To Ernest Benach

Parlant de fórmules contra la crisi, com bé dius tu aquesta crisi té un component important econòmic, que es basa en la insostenibilitat del dèficit extern que té Espanya amb el món, i la impossibilitat de seguir financiant-lo, que al cap i a la fi, és la raó de la manca de crèdits. L'única proposta seriosa i ben feta tècnicament que jo he vist ha vingut de l'últim premi nobel Paul Krugman, que estima que Espanya necessita una desvaloració interna d'un 20%. Ell ha viatjat a Madrid per presentar aquesta proposta a Zpt personalment però, o bé no l'entenen, o bé no la volen entendre. Què fem, doncs, els catalans? Esperem que el nostre país s'enfonsi sota el seu propi pes, o què?

Corfu

The Economics of the German VAT Hike

The Clock Is Ticking Away Under Latvia

As the European Commision and the IMF conduct their latest post-Keynesian "social and economic experiment" in Latvia to see whether an economy which is contracting at an annual rate of 18% under the weight of debt deflation can achieve growth through the weight of fiscal cuts alone - a process which is today glorified with the name of "internal devaluation" but which in the 1930s was simply called what it is: wage and price deflation - a new problem looms its head. What will the long run consequence be for Latvia's already fragile demographic dynamic? The question I am simply asking here is whether short term decision taking - on the part of potential Latvian parents - may not result in further birth postponement, such that impact of the crisis is only a further deterioration in long run population dynamics, and hence, in potential economic performance?

But before we go into the nitty gritty of all this, lets just take a quick look at two charts.



Structurally, they look quite similar don't they? They are both output charts, showing year on year changes in production. The second is a chart for industrial produce, and the second is a chart for children. Strange they should look so similar, isn't it? Or is it? Here we will go into some attempts at providing a theoretical interpretation of what is happening, then, at the end of the post we will take a brief look at what conclusions may be drawn from what is happening.

Theoretical Background

Basically there are two key ideas that you need to get straight here, one of these is Wolfgang Lutz's Low Fertility Trap hypothesis, and the other is Richard Easterlin's cohort size driven relative income hypothesis. You can find a nice summary of Wolfgang Lutz's low fertility trap hypothesis in this post by Claus Vistesen. Essentially there are three basic components to this hypothesis as shown in this diagram which Lutz himself prepared for a presentation:



As Lutz says the key idea is that once fertility falls below a certain level (and even in the event that the hypothesis proved to be well founded this level could only be determined empirically, on the basis of actual experience) a self-reinforcing demographic regime may be established from which it is hard to escape, in the sense of raising fertility back up towards replacement levels. The cut-off point which Lutz et al start from is 1.5 (and in this they take their lead from a proposal by Peter Macdonald in this paper ). This figure does seem to have some coherence in terms of actual experience to date, since with the exception of Denmark - which did briefly fall under 1.5 tfr in the 1990s - no country seems to have gone below this and come, and stayed, back up again.

Now Lutz identifies three potential self reinforcing processes - population momentum, ideational processes, and economic factors - but in this post I want to focus on one of these, the economic one. The explanatory mechanisms we are offered are full of self-reinforcing feedback processes, as can be seen from the diagram below (incidentally please click over the image for better viewing):





Based on the work which Claus and I have been doing on the Life Cycle Model of consumption and savings in the context of rising median ages (see, for example, this post)I think we may well have come up with just some of these.

Essentially the argument, as it is presented here, is that as median ages rise beyond a certain point - 42/43 let's say - the structural characteristics of the economy change. While younger economies - let's say with median ages in the 35 - 39 range - are driven by large scale borrowing (on aggregate), domestic consumption surges, and, of course imports and current account deficits to match the domestic savings weaknesses, the more elderly ones can exhibit higher relative savings levels (Japan, German, Italy, Finland, possibly Switzerland), can no longer rely on domestic consumption to anything like the same extent, and increasingly come to depend on export growth for GDP growth.

Now, of course, this produces a mechanism whereby four things happen:

1) In order to compete for exports these economies have a permanent pressure on their tradeable sectors, whereby outsourcing is continuous and ongoing, wages are continuously compressed, and structural reform is permanent. Since the very export dependence is only further reinforced by the continuing process of change in the population pyramid (ie domestic demand never "recovers" as such) this is all self-reinforcing. That is the more time passes the more there is downward pressure on the wages of young people.

2) Due to the comparatively lacklustre economic growth performance there is a constant shortfall in the tax income necessary to guarantee existing welfare and pension commitments. This shortfall is produced by the low levels of trend growth (think Italy, Germany and Japan) which you can generate exclusively on the basis of export growth. Since the changing pyramid structure (here is another part of the feedback loop) means that an increasing part of the voting population comes to be over 50, the tendency, as we are in fact seeing, is to attempt to maintain welfare commitments by increasing the tax burden, which affects the consumption and earning possibilities of the young directly.

3) Migration factors. The general lack of growth in the economy, and the tendency towards increase retirement ages and higher participation rates at the older ages, all mean that there is a relative lack of well paying jobs at the entry level, a phenomenon which makes outward migration an increasingly attractive proposition for educated young people (again, as we are seeing in Germany and in Italy). This out-migration once more feeds back into the structural evolution of the population pyramid. If the out migration is in part compensated for by in-migration of lower skilled workers, then this tends to retard the process of moving towards higher value work, a feedback which one more time would seem to find reflection in lower wage levels on average in the younger age groups.

4) Impediments on pro-natal policies. The pressure on fiscal resources which result from the previous three factors mean that effectively it becomes increasingly difficult to generate the resources to finance really meaningful pro-natal policies which might attempt to "tease" fertility back up towards a higher level. As time goes by this problem only gets worse.

Easterlin and Macunovich

In the main Lutz bases his economic feedback mechanism on the cohort impact theory of Richard Easterlin and his associated relative income hypothesis. According to Easterlin changing cohort size produces either a crowding-out (the baby boom) or a crowding-in (declining fertility) phenomenon. The hypothesis posits that, other things being constant, the economic and social fortunes of a cohort (those born in a given year) tend to vary inversely with the relative size of that cohort, which is itself approximated by the crude birth rate in the period surrounding the cohort's birth. The cohort mechanisms operate mainly through three main social institutions – the family, school and labour market. Diane Macunovich has a good summary of Easterlins ideas and their application to fertility changes in Relative Cohort Size, Source of A Unifying Theory of the Global Fertility Transition (Macunovich, 2000).

The operation of this general 'crowding mechanism' means that large birth cohorts face adverse economic and social conditions, higher unemployment, and lower than expected wages, outcomes which are significantly at odds with their material aspirations. As a result, they postpone family formation and have fewer children. This line of research now represents a long-standing tradition in the United States, where an ongoing body of work (Easterlin 1975, 1978, 1980, 1987, Macunovich 1998a, 1998b, 2000, 2002, Bloom, Freeman, and Korenman, 1987, Korenman and Neumark, 2000) has posited the idea that the relative size of young cohorts entering the labour market has far-reaching implications for wages, inflation, unemployment rates, etc, as well as for a variety of cohort impacting factors like living standards and family behaviour. The core idea behind the crowding thesis is also now being applied in studies of the 'greying' phenomenon in the United States as the large 'boom generation' steadily approaches retirement age. .


On the other hand, the crowding-in syndrome would mean that the reduced cohorts which follow the fertility decline should find work more easy to obtain, and salaries relatively higher. The result are rising income expectations and aspirations for a better life all round. Insofar as these are realised there is an associated "birth spurt" as young people's confidence in starting families (or adding to them) grows and grows. This is the phenomenon we saw at work in Latvia - complete with the very high rates of wage inflation - in the years of boom. Now we see the other side of the coin, as the sharp contraction produced by the rapid deflating of the earlier situation throws everything into reverse gear.

So far Maconovich and Easterlin, but Lutz and his colleagues offer a further, and most suggestive) direction for further analysis: low fertiliy leads to the acceleration of societal ageing, this produces cuts in welfare and pension benefits, generates a general pessimism about the future and lowers expectations about future income. Thus those rising income expectations which were previously associated with those "narrow" cohorts, now become more difficult to sustain as the fiscal burden weighs down on younger generations, and this has the consequence that they continually postpone starting families. The general pessimism, coupled with pension reforms which reduce guaranteed benefits, when coupled with anticipation of increased life expectancy, produces an increase in saving for the future, which, of course represents a drag on current consumption. The drag on consumption leads to a far more lethargic level of economic growth, and this only adds to the negative cycle ny induce young people to delay further having children in order to attempt to maintain current income. This type of economic chain reaction, especially plausible in the light of what we have actually seen happening in Germany and Japan (the two countries who have advanced furthest in this particular demographic transition), does seem to be one of the possible mechanisms through which Lutz's trap - should it in fact exist - might operate.

