handled the U.S. budget, imagine what things would be like if congress was also in charge of the money supply.  By insulating the Fed from political pressure, we are able to maintain a much lower rate of inflation than we would otherwise have.  If congress were to take direct control of the U.S. money supply you can be assured that they would quickly give in to the temptation of simply printing whatever money they needed for their desired level of spending.  Delegating control to a central bank that is insulated from political influence makes it difficult or impossible to give in to that temptation.

While having an independent central bank does alleviate some problems, it creates others.  One argument against a central bank is that it is undemocratic.  Monopoly control of the money supply is placed in the hands of officials who are not answerable directly to the public.  This often leads to the perception that the money supply is in the hands of special interests who do not have the best interests of the public in mind.  In some countries and in many historical cases this perception is justified.  It is not so justified in the case of the Fed.

There are alternatives to the Federal Reserve System that are democratic in nature but not prone to inflation.    For example, from 1716 to 1845 Scotland had a free banking system of sorts, where two competing central banks each issued currency.  More generally, free banking would allow commercial banks to issue whatever currency they desired and they could back this currency however they wished as long as the backing was truthfully disclosed. Competitive free banking would allow some banks to issue monies backed by gold or other commodities.  Consumers would be free to choose what type of money they wished to hold and sellers could choose what types of money they would accept as payment.  One interesting new technological option that has many of the aspects of free banking is BitCoin, an online payment system that settles payments on a peer-to-peer basis without using a bank or even a currency controlled by a central bank.

Free banking is unlikely to be adopted as official U.S. policy anytime in the near future.  In the meantime, the Fed will continue to control the supply of dollars.  Despite its shortcomings, the Fed is a much better arrangement that most of the alternatives.

Why Prices are Important

Runway Inflation in Hong Kong: Miners could teach infrastructure planners a thing or two
from the Wall Street Journal, July 14th, 2011

Should the Hong Kong airport be expanded to include a new 3rd runway at a cost of $17.5 billion?  Why not let the market decide?

"...we must figure out how much ... is "enough" over the long term as we also tailor our demand to resource availability at any given moment. This is easy, relatively speaking, for miners and nearly impossible for airport planners because miners have something the planners don't: a market price for their product and for their capital.

"In the airport context, putting a price on capacity would mean fully liberalizing the air traffic market and then auctioning off take-off and landing slots. Hong Kong could adopt a unilateral open-skies policy to welcome any and all comers, and also remove the remaining restrictions on so-called fifth-freedom traffic rights that would allow a carrier from Country A to fly between Hong Kong and Country C. Meanwhile, auction take-off and landing slots to the highest bidders, each slot being valid for some reasonable number of years.

"Then, let the airport operator figure it out. Privatize the Airport Authority (currently a government body), and see if the bond market thinks its expected income from slot sales will be sufficient to cover the capital expense of new capacity. Just like a mining firm."

The price mechanism could be implemented in lots of places that currently it is not.  This is just one good example.

USD weathers blizzard

The US Dollar has done well against the Euro with the impending bankruptcy of the PIIGS.  It's also holding up against the Blizzard of 2010:

After getting a B.A. in economics from BYU in 1998, I went to work for Thredgold Economic Associates for two-and-a-half years. Jeff Thredgold took an unconventional route to becoming a Chief Economist for major banks. He came up as a bond portfolio manager. As such, I always felt like he had very good intuition for what was happening in markets on a day-to-day basis.

One of Jeff's most insightful arguments is one that he has been making for as long as I've known him. In this week's issue of his weekly economic newsletter, The TEA Leaf, Jeff drives the point home, yet again, in compelling fashion.

"What [Ron] Paul and other Fed critics don't understand is that the Federal Reserve has an overseer...something or someone IT has to answer to. That something is the American bond market."

Why do the poor pay more?

| 1 Comment
A good friend (Suzanne Bates) pointed me to this provocative and insightful article in The Washington Post from May 18, 2009 entitled "Poor? Pay Up." The article carefully documents many of the ways in which the poor pay more for the same goods and services that higher income households consume. The clever opening line is, "You have to be rich to be poor."
The Consumer Price Index (CPI) numbers for June were released today, and the initial press was that inflation was higher than expected. The inflation hawks would point to today's numbers as an indication that the massive injections of money by the Federal Reserve and Congress are starting to increase prices toward the great inflation they have been predicting. But don't go there so fast. Headline CPI inflation increased by 0.7% in June, the highest monthly increase since June 2008. However take a look at the figure below of the headline CPI percent change over the last 12 months.

How would interest rates be different if we all "aged" like Benjamin Button?  The movie made me wonder if consumption and youth might be complements--would you rather have the red convertible at 56 or 16?  Would rates be different still if our minds (and not just bodies, as in the movie) aged in reverse?  For example, we seem to get more risk averse as we grow older.
The employment numbers that came out today show that the economy is still in the process of gearing down. The normalized peak plot below shows U.S. employment levels as a percentage of their peak level in the last 14 recessions back to the Great Depression (dark black line). Employment in our current recession (the heavy lime green line) is 4.7% lower than its peak back in December 2007. The only recession that looks like this since the Great Depression is the post WWII reduction in spending in 1945. It looks like the recession still has some room to run. Similar comparisons of GDP and stock prices are in my post from a month ago.