In fact Macunovich takes the Easterlin theory and tries to use it to develop a general theory of the whole demographic transition as a process operating almost in its entirety via cohort effects, and at this level her argument is not convincing. The cohort dimension is however very evident in the US baby-boom phenomenon, and the subsequent fertility reaction, and indeed this is having the consequence that population ageing is being seen very much as a cohort phenomenon in the United States, but this US experience is perhaps hard to generalise. What is evident though, is that the cohort phenomenon, and the changes in economic dynamic that this produces, does generate very real and important short run effects, and this is just where Lutz's idea becomes important, since if the population process is not a homeostatic one (which it isn't at this point) but rather a path dependent one, where long run outcomes depend on short run changes, then the short run impacts we are seeing operating now in a country like Latvia (and Hungary, and Ukraine) become potentially very important, since - via another of Lutz's pathways (the population momentum one) they can in fact make the difference between long run sustainablility and unsustainability for a country, and I do with that the EU Commission and the IMF would open up their ears, and listen to this argument, at least just a little bit.

The Relative Income Low Fertility Trap Mechanism At Work In Latvia?

Well, as I said ealier the evidence for how a restricted cohort might lead to strong rising income expectations is clear enough, and now there is little doubt that Latvia is facing a very sharp economic contraction. This is leading to falling living standards, deteriorating employment stability expectations, growing pessimism, and of course (as we will see below) falling births.

Indeed only this weekend the Latvian Cabinet met emergency session, in order to reach to agreement a the package of measures to be put before parliament. These measures - I think it is hard to believe this part - as actually being demanded by the leaders of the European Union (via their representatives on the European Commission) in order to agree the release of the next tranche of the Latvian "bail out" loan. Among measures being discussed are a reduction of 10% in state pensions by 10% and ans a maternity and child care benefit cut of 10%. The former may be hard, but justifiable, the latter, as we will see, more or less amounts to voluntarily agreeing to slit your own thoat.

Let's take a look at the problem. Births have long been falling in Latvia. In the mid 1980s they hit a peak, at a little over 40,000 annually. Then, in harmony with what most economists and demographers woudl expect, fertility dropped to a historic low in the mid 1990s (under the impact of the transition shock) - with a peak to trough fall of over 50%. As we can then see, fertility has rebounded as we entered the late 1990s under the impact of rising living standards and due to the fact that more or less record numbers of people entered the childbearing age group.

Unsurprisingly then, the Latvian period fertility measure (the total fertility rate) started to tick upwards again from the record low of 1.12 hit in 1998.

But what has been happening to births since the crisis broke out? Well, fortunately the Latvian statistics office do publish monthly live birth stats, so this is one indicator we can track fairly easily. Here's the chart from the start of 2007, but there is so much volatility (seasonal variation?) that it is hard to see exactly what is going on.

However, if we apply an old economist's trick, and look at the year on year variation, the pattern gets a bit easier to see.

And then if we apply another seasoned economist's "quick and dirty" procedure to iron out a bit of the seasonal variation by smoothing with a three month moving average chart, the picture seems very clear indeed. As output drops, and living standards fall, so to does Latvian society's "production of children".

And of course, the negative population dynamic goes even further than this, since we have out-migration to think about. We have official monthly figures from the stats office, and even if these undoubtedly underestimate the size of the movement, the data quite possibly does give reasonable evidence of the trend, and what we can see in the chart below is not good news, since the rate of emigration is obviously rising.

Now these two factors, migration and births have a direct impact on a third indicator - population median age, and as we can see this is rising in Latvia, and very rapidly, with pronounced and important implications for both elderly dependence and economic performance. And of course, the median age assumptions for future fertility between now and 2020 where made on the more postivive outlook of improving fertility which prevailed before the crisis.

Now, from our more general studies of the economic impacts of ageing population, it is apparent to Claus Vistesen and I that the medain age of forty is something of a watershed for any population. The entire structural characteristics of an economy begin to change from this point in the ageing process, and the economy becomes increasingly export dependent as we can see in the case of high median age societies like Japan, Germany and Sweden.

But something is different in the Baltics, since male life expectancy is much lower than in the above mentioned countries, on average nearly 10 years lower, as can be seen from the comparison between Germany and Latvia to be seen in the chart below.

Now, from a strictly pragmatic point of view someone might be tempted to say, well "where's the problem there, less pensions to pay" (leaving aside the obvious humane issues), but this isn't the point, since the dependency ratios are set to rise sharply even assuming this mortality rate. The problem is that most of the remedies for offsetting the ageing population dependency issues assume the viability of raising labour force participation levels in the 55 to 65 age groups, and in the Latvian case many of the men involved - the ones whose infusion into the labour force is set to "dynamise" the economy - either simply aren't there, or are in very poor health.

So no, this is not simply one more plea for leaders of Latvia to get to work and devalue the currency. It is a plea to those leaders to stop and think a little about the implications of what they are doing. Surely no one can be happy to see their country flushed down the tubes in quite this way?


References


Bloom, D., R. Freeman and S. Korenman. 1987. “The Labor Market Consequences of Generational Crowding”, European Journal of Population, 1987, 131–176.

Easterlin RA (1975). “An Economic Framework for Fertility Analysis” Studies in Family Planning, 6(3):54-63.

Easterlin RA (1978). "What Will 1984 be Like? Socioeconomic Implications of Recent Twists in Age Structure," Demography, 15(4):397-432 (November).

Easterlin RA (1980). Birth and Fortune: The Impact of Numbers on Personal Welfare, Basic Books: New York.


Easterlin RA (1987). “Easterlin Hypothesis”, pp.1-4 in J Eatwell, M Milgate, P Newman (eds) The New Palgrave: A Dictionary of Economics 2, Stockton Press: New York.


Korenman S and Neumark D (1997). Cohort Crowding and Youth Labor Markets: a cross-national analysis”, NBER #6031,
Cambridge, MA.

Lutz, Wolfgang, Maria Rita Testa, Vegard Skirbekk, 2006. The "Low Fertility Trap" Hypothesis, Paper presented at the Population Association of America (PAA) 2006 Annual Meeting, March 30 - April 1, Los Angeles, California


Lutz, Wolfgang, Maria Rita Testa, Vegard Skirbekk, 2005. The "Low Fertility Trap" Hypothesis power point presentation at the Postponement of Childbearing in Europe conference held at the Vienna Institute of Demography, 1-3 December 2005, Vienna, Austria

Macunovich, D.J. 2002, Birth Quake: The Baby Boom and Its Aftershocks. Chicago: University of Chicago Press

Macunovich, D.J. 2000, Relative Cohort Size: Source of a Unifying Theory of Global Fertility Transition? Population and Development Review, Volume 26 Issue 2, June 2000

Macunovich, D.J. 1998a, Relative Cohort Size and Inequality in the U.S. American Economic Review (Papers and Proceedings) May 1998 88(2):259-264

Macunovich, D. J. (1998) “Fertility and the Easterlin hypothesis: An assessment of the literature.” Journal of Population Economics 11:53-111.

Special Drawing Rights

Brazil, Russia, India and China’s plan to shift some foreign reserves into International Monetary Fund bonds may be more a signal of their growing financial clout than a lack of demand for U.S. assets.

“They’re saying they are part of the big leagues,” Alberto Ramos, an economist at Goldman Sachs Group Inc., said in a telephone interview from New York. “They’re not buying IMF bonds to diversify reserves. They want to be seen as having a large voice” in global markets, he said.

Russia and Brazil announced plans yesterday to buy $20 billion of bonds from the IMF and diversify foreign-currency reserves. China will purchase $50 billion and India may announce similar funding, Brazil’s Finance Minister Guido Mantega said. The countries are seeking a stronger voice in international financial institutions such as the IMF, according to He Yafei, a vice foreign minister at China’s Ministry of Foreign Affairs.

Treasuries declined yesterday, pushing benchmark 10-year yields to the highest since October, after the government sold $19 billion of the securities and Russia said it may move out of U.S. debt to buy the IMF bonds. The so-called BRICs, an acronym coined by Goldman Chief Economist Jim O’Neill in 2001 for the biggest emerging markets, have combined reserves of $2.8 trillion and are among the largest holders of Treasuries.

‘Much Bigger’

“If this was the beginning of something much bigger, then the market would front-run that,” said Dominic Konstam, head of interest-rate strategy at Credit Suisse Securities USA LLC, in an interview from New York. “It wouldn’t be in the interests of Russia or China to watch the value of their assets go down.”

The 10-year yield climbed to as high as 3.99 percent yesterday from 3.86 percent, according to BGCantor Market Data. It was at 3.87 percent at 2:47 p.m. in New York. The yield has surged from 2.21 percent on Dec. 31 as the U.S. steps up debt sales to finance a record budget deficit and pull the economy out of the deepest recession since the 1930s.

The dollar’s status as the world’s sole reserve currency may deteriorate, said Nouriel Roubini, the New York University economics professor who predicted the financial crisis.

“We may see complementary reserve currencies,” Roubini said at a conference today in Athens. While it’s “not going to happen overnight,” the development “will diminish the role of the dollar over time,” he said.

Former U.S. Federal Reserve Chairman Paul Volcker said today that there are “no practical alternatives” to the dollar as an international currency, in the text of a speech delivered in Beijing.

‘Sudden Shock’

Treasuries slid yesterday in part because the announcement by Russia and Brazil was a “sudden shock,” said David Spegel, head of emerging-market strategy at ING Groep NV in New York.

China has 3.66 percent of votes in the IMF, Russia 2.69 percent, India 1.89 percent and Brazil 1.38 percent, according to the fund’s Web site. The U.S. has a 16.77 percent.

“We are asking to increase the voice and representation of emerging economies,” China’s He said at a June 9 briefing ahead of a BRIC summit next week in Russia.

Alexei Ulyukayev, first deputy chairman of Bank Rossii, said Russia would sell some of its $140 billion of Treasuries to make room for the purchase of the IMF bonds. Mantega said Brazil’s central bank would decide which assets to sell from its reserves portfolio for the transaction.

China’s State Administration of Foreign Exchange said last week that it’s “actively” considering buying as much as $50 billion of the IMF bonds.

India

India would be “perfectly capable of contributing” to the IMF’s bond program, Montek Singh Ahluwalia, deputy chairman of the nation’s Planning Commission, said in April. The nation may buy IMF bonds worth as much as $10 billion using part of its reserves, India’s Financial Express newspaper reported in April.

BRIC nations can’t pull out of the Treasury market because there “aren’t a lot of alternatives out there that are AAA rated,” Spegel said. “With their reserve levels so high -- $2 trillion from China -- where are they going to put their money?”

The IMF board may consider late this month or in July the proposal to sell the notes, which would be the fund’s first issue, IMF spokeswoman Conny Lotze said today by e-mail. The plan will likely determine other aspects regarding use of the securities, such as whether they can be traded among countries much like U.S. Treasury bonds.

IMF Yields

The debt will pay a yield similar to U.S. Treasuries and will be denominated in the fund’s basket of currencies, known as Special Drawing Rights, Mantega said yesterday in Brasilia. The IMF calculates the value of SDRs daily, with 44 percent weighted toward the dollar, 34 percent to the euro and the remainder split between the yen and the pound, according to its Web site.

Officials from the BRIC nations are scheduled to meet June 16 in Yekaterinburg, Russia, where they plan to discuss the status of the dollar as the world’s reserve currency. Ulyukayev said Russia will sell Treasuries “because a window of opportunity for working with other instruments is opening,” according to Interfax news wire. The remarks were confirmed by a Bank Rossii official who declined to be named, citing bank policy.

Treasury Secretary Timothy Geithner said in Beijing on June 2 there will be enough demand for record sales of U.S. debt. The U.S. budget deficit is projected to reach $1.75 trillion in the year ending Sept. 30 from last year’s $455 billion, the Congressional Budget Office says.

The spread between 2- and 10-year Treasuries, which reached a record 2.81 percentage points this month, averaged 0.69 percentage points during the fiscal year 2001. During the four- year period of government budget surpluses from 1998 through 2001, the spread averaged 0.22 percentage points.

BRIC Reserves

Geithner met with Chinese officials after Premier Wen Jiabao called in March for the U.S. “to guarantee the safety of China’s assets” and central bank Governor Zhou Xiaochuan proposed a new global currency to reduce reliance on the dollar.

BRIC nations have been adding to their foreign reserves over the past month to stem currency rallies sparked by speculation that the developing nations will help lead the world out of recession. The Brazilian real is up 20 percent against the dollar the past three months. Russia’s ruble has gained 13 percent and the Indian rupee has climbed 10 percent.

The four countries increased international holdings by more than $60 billion last month, according to data compiled by central banks and strategists.

“They want to be seen as good citizens of the IMF,” Goldman’s Ramos said. “It’s an investment that can empower them in the institution.”

Brad Setser Need Be Curious No Longer

Earlier this week Brad Setser was opining on his blog:

“Like everyone else, I am curious to see what China’s May trade data tells us. If China truly is going to lead the global recovery, China needs to import more – and not just import more commodities for its (growing) strategic stockpiles.”

Well Brad need restrain his curiosity no longer, since the morning we learnt

China’s exports fell by a record in May as the global recession cut demand for goods produced by the world’s third-largest economy. Overseas sales dropped 26.4 percent in May from a year earlier. That compares with the median estimate for a decline of 23 percent in a Bloomberg News survey of 15 economists, and a 22.6 percent contraction in April.

The decline was the biggest since Bloomberg data began in 1995. And more to the point as far as Brad is concerned China’s imports dropped 25.2 percent last month, compared with a 23 percent fall in April. Hence China just one more time ran an increased trade surplus (up to $13.4bn in May from $13.1bn in April), and it is no clearer to me than it is to Brad how a country running a trade surplus can be leading a surge in global demand. Indeed this months data, far from prodiving evidence of an accelerating "recovery" continues to pointing to ongoing weakness in global demand, just like the evidence we are receiving from Germany, and from Japan.

On the other hand there was a 38.7 percent year on year rise in fixed asset investment in May. This marked a larger increase than in April, when FAI rose 33.9 per cent. For the first five months of this year, investments increased 32.9 per cent from the same period in 2008, compared with 30.5 per cent in the first four months of the year and against an estimate of 31 per cent. According to Alaistair Chan, at Moody’s Economy.com.

“Fixed asset investment in China continues to increase on the back of state-directed projects ... This will help keep the economy growing but there are increasing concerns about the amount of lending that has been required to fund the projects"

Quite. And as a Chinese economist friend wrote me to say: "just how much of current property demand is speculative? I also have my doubts whether even official inventory levels accurately reflect all the inventory out there, especially when I read anecdotes like this ...

As a Beijing homeowner myself, I’ve experienced this puzzling phenomenon firsthand. We have been told that the value of the condo we bought last year has gone up 30% based on sales of new nearby developments, but it’s impossible to confirm since there is no secondary market. Originally we tried to rent the place, but we couldn’t find takers at any price that could remotely cover the mortgage, despite a prime location. When we decided to move in instead, we discovered that while the building was sold out long ago, hardly anyone actually lives there. Same with another 800-unit project down the street: every unit went for top dollar well before completion, but now the lights are off and nobody’s home.

In fact the volume of empty apartments across the country hit 91million sq metres at the end of last year, up 32.3 per cent from a year earlier, according to official figures. But those numbers included neither the huge volumes of completed real estate projects whose owners are waiting for market conditions to improve before they put them on the market, nor the estimated 587 million sq m of apartments sold in the past five years but left empty by their owners.

But finishing up where I started, and with the trade balance, as Brad said: "China needs to import more – and not just import more commodities for its (growing) strategic stockpiles". However, to quote again my Chinese economist friend: And Macroman's data on China's imports of commodities is surreal too. And as Claus Vistesen responded: "Yep, this was what I thought and we should expect Brad Setser to be all over this". We certainly should, we certainly should.