The U.S. CPI numbers came out today (see chart below). A lot of noise was made last week about inflation worries starting to surface in yields from the auctions of U.S. Treasuries. This WSJ piece from last Thursday posited that the higher yields might be signaling inflation in six-to-nine months. Jim Hamilton had a great analysis two weeks ago explaining why we should probably still be more worried about deflation than inflation. I had a post a few months ago debunking some of the inflation rhetoric from the far right. Below is a chart of the core CPI (overall prices minus food and energy) in terms of year-over-year percentage change. We're definitely not in high inflation territory yet.

The Cleveland Fed has put up a site that shows in glorious graphical detail how the Fed's new policy of quantitative easing has developed and grown over the last eight months. The light orange area in the graphic below represents traditional monetary policy. You can navigate through different date ranges and different detail views using menu bars across the top and left sides of the graph. They also include dowloadable source data, brief explanations of the data, as well as a link to a more detailed article.

Thanks to Mark Showalter for pointing me to this great resource, and thanks to the Cleveland Fed for the most simple, beautiful, and interactive display of economic data that I have seen yet. Here's to central bank transparency!


Ford tough, GM rough

With bankruptcy plans finally announced for GM today, I thought it would be nice to revisit a previous post. On December 20, 2008, I posted an article entitled, "Ford tough," in which I praised Ford's decision not to accept government bailout money. I said the following:

The proposed auto bailout has been one of the most discouraging pieces of government action since the beginning of our current financial crisis. Ford's decision to stick with the market is one of the silver linings in the ominous clouds of the global recession. Ford does, of course, run the risk of not beeing able to compete in the short-run with GM and Chrysler and their new influx of government cash. But that's not really where the competition is anyway. The real contest is to see which U.S. company will be able to compete with their Japanese counterparts. I think the market will look favorably on Ford's long-run positioning.

Just look at what has happened to the stock prices of Ford and GM since December 20, 2008. The market has spoken.


Short the Government

| 1 Comment
I've been thinking that a decent investment strategy might be to go short anything the government gets heavily involved in (think housing and banking).  Of course timing is everything here and it's hard to know when the bet will pay off (will health-care fall apart sooner or later?).

Well, I just came across a fund that is taking a like-minded strategy.  The fund is called the Congressional Effect Fund.  The fund's basic strategy is to capture the above average returns on the stock market on those days when Congressmen are on vacation.  A great idea and much easier to implement than my strategy.  The average annualized return to the S&P 500 when congress is in session (1965-2009)? 0.31%.  The average annualized return to the S&P 500 when congress is out of session?  16.15%.

Hat tip to DoL'er (and fellow Georgian) Frank Stephenson.

Which bailout plan now?

Mark Thoma writes:
"In addition, as time has passed and prices have fallen, solvency issues have come to the forefront - the balance sheet problems are no longer hidden by overpriced assets - and the solvency problems must be addressed directly. That means that if there is no separate program to provide an infusion of capital, simply removing the toxic assets from the balance sheets through government purchases at current prices - prices so low that the banks are insolvent - won't be resolve the problem."

If the prices of "toxic" assets has fallen overtime, isn't this evidence of a very low true value of the assets?  The original argument was that a panic had temporarily suppressed the prices of said assets and that the government only need take hold of these assets until prices rebounded.  From what I can tell, the credit crisis is not as severe as last fall.  So if the price of assets is lower now and the credit crisis not as severe, shouldn't one conclude that the continuing fall in these asset prices is due to a deterioration in the fundamentals of those assets?

I couldn't resist posting and responding to this Glenn Beck video (1/29/09) because I know that he has been advised by multiple parties against the arguments that he is pushing. We all should have reason to be worried about the economy, but not for the reasons Beck is trumpeting.

Banking Panics

Some sentences I'll be thinking about over spring break (from Gary Gorton's "Subprime Panic"):

"How do banking panic's come to an end?  Some history is instructive.  During the 19th century, in the USA, the solution to banking panics was the institution of the private bank clearinghouse, which evolved over the century to the point where banks' response to panics was fairly effective... This system was abandoned with the founding of the Fed and the subsequent adoption of deposit insurance.  These were institutions aimed [at] preventing a panic from happening.  But they are not equipped to solve the information problem that arises if a panic does happen.  Clearinghouse loan certificates attacked the problem directly."

More unhappy data

Rick's been posting some disturbing data.  As much as I'd like to cheer things up, I can't get over what's been going on in the U.S. Stock markets in the last couple of days.  Check this out:

I feel really bad for those nearing retirement.  But I guess we have to remember that this is a huge transfer to those of us in the younger generations, not a "destruction of wealth" as properly defined.