They Don't Miss A Trick

Russia’s central bank may switch some of its reserves from U.S. Treasuries to International Monetary Fund bonds, the bank’s first deputy chairman, Alexei Ulyukayev, said in Moscow today. His comments were confirmed by a bank official who declined to be named, citing bank policy.

Finance Minister Alexei Kudrin said last month that Russia planned to buy $10 billion of IMF bonds using money from its foreign reserves.


and.....

Russian Agricultural Bank, the state- owned lender to the farming industry, plans to sell dollar bonds in the first offering by a Russian lender to foreign investors this year.

The issue by Rosselkhozbank, as the Moscow-based lender is also known, follows OAO Gazprom’s $2.25 billion sale in April, Russia’s only other dollar bond deal of 2009, according to data compiled by Bloomberg. Rosselkhozbank hasn’t set the maturity of its notes, according to a banker involved in the transaction, who declined to be identified before the deal is completed.

Rosselkhozbank hired Barclays Capital and Citigroup Inc. to organize the sale, said the banker. The lender is rated Baa1 by Moody’s Investors Service, the third-lowest investment-grade ranking, and one level lower at BBB by Fitch Ratings.

Vnesheconombank, the nation’s state development bank, is planning a $2 billion sale of one-year notes tomorrow that will be privately placed with Russian commercial lenders and the central bank.

The sale of 10-year notes by Gazprom, Russia’s gas export monopoly, was the country’s biggest-ever corporate bond offering and the first in dollars since July, Bloomberg data show.

Expect The Best And Prepare For The Worst

Readers of the English language financial press are pretty much agog at the moment at the sight of two of the worlds best known contemporary intellectuals having a very public and very bitter argument. And the topic of their feud? The size of the US fiscal deficit, and whether having it is deadly, tolerable, or simply a good thing.

There have, of course, been numberous high profile economic disputes before (the one between the then IMF Chief Economist Ken Rogoff and Nobel Economist Joeseph Stiglitz immediately comes to mind ), but the latest embroglio between Harvard historian Niall Fegurson and the world's newest addition to the list of Nobel Laureates, Princeton economist and New York Times columnist Paul Krugman, looks set to break all previous records, at least in terms of audience ratings.

In essence Professor Ferguson is putting forward three arguments: first, the recent sharp rise in US government bond rates is a sure sign that the bond market is “trembling” in the face of the huge bond issuance that is now looming on the horizon; second, such large fiscal deficits are both unnecessary and counterproductive; and, finally, there is every reason to fear they will have a strong inflationary impact.

Krugman, for his part fears deflation not inflation, argues that such large fiscal deficits are necessary, and even desireable in current circumstances, as the private sector pays down its debt, and suggests that the rise in longer term interest rates is due not to inflation fear, but rather to the expectation that Ben Bernanke will raise short term interest rates sooner, rather than later, to avoid just such an outcome. Investors are, on Krugmans view, simply positioning themselves in the face of what they now feel is inevitable.

What both participants are agreed on is that rates on 10 year US treasuries have been rising sharply recently. Yields on 10-year US Treasuries – generally seen as the benchmark for long-term interest rates – hit 3.91 percent on June 8. At one time that would have been considered pretty low. But the financial crisis changed all that: at the end of last year, the yield on the 10-year nond fell to 2.06 per cent. In other words, long-term rates have risen by 167 basis points in the space of five months. In relative terms, that represents an 81 per cent jump.

At the heart of the problem is what appears to be a negative feedback loop, since investor expectation that the inflationary pressures which may accompany any economic recovery will lead the Federal Reserve to raise short term rates may well end up delaying that very recovery they so hope for. Ferguson blames the rapid increase in the money supply for creating the situation, while Krugman says that with so much excess capacity in the system inflationary pressure is a long way off at this point.

Meanwhile the Federal Reserve been working overtime to try to bring rates down again. The fundamental reason the Federal reserve started buying Treasury debt in the first place was to lower mortgage rates to revive the moribund housing market. That was starting to work, but the big danger comes from the fact that the interest rate rise is pushing mortgage rates back up again, and this is likely to delay any rebound in the housing market and derail the broader economic recovery in the process.

Unsurprisingly results from Freddie Mac's Primary Mortgage Market Survey, released at the start of June, showed a jump in the 30-year fixed mortgage rate to an average of 5.29% for the week ending June 4, compared with an average rate of 4.91% the week before. That was the highest rate recorded since the week ending Dec. 11, 2008. With Treasury yields rising even higher over the last week, the 30-year mortgage rate is most probably somewhere around the 5.50% at this point.

Ferguson or no Ferguson, it is obvious that the US bond market has gotten ahead of itself in anticipating a return of inflationary pressures. Longer term inflation expectations - or so it is argued by a broad spectrum of monetary economists - may work against the fluid operating of a quantitative easing regime in or on the boundary of a liquidity trap, not because investors fear that a country like the United States is about to become the new Zimbabwe, but precisely because they know it won’t. Indeed, as I frequently find myself saying of late, the United States is not Argentina, gee, it isn’t even Italy, by which I mean that investors know perfectly well how Ben Bernanke and his colleagues over at the Federal Reserve will react to a situation where inflation is perceived as rising above their target range - they will start to raise short term interest rates, and it is this expectation of future increases in short term rates which ironically cause longer term interest rates to rise, in just the way they are doing right now, in what is almost a text book case study in the United States.

The dollar also gained against the yen on speculation the Federal Reserve will raise interest rates later this year, reducing the advantage of borrowing in the U.S. to fund purchases elsewhere. Traders added to bets the central bank will increase its target rate for overnight loans between banks by its November policy meeting, according to futures traded on the Chicago Board of Trade. The contracts show a 66 percent chance of a rate increase by then,compared with 24 percent odds a week ago.

So, far from the position being as Niall imagines it is, with investors demanding enhanced premiums for holding US assets due to their fear of impending inflation, what we have here is a kind of see-saw process, whereby bad economic data, which leads investors to anticipate interest rates being held low in the US for some considerable time, raises risk sentiment and sends them off into riskier emerging market assets (with Big Ben playing sheet anchor) in the process sending the grenback to ever lower levels, while positive economic news makes playing carry with the USD as one of your currency pairs increasingly riskier, and thus leads the punters themselves to retreat, sending the dollar cruising back up again. All of which is very counterproductive, since given the knife edge character of the current US “recovery” all it does is slow things down (since the cheaper USD is good for exports) and ramp up the deflationary pressure.

Right now, the fear in the bond market is that even though the federal budget deficit is likely to moderate as the economy revives, the budget gap might stay around $800 billion for the next decade. The faster the economy can grow, the more the government will be able to boost tax revenues, and the lower the deficit will be. "For the moment, the working assumption is massive deficits as far as the eye can see, and I think that's going to be a problem for the bond market," she says.

The Fed must decide, perhaps as soon as its June 23-24 policy meeting, whether to increase its purchases of Treasury bonds. It is on course to buy $300 billion worth of bonds by September. If investors perceive the Fed’s actions as an effort by the central bank to facilitate bigger deficits, they could conclude inflation is coming and flee Treasurys, pushing interest rates up. Mr. Bernanke’s comments were aimed at thwarting that perception.


Jim Bianco, president of Chicago-based Bianco Research LLC. “The Fed wants to operate in predictable ways,” Bianco said. “They are also trying to not just look arbitrary, which makes people think ‘I can’t ever go to the bathroom because there could be a press release that the Fed changed the buybacks.’ That’s been a real concern: ‘Wow, I just went to the bathroom and lost $2 million dollars.’”

Japan Firms Cut Capex Spending

Japanese companies plan to slash capital-investment spending by 16% in 2009, the steepest drop in the history of a survey by Nikkei Inc.

According to a story in Monday's online edition of the Nikkei business daily, companies expect to spend 22.7 trillion yen ($230 billion) on capital investments in fiscal year 2009, a 4.28 trillion yen decrease from a year ago, according to the survey of 1,475 firms.

Previously the steepest cut in spending was a 12% decline in 1993. This year's decline marks the second year in a row that capital-investment spending dropped, according to the report. The last time spending fell two consecutive years was 2001 and 2002, when the tech bubble burst.

The Nikkei reported that with 15 of 17 manufacturing sectors planning capital-investment cuts, spending by manufacturers overall is expected to drop a record 24% to a total of 11.7 trillion yen.

According to the survey, electronics firms will spend 3 trillion yen, a 29% drop from a year ago, and automakers said they'd spend 2.3 trillion yen, a 33% decrease. Among manufacturers, only the food and pharmaceutical industries intend to increase spending, according to the Nikkei report.

Non-manufacturers' investment outlays will total about 11 trillion yen, a 4.5% drop, with telecommunications firms spending an estimated 2.6 trillion yen, an almost 6% decrease, and retailers spending an estimated 971 billion yen, a 10% decline, and real-estate firms slashing investments by 42% to about 445 billion yen.

Meanwhile, electric utilities are increasing their spending by about 6%, to 2.6 trillion yen as they invest in solar-power facilities and power-grid upgrades, according to the report. Railway and bus operators intend to spend about 1.8 trillion yen, a 6% increase.

The Nikkei reported that in fiscal year 2010, companies expect to increase investment in capital projects by about 2%, according to 646 respondents, but that does not include many leading electronics and auto makers.

Late last week, the Japanese government reported companies' capital investment plunged during the first three months of this year, as exports and production withered.

Capital spending fell 25.3% in the January-March period from the year-earlier quarter, Ministry of Finance data showed. Recurring profits dropped 69%

David Takes On Goliath and Loses: The Ferguson - Krugman Exchange

Well, I think the title to this post makes my view on the high-profile shenanigans we are currently witnessing on the part of two widely respected contemporary intellectuals clear enough, even if Paul would probably respond that he is perfectly well able to take care of himself, than you very much. Nonetheless, looking at the way the tone of his most recent and most public debate with Niall Ferguson has deteriorated (yes, it is Niall I'm talking about here, and not Sir Bobby, although sometimes even I have my doubts), let me confess, I am not entirely convinced on this point (Niall Ferguson's argument can be found summarised in his Financial Times Op-Ed here, and in his rejoinder letter to Martin Wolf reproduced by the FT Alphaville's ever interesting Izabella Kaminska here, while Paul Krugman's "input" to the debate can be found here, here, and here). So, since the thunder and lightening that such high profile exchanges generate tend to obscure more than they reveal, let me be so bold as to add my own 2 centimes worth - even if, apologies in advance, the whole affair ends up being most terribly "wonkish". If you want to save yourself a good deal of trouble, and heart searching, the central point is a simple one: are long term US interest rates rising becuase investors are worrying about having to buy so much public debt (as K would point out, what else were they thinking of doing with the money - which isn't really "money" at all, but, oh, never mind), or are they rising because investors expect the time path of US short term interest rates to move steadily upwards. It's as easy, or as hard, as that. So now, you decide!

Someone To Watch Over You

Amidst so much disagreement one point is, at least, agreed common ground: Paul Krugman is a macro economist, while Niall Ferguson is a historian, one who believes, if we are to take him at his word, that cats may sometimes look at kings, and live to tell the tale. Let's see.

The other point we are all agreed on, I think, is that yields on 10 year US treasuries have been rising of late, and this phenomenon lies at the heart of the debate. Indeed, if I read him aright, this is Niall's main point of current concern.

On Wednesday last week, yields on 10-year US Treasuries – generally seen as the benchmark for long-term interest rates – rose above 3.73 per cent. Once upon a time that would have been considered rather low. But the financial crisis has changed all that: at the end of last year, the yield on the 10-year fell to 2.06 per cent. In other words, long-term rates have risen by 167 basis points in the space of five months. In relative terms, that represents an 81 per cent jump.

Where we are not agreed - economists and historians among us that is - is in the significance to be placed on this evident fact. Although, having said this, Niall does rather seem to suggest that the development is some sort of litmus test for his argument, since he argues it "settled a rather public argument between me and the Princeton economist Paul Krugman". Now what was it they used to say about rushing in where angels fear to tread.

Of course, Niall is no fool, he is an excellent historian, and I greatly enjoy reading his books, but he really, really should know better than to get himself involved in the kind of technical argument which his experience and background ill equips him for. Citing the Chinese central bank as authority for your monetary views (see below) may go down well with the after dinner port and stilton set, but it is hardly rigorous argument, and Niall must surely well know that.

The thing you should always bear in mind when you enter the fray in areas where other people have the expertise is that there may be more than one available interpretation for the phenomena, and, as is so often the case in science, the counter intuitive explanation may have more going for it than the layman may grant at first sight (wasn't that the sun I just saw hurtling past across the sky). In this sense, the recent rise in long term US treasury interest rates has just provided some of us with a fascinating example of a phenomenon that those economists who have busied themselves studying the use of quantitative easing in Japan have been flagging for some time, and that is, that long term interest rates may indeed be unduly influenced by longer term inflation expectations, but not necessarily in the way a layman Niall and others may imagine they are.

Longer term inflation expectations - or so it is argued by a broad spectrum of monetary economists - may work against the fluid operating of a quantitative easing regime in or on the boundary of a liquidity trap not because investors fear that a country like the United States is about to become the new Zimbabwe, but precisely because they know it won't. Indeed, as I frequently find myself saying of late, the United States is not Argentina, gee, it isn't even Italy, by which I mean that investors know perfectly well how Ben Bernanke and his colleagues over at the Federal Reserve will react to a situation where inflation is perceived as rising above their target range - they will start to raise short term interest rates, and it is this expectation of future increases in short term rates which ironically cause longer term interest rates to rise, in just the way they are doing right now, in what is almost a text book case study in the United States. As Krugman's former PhD student Gauti Eggertsson put it in one highly relevant paper (Eggertsson and Ostry: 2005, see references below).

A central bank following a Taylor rule raises interest rates in response to inflation above target and output above trend. Conversely, unless the zero bound is binding, the central bank reduces the interest rate if inflation is below target or output is below trend (an output gap). If the public expects the central bank to follow the Taylor rule, it anticipates an interest rate hike as soon as there are inflationary pressures in excess of the implicit inflation target. If the target is perceived to be price stability, this would imply that quantitative easing has no effect, because commitment to the Taylor rule would imply that any increase in the monetary base would be reversed as soon as deflationary pressures had subsided.

Indeed talking of the Taylor rule, none other than John Taylor himself recently came out and argued that -applying his rule - the Federal Reserve would need to start once more to raise interest rates in the near future, “My calculation implies we may not have much time before the Fed has to remove excess reserves and raise the rate,” he said recently at an Atlanta Fed conference. And if John can do the calculations so too can other investors.

Of course the United States Federal Reserve is not at this point following a Taylor-type rule (although Bernanke is a known supporter of some sort of inflation targeting) but let us not get bogged down in that minor, rather technical detail, the key issue is that long term interest rates are influenced more by the expected time path of short term rates than by any other single factor, and if, instead of beating about the bush, we go right to the heart of the matter, what do we find, well Lo & Behold, only last Friday:

The dollar advanced the most against the yen in more than three months and rose versus the euro as economic data showed evidence the U.S. recession is easing, boosting demand for the nation’s assets. The greenback climbed this week as a government report indicated slower deterioration of the labor market, supporting bets dollar-denominated assets will gain as the U.S. leads the global economy out of its slump.....

The dollar also gained against the yen on speculation the Federal Reserve will raise interest rates later this year, reducing the advantage of borrowing in the U.S. to fund purchases elsewhere. Traders added to bets the central bank will increase its target rate for overnight loans between banks by its November policy meeting, according to futures traded on the Chicago Board of Trade. The contracts show a 66 percent chance of a rate increase by then,compared with 24 percent odds a week ago.

Well, there you are, investors (I have no idea whether they are being rational or not) simply act as theory predicts, and chaffe at the bit (sometimes called "getting ahead of themselves") to take positions in anticipation of expected future hikes in US interest rates, something which sends rates rippling upwards all along the yield horizon. Incidentally, can someone kindly tell me where I have to write to become a formal member of the "Thank God For Bloomberg" brigade, since where would we really be without those dedicated scribes, who will, incidentally, obviously provide so much material for future generations of historians?

So, far from the position being as Niall imagines it is with investors demanding enhanced premiums for holding US assets due to their fear of impending inflation, what we have here is a kind of see-saw process, whereby bad economic data, which leads investors to anticipate interest rates being held low in the US for some considerable time, raises risk sentiment (see this post: Don't Get Carried Away Now) and sends them off into riskier emerging market assets (with Big Ben playing sheet anchor) in the process sending the grenback to ever lower levels, while positive economic news makes playing carry with the USD as one of your currency pairs increasingly riskier, and thus leads the punters themselves to retreat, sending the dollar cruising back up again. All of which is very counterproductive, since given the knife edge character of the current US "recovery" all it does is slow things down (since the cheaper USD is good for exports) and ramp up the deflationary pressure.

But this story about investors being nervous about holding US Treasuries due to the high inflation risk, well, as far as I am concerned, go tell it to the marines, or at least to the those people over at the Chinese central bank (you know, the ones who have been running up all those dollar reserves) who Niall seems to regard as his economic authority in these matters.

"Monetary expansion in the US, where M2 is growing at an annual rate of 9 per cent, well above its post-1960 average, seems likely to lead to inflation if not this year, then next. In the words of the Chinese central bank’s latest quarterly report: “A policy mistake ... may bring inflation risks to the whole world.”"

What we have here, is what the late Niklas Luhman would have termed a "narrative discourse". Repeating the same arguments ad infinitum may produce a pleasing to sensation among the theory's adherents, but that does not make them "true", nor is it a substitute for rigourous economic analysis, or a basic understanding of what is actually going on. It does go down well with the port and stilton set though, and would undoubtedly make one VI Ulyanov (aka Lenin) turn merrily over in his mausoleum, since evidently he was right: "every cook can and does govern".

But back to the basic thread, putting all this pressure on public officials at this point is a completely counterproductive exercise, since the surge in long term interest rates - produced by the rise in expectations that the central bank will move to reign-in inflationary pressures sooner rather than later, simply leads to further signs of weakness in the US economy, which means the expectation once more grows that rates will stay lower longer, and on and on we go. But of course, as Niall Ferguson points out, it is none other than Bernanke himself who has most recently and most evidently been expressing concern about the future size of the Federal deficit, and again this would seem to me to be a reflection of the political pressure that this mistaken narrative is exerting. Accodring to the Wall Street Journal:

The Fed must decide, perhaps as soon as its June 23-24 policy meeting, whether to increase its purchases of Treasury bonds. It is on course to buy $300 billion worth of bonds by September. If investors perceive the Fed's actions as an effort by the central bank to facilitate bigger deficits, they could conclude inflation is coming and flee Treasurys, pushing interest rates up. Mr. Bernanke's comments were aimed at thwarting that perception.

Counter intuitively, the only real way to break this spiral is for Bernanke to commit to holding rates near the zero bound for an extended period of time - or to "commit to being irresponsible" in the immortal words of Eggerston and Woodford. At this point I find myself asking if it isn't ALL Princeton monetary economists - including Lars Svennson - Niall doesn't like rather than his simply Krugman holding in bad rather odour, which I could have understood more as a dislike of his fairly well known political views than as a rejection of a far more technical corpus of economic analyses, which I am sure Niall would have to admit he is insufficiently equipped to really get to grips with.

Personally, I have no idea whatsover as to the properties semi-conductors may exhibit at temperatures below absolute zero, but then I would not join issue with a theoretical physicist who mentioned preposterous sounding processes by starting off saying "well when I heat milk in a saucepan, eventually it boils" Still, if you are foolish enough to stick your neck in the noose, in the noose it will go!.

As Eggertsson points out in the Japan context long-term interest rates depend on expectations about future short-term interest rates and the risk premium, and neither of these depends on the quantity of long-term bonds in circulation or on the monetary base at zero interest rates (my emphasis thoughout), and this is a technical finding - which may ultimately be right or wrong, but I doubt that the opinion over at the Chinese central bank counts as evidence one way or another, nor does it seem reasonable to say that a growth in M2 of 9 per cent a year "seems likely to lead to inflation if not this year, then next" without a much more rigourous technical analysis, since if Niall can be so sure of this, the people over at the Bank of Japan would almost certainly like to know how.

And then, gettinmg horribly wonkish, we have the so called portfolio channel, and how this can undermine government attempts to steer down interest rates at the long end of the yield curve by purchasing longer term bonds (see Bernanke and Reinhart: 2002), since as Eggertsson and Woodford found, making the normal assumptions implicit to a general equilibrium model, purchases of long-term government bonds have no effect on long-term yields if expectations about future interest rates remain constant.

It has been suggested that the irrelevance results outlined above can fail due
to a portfolio channel (see, e.g., Meltzer, 1999; McCallum, 2000; and Coenen and
Wieland, 2003). If the monetary base is expanded by purchasing assets other than
short-term governments bonds, the BoJ may be able to change the prices of those
assets. One example is purchases of long-term government bonds, a policy the BoJ
has in fact adopted. Eggertsson and Woodford (2003), however, cast doubt on the
effectiveness of such a portfolio channel, arguing that in a general equilibrium
model, purchases of long-term government bonds have no effect on long-term
yields if expectations about future interest rates remain constant.

The reason is that the long-term interest rate depends on expectations of future
short-term interest rates and a risk premium. Neither of these, however, depends on the quantity of long-term bonds in circulation or on the monetary base at zero interest rates. Open market operations involving purchases of long-term bonds, but which provide no credible indication about the duration of the quantitative easing policy, are thus unlikely to be effective.

Of course, all of this is highly obscure and technical. Fortunately the debate does have its lighter moments, as for example when Niall cites Krugman as the point of reference for the savings glut idea:

"Did I not grasp that the key to the crisis was “a vast excess of desired
savings over willing investment”? “We have a global savings glut,” explained Mr
Krugman, “which is why there is, in fact, no upward pressure on interest rates."

In fact, as those of us who have been following the liquidity debate over the last years well know, the global savings glut thesis is famously an idea which was first initially advanced not by Krugman but by none other than Ben Bernanke, and even more to the point the whole issue goes back well before the onset of the present crisis. Or this point:

"It is hardly surprising, then, that the bond market is quailing. For only on Planet Econ-101 (the standard macroeconomics course drummed into every US undergraduate) could such a tidal wave of debt issuance exert “no upward pressure on interest rates”."

Well I'm sorry Niall, but there is another place where a tidal wave of debt issuance has exerted “no upward pressure on interest rates”, and that place is planet Japan. And

Even A Stopped Clock Is Right Twice a Day

Which takes me over to the rather historical issue of stopped clocks, and what has now been happening to Japan over the last decade and a half. At times even Daily Telegraph economics correspondent Ambrose Evans Pritchard has something interesting to say, since, of course, even stopped clocks are not wrong all the time. The point he makes here is very, very relevant:

"It is striking how many of those most alert to the deflation danger are either veterans of Japan's Lost Decade or close students of it: Albert Edwards at Société Générale, Russell Jones at RBC Capital, Nobel laureate Paul Krugman, the Fed's Ben Bernanke, and Athanasios Orphanides, who helped draft the Fed's study on the Japan trap. "People always thought Japan's bond yields had to rise, but they kept falling and Japan is still not really out of deflation," said Mr Edwards. Indeed, 20 years after the Nikkei peaked at over 39,000 it stands today at 9,280. Interest rates are 0.01pc. The yield on two-year state bonds is 0.34pc. Still there is not a whiff of inflation."

And guess what, Japan gross debt to GDP is about to push its way skywards through the 200% mark in the next year or two, which makes this retort to the FT's Martin Wolf (who had the temerity to question Niall's arguments):

Mr Wolf blithely writes: “Historically well-run economies are certainly able to support higher levels of public debt very comfortably.”His favourite macroeconomics textbook may make this claim. But the annals of history provide very few cases of economies with public debts in excess of 100 per cent of gross domestic product that were either well-run or very comfortable.

look frankly quite ridiculous, since while it may well be the case that Japan is neither well run nor a comfortable place to be (no comment, I have no opinion), it is still the world's second largest economy, so hardly an irrelevant comparison, and the Japanese government has been shoveling JGBs onto the market for years without the much predicted surge in interest rates.

So what exactly are we being offered here, an empirically testable prediction, or just another load of old waffle?

At the end of the day what I think is, if I were a historian and not an economist, then I might like to be just a bit more modest in what I had to say (and even more modest in how I said it), be a bit more prepared to listen, and if at the end of the day if I still found I wanted to differ from the experts I would at least try to understand what exactly it was they were trying to say first. Otherwise, I might find myself worrying that I was being more of a Xenophon than a Thucidydes, since while both were reputedly excellent generals, the latter stuck to what he was good at (writing history) while the former offered us a version of philosophy in his life of Socrates which frankly made the man look more of a port and stilton bufoon than anything else. And it would worry me to think that over two thousand years later people might still be remembering me more for what I was bad at than for anything else.


Appendix

Extract From - Monetary policy with a zero interest rate, Lars E O Svensson, speech at SNS, Stockholm, February 17, 2009

Why not just increase the money supply in order to create expectations of a higher future price level? As long as the interest rate is zero then households and firms, as we have already seen, are indifferent about the choice between money and securities such as Treasury bills or bonds. An increased supply of money will then have no effect other than households and firms holding more money and fewer bills and bonds. However, at some time in the future the economy will return to normal, the interest rate will be positive and households and firms will no longer be indifferent when choosing between money and these securities. Somewhat simplified, we can say that the money supply will once again become approximately proportional to the price level. A larger money supply in the future will lead, all else being equal, to a higher price level in the future. If the central bank could thus credibly commit to a permanent and lasting increase in the money supply, the expected future price level would rise. The problem here is, however, that there is no way for the central bank to make a credible commitment to a larger money supply in the future. There is nothing to prevent the central bank from reneging on such a commitment and reducing the money supply in the future in order to reduce future inflation and keep it in line with the inflation target.

Experience from Japan's period of "quantitative easing" also shows that the extreme expansion of approximately 70 per cent of the monetary base between March 2001 and March 2006 did not noticeably affect expectations of inflation and the future price level.17 For example, the yen did not depreciate as it should otherwise have done. Firms and households clearly believed that the expansion of the monetary base was temporary and not permanent, which subsequently proved to be true. The monetary base fell back to normal levels when the interest rate was later raised to above zero.

Even if short-term interest rates are zero or close to zero, bond rates at longer maturities may still be positive. If the central bank therefore buys long-term bonds it may perhaps be able to squeeze down the long-term interest rates somewhat, which should stimulate the real economy. The central bank can also promise to keep the policy rate at zero for a prolonged period in
order to create expectations of lower future interest rates and a more expansionary monetary policy in the future.

Bibliography

Paul Krugman: It's Baaack! Japan's Slump And The Return Of The Liquidity Trap

Ben S. Bernanke and Vincent R. Reinhart, Director, Division of Monetary Affairs, Federal Reserve. Conducting Monetary Policy at Very Low Short-Term Interest Rates. Paper Presented in the form of a Lecture at the International Center for Monetary and Banking Studies , Geneva, Switzerland, 2002.


Ben S. Bernanke, Japanese Monetary Policy: A Case of Self-Induced Paralysis?, University of Princeton, Working Paper, 1999

Athanasios Orphanides, Board of Governors of the Federal Reserve System, Monetary Policy in Deflation: The Liquidity Trap in History and Practice, December 2003.

Kobayashi, Takeshi, Mark M. Spiegel, and Nobuyoshi Yamori. "Quantitative Easing and Japanese Bank Equity Values.", Journal of the Japanese and International Economies, 2006

Oda, Nobuyuki, and Kazuo Ueda. 2005. "The Effects of the Bank of Japan's Zero Interest Rate Commitment and Quantitative Monetary Easing on the Yield Curve: A Macro-Finance Approach." Bank of Japan Working Paper Series, No. 05-E-6.

Baba, Naohiko, Motoharu Nakashima, Yosuke Shigemi, Kazuo Ueda, and Hiroshi Ugai. 2005. "Japan's Deflation, Problems in the Financial System, and Monetary Policy." Monetary and Economic Studies 23(1), pp. 47-111.


Gauti Eggertsson and Jonathan D. Ostry, Does Excess Liquidity Pose a Threat in Japan?, IMF Working Paper, April 2005.

Gauti B. Eggertsson, How to Fight Deflation in a Liquidity Trap: Committing to Being Irresponsible, IMF Working Paper, March 2003


Gauti B. Eggertsson, and Michael Woodford, 2003, “The Zero Bound on Short-Term Interest Rates and Optimal Monetary Policy,” Brookings Papers on Economic Activity, No. 1, pp. 139–
211.

Paul Krugman: It's Baaack! Japan's Slump And The Return Of The Liquidity Trap

Lars E.O. Svensson, "The Zero Bound in an Open Economy: A Foolproof Way of Escaping from a Liquidity Trap,", Monetary and Economic Studies 19(S-1), February 2001.

To Print Or Not To Print

History lesson for economists in thrall to Keynes

By Niall Ferguson

Published: May 29 2009 19:23 | Last updated: May 29 2009 19:23

On Wednesday last week, yields on 10-year US Treasuries – generally seen as the benchmark for long-term interest rates – rose above 3.73 per cent. Once upon a time that would have been considered rather low. But the financial crisis has changed all that: at the end of last year, the yield on the 10-year fell to 2.06 per cent. In other words, long-term rates have risen by 167 basis points in the space of five months. In relative terms, that represents an 81 per cent jump.

Most commentators were unnerved by this development, coinciding as it did with warnings about the fiscal health of the US. For me, however, it was good news. For it settled a rather public argument between me and the Princeton economist Paul Krugman.

It is a brave or foolhardy man who picks a fight with Mr Krugman, the most recent recipient of the Nobel Prize for Economics. Yet a cat may look at a king, and sometimes a historian can challenge an economist.

A month ago Mr Krugman and I sat on a panel convened in New York to discuss the financial crisis. I made the point that “the running of massive fiscal deficits in excess of 12 per cent of gross domestic product this year, and the issuance therefore of vast quantities of freshly-minted bonds” was likely to push long-term interest rates up, at a time when the Federal Reserve aims at keeping them down. I predicted a “painful tug-of-war between our monetary policy and our fiscal policy, as the markets realise just what a vast quantity of bonds are going to have to be absorbed by the financial system this year”.

De haut en bas came the patronising response: I belonged to a “Dark Age” of economics. It was “really sad” that my knowledge of the dismal science had not even got up to 1937 (the year after Keynes’s General Theory was published), much less its zenith in 2005 (the year Mr Krugman’s macro-economics textbook appeared). Did I not grasp that the key to the crisis was “a vast excess of desired savings over willing investment”? “We have a global savings glut,” explained Mr Krugman, “which is why there is, in fact, no upward pressure on interest rates.”

Now, I do not need lessons about the General Theory . But I think perhaps Mr Krugman would benefit from a refresher course about that work’s historical context. Having reissued his book The Return of Depression Economics, he clearly has an interest in representing the current crisis as a repeat of the 1930s. But it is not. US real GDP is forecast by the International Monetary Fund to fall by 2.8 per cent this year and to stagnate next year. This is a far cry from the early 1930s, when real output collapsed by 30 per cent. So far this is a big recession, comparable in scale with 1973-1975. Nor has globalisation collapsed the way it did in the 1930s.

Credit for averting a second Great Depression should principally go to Fed chairman Ben Bernanke, whose knowledge of the early 1930s banking crisis is second to none, and whose double dose of near-zero short-term rates and quantitative easing – a doubling of the Fed’s balance sheet since September – has averted a pandemic of bank failures. No doubt, too, the $787bn stimulus package is also boosting US GDP this quarter.

But the stimulus package only accounts for a part of the massive deficit the US federal government is projected to run this year. Borrowing is forecast to be $1,840bn – equivalent to around half of all federal outlays and 13 per cent of GDP. A deficit this size has not been seen in the US since the second world war. A further $10,000bn will need to be borrowed in the decade ahead, according to the Congressional Budget Office. Even if the White House’s over-optimistic growth forecasts are correct, that will still take the gross federal debt above 100 per cent of GDP by 2017. And this ignores the vast off-balance-sheet liabilities of the Medicare and Social Security systems.

It is hardly surprising, then, that the bond market is quailing. For only on Planet Econ-101 (the standard macroeconomics course drummed into every US undergraduate) could such a tidal wave of debt issuance exert “no upward pressure on interest rates”.

Of course, Mr Krugman knew what I meant. “The only thing that might drive up interest rates,” he acknowledged during our debate, “is that people may grow dubious about the financial solvency of governments.” Might? May? The fact is that people – not least the Chinese government – are already distinctly dubious. They understand that US fiscal policy implies big purchases of government bonds by the Fed this year, since neither foreign nor private domestic purchases will suffice to fund the deficit. This policy is known as printing money and it is what many governments tried in the 1970s, with inflationary consequences you do not need to be a historian to recall.

No doubt there are powerful deflationary headwinds blowing in the other direction today. There is surplus capacity in world manufacturing. But the price of key commodities has surged since February. Monetary expansion in the US, where M2 is growing at an annual rate of 9 per cent, well above its post-1960 average, seems likely to lead to inflation if not this year, then next. In the words of the Chinese central bank’s latest quarterly report: “A policy mistake ... may bring inflation risks to the whole world.”

The policy mistake has already been made – to adopt the fiscal policy of a world war to fight a recession. In the absence of credible commitments to end the chronic US structural deficit, there will be further upward pressure on interest rates, despite the glut of global savings. It was Keynes who noted that “even the most practical man of affairs is usually in the thrall of the ideas of some long-dead economist”. Today the long-dead economist is Keynes, and it is professors of economics, not practical men, who are in thrall to his ideas.

The writer is Laurence A. Tisch professor of history at Harvard University and author of The Ascent of Money (Penguin)

There are two separate issues here. Can a central bank necessarily
always create inflation (ie even when it wants to), and why longer
term interest rates are higher than people would like to see.

Let's deal with the second (briefly first). Basically, that long term
interest rates remain higher than hoped for under the initial bout of
QE (that is it is factored in) according to the Krugman theory. Here
an extract from Eggerston and Ostry on the Japan experience
(Eggerston was Krugman's PhD student). This doesn't mean the Krugman
theory is right, just that it says that what is happening will happen,
unless....

*********************************************************************************************

Since there is a relationship between the future interest rate and
future money supply, another way of stating this result is that
successful monetary easing in a liquidity trap involves committing to
lower the future nominal interest rate for any given price level once
deflationary pressures have subsided (see, for example, Jung and
others, 2001; Reifschneider and Williams, 2003; and Eggertsson and
Woodford, 2003). This was indeed the rationale for the BoJ’s
announcement that it would keep the interest rate low for a
substantial period of time (as it was for the Federal Reserve, when it
announced that it would keep interest rates low for a “substantial
period” once policy rates had been lowered to 1 percent, a point
beyond which it was reluctant to go).

According to the view outlined above, quantitative easing will only
increase demand if it changes expectations about the future money
supply, or the path of future interest rates. The Keynesian liquidity
trap is thus only a true trap if the central bank is unable to move
expectations. There are several plausible conditions under which this
is the case, so that quantitative easing indeed becomes irrelevant.
Krugman (1998), for example, shows that if the public expects the
money supply in the future to revert to some constant value,
quantitative easing will be ineffective.

***********************************************************************

unless Bernanke commits to holding the rate down for long enough.
This, at least, is the theory. And this is what I expect him to do
next. What happens then we will get to see eventually.

There are doubts, since the US is not either Germany or Japan, so I'm
not clear how long deflation can hit them for.

The German case is clearer. Year on year CPI went negative this month,
and I don't expect it to breal water again for a long, long
time. Which is what will put so much pressure on the Eurozone, since
countries like Spain have to correct vis a vis Germany, and German
prices are already falling.



"The you roll out the printing presses (or start clicking the mouse
real fast), and create inflation"

It doesn't allow for the possibility of a liquidity trap. Also, what
may (indeed I think will) happen is:

The you roll out the printing presses (or start clicking the mouse
real fast), and create inflation.............. in India and Brazil.



What a carry on!

Long Term Short Time In Spain

Arcelor in deal to lay off thousands in Spain
By Peter Marsh in London

Published: June 3 2009 19:09 | Last updated: June 3 2009 19:09

ArcelorMittal has struck a deal that would allow it to lay off up to 40 per cent of its 12,000 workers in Spain until at least the end of the year in the starkest sign yet that the world’s biggest steelmaker is preparing for a prolonged slowdown.

Global demand for steel this year is expected to fall by at least 15 per cent, making the year-on-year drop the worst for 60 years. ArcelorMittal – which accounts for nearly 10 per cent of world production – has been among the worst hit groups, cutting output at most of its plants by up to half.

The company said Wednesday it had agreed with the Spanish government the outline of a deal under which a large proportion of its employees in the country would be sent home for limited periods, with part of their wages while not working being paid for by the Spanish taxpayer.

The number of lay-off hours would be limited to 40 per cent of the total number of hours that ArcelorMittal’s employees in Spain would be expected to work during normal periods.

The move comes the day after BBVA, Spain’s second-biggest bank, offered its 30,000 Spanish staff the chance not to come to work for up to five years – in exchange for nearly a third of their usual salary and a guaranteed job when they return.

While ArcelorMittal said Wednesday that if an upturn takes place in the coming months it will not need to take advantage of the lay-off facility, the move fits in with growing indications in the steel industry that there is little imminent prospect of the sector returning to health.

Charles Bradford, a partner at Affiliated Research Group, a US consultancy, said: “If I were Lakshmi Mittal [ArcelorMittal’s chairman and main shareholder] I’d be preparing for the possibility that the upturn he’d like to see later in the year won’t happen.”

ArcelorMittal said it was sticking to its line earlier in the year that it expected a “technical recovery” in steel demand later in the year. It said the agreement with the Spanish government covering working hours and lay-offs was needed to ensure that Madrid paid for a proportion of employees’ wages while they were at home, with workers also continuing to be paid by the company.

Under the scheme – similar to those in place in other continental European nations but not in Britain – ArcelorMittal’s Spanish employees affected by the programme could receive 90 per cent of their normal pay, even while not at work.


A very unusual and novel cost cutting measure from BBVA, the Spanish bank. The 70% cost reduction, with a guaranteed pool of employees after the period is up is certainly a new approach.

Employees of BBVA, Spain's second biggest bank, are being offered 30 per cent of their usual salary in return for staying away from work for between three and five years.

Anyone signing up to the scheme is guaranteed a job when their extended leave comes to an end. They will also have their health care costs covered for the length of their sabbatical.

The offer is targeted at long-term employees of the company who have "personal or professional projects" they wish to undertake during their time off.

Juan Ignacio Apoita, BBVA's head of human resources, told the Financial Times: "We're looking at offering alternatives to people. It's obvious as well that it has an impact on costs."

Other options open to the bank's 30,000 Spanish employees include a shorter working week on reduced pay, or time off arrangements to allow staff to look after relatives or go back in to education.

Although Spanish banks have escaped the worst of the global downturn because of tight regulation, they have found it difficult to impose redundancies because staff are entitled to large payoffs under domestic labour laws.

In Britain, manufacturing workers at firms including Jaguar Land Rover have agreed to accept four-day-weeks and temporary factory shutdowns in an attempt to minimise job cuts and keep their employers afloat.

Japan Capex Revisions

Japan capex cuts point to GDP upgrade
TOKYO, June 4 – Japanese companies cut spending on plant and equipment by less than expected in January-March, suggesting that gross domestic product for the quarter may be revised up slightly to a 3.8 per cent contraction from a preliminary reading of a record 4.0 per cent decline.

The figures will likely be seen as supporting the view of the government and economists that after bottoming out in the first quarter Japan is on a slow path to recovery from its worst recession since World War Two.

The economy is likely to grow only gradually from the second quarter as overseas demand is not strong enough to encourage Japan’s manufacturers to rapidly boost spending. Falling wages and a rising jobless rate will also weigh on growth in the coming months, economists say.

”Overall, corporate earnings conditions remain severe, so declines in capital expenditure were inevitable. While the pace of decline was smaller than expected, there’s no doubt capital spending was weak in the first quarter,” said Kyohei Morita, chief economist at Barclays Capital.

Corporate spending declined a record 25.3 per cent in the first quarter of 2009 from a year earlier, the Finance Ministry said on Thursday, slightly less than a market forecast for a 26.5 percent slide.

The fall in first-quarter capital spending followed a 17.3 per cent drop in the final three months of last year. The figures will be used to help calculate revised GDP due on June 11.

In preliminary data the capex component fell 10.4 per cent, slashing Japan’s overall GDP by 1.6 percentage point. The capex figure may be revised up to a 9.1 percent decline, leading to GDP being revised to a 3.8 per cent fall, Morita at Barseclays said.

Also the value of inventories fell by 5.6 trillion yen ($58.29 billion) in the first quarter from a year earlier, faster than a 4.6 trillion yen annual decline in the previous three-month period, which could mean GDP being revised to a 3.6 per cent decline