Related to these recent numbers, Bryan Caplan posits an excellent question:
"If the government had followed a laissez-faire policy for the last six months, and output, employment, housing, and financial markets stood exactly where they stand today, what fraction of people would conclude that 'Events decisively prove that laissez-faire is a disaster'?"
The only significant policy difference between the current period of global recession and the Great Depression is monetary policy and financial market intervention. The government spending part is looking like it will be the same. The annual deficit is projected to rise from its current 2008 level of just under 3% of GDP to potentially 10% of GDP in 2009. However, this rise in the deficit is also similar to the early 1980s and 2000. (The big blip is World War II.)


More mean reversion?

I posted a graph a while back showing how home prices for the 100 years leading up to the mid 1990s showed no growth, but fluctuated around a mean.  Seems home prices are heading back there now. 

And the fall in the price of oil from mid-2008 levels ought to put a lid of the "peak oil-ers".

So maybe mean reversion is the best way to model and forecast home and commodity prices.  Is it also the best way to forecast the growth in the value of equities?  Mankiw posts the following picture:


Today's CPI: Missed it by that much

Alright, I stuck my neck out yesterday and predicted that the core CPI numbers released today would show a decline of between -0.1 and -0.4 percent, based largely on the Fed minutes from last month. Well, the final tally is no change, although the exact amount was a decrease of -0.015 percent. That is virtually zero, but it was a decline. This just pushes the deflation watch forward another month. I still think that the core CPI is a bellwether as to whether the economy is responding to all the stimulus being poured in. And the previous three months do now rank as the biggest quarterly decline in prices since the late 1950s, and probably since the Great Depression. Stay tuned.

Every Breath You Take

| 1 Comment

One of the best economics music videos out there:


I know it's been a while since this first made the rounds, but it's still a great piece of work. Thanks to a reader for suggesting we archive it on the jokes page. 

For more (and some more recent) work by Columbia B-school students, go to

Three main risks to the economy emerged from the minutes of the December 15-16, 2008 meeting of the Federal Reserve's Federal Open Market Committee (FOMC)--Decline, Deflation, Division.
The December 2008 Journal of Economic Literature published the 105th annual list of doctoral dissertations in economics published between July 2007 and July 2008. This is really just a shameless plug by Rick and Jason for our two of favorite entries in this year's JEL list. The first is entitled, Three Essays on Openness, International Pricing, and Optimal Monetary Policy, and the second is entitled, Essays on Dynamic Political Economy.

Some positives in global forecasts

The Globalization and Monetary Policy Institute (GMPI) at the Federal Reserve Bank of Dallas just released its most recent International Economic Update today. One bright spot in this report comes from the chart below that forecasts that the global economy (as represented by the U.K., Euro-area, and Japan) will return to positive growth in the second quarter of 2009. I think this forecast, taken from Consensus Economics, might be a little overly optimistic.

After the decline of the core CPI of -0.1% for October 2008 (reported last month), I have been telling students and associates to watch out if we had another decline in the core CPI in November. Two consecutive declines in this more stable measure of consumer prices (it excludes the volatile food and energy components) would signal an increased likelihood that a destructive deflationary spell is upon us. The Bureau of Labor Statistics reported today that core inflation actually increased by 0.02%. This is a very small number that is practically zero. But at least it is positive. In keeping with the analogy of my last post, we have dodged the deflation bullet for the month of December (November CPI).
The Federal Reserve's decision today to lower the fed funds rate to a target range of 0.00-0.25% represents the Fed's last shot they can take at the recession with the fed funds gun. They are literally out of ammo with that instrument. You can't lower the rate below zero. The effective fed funds rate for Wednesday, December 10, was 0.13%. We are now really in uncharted territory. How can I say this any more forcefully? This is like Japan in the 1990s, except every other country in the world is entering a recession as well. The only difference is that the Fed is trying to signal more willingness to do anything and everything than Japan did in the 1990s. We'll see if it will be enough.


Rules versus Discretion

In an excellent piece on the response to the financial crisis, John Taylor highlights the important concept of rules versus discretion in government policy.

Taylor shows that monetary policy during the start of the housing boom deviated significantly from the "rule" it had been following for the previous 20+ years.  Taylor and his coauthors find evidence that this amplified the boom and bust in the housing market.   While not everyone agrees with this conclusion, Taylor presents some convincing counter factual experiments.

Argument against the gold bugs

John Tamny had a post today on Real Clear Markets arguing that the way to make the value of the dollar more stable against currency depreciation is to tie it to some commodity like gold. I would argue that his timing is off and his argument is flawed.

Pennies, revisited

| 1 Comment
As an update to a previous post (I promise that I won't do this for every Treasury auction), the Treasury today auctioned $27B for three months at an annualized discount rate of 0.005%.  That's ½ a basis point.  So the treasury will pay about  $338,000 to borrow $27 BILLION for 3 months.  As a side note, this is the lowest three month yield since 1929 (cue scary music)...

See here for all of the details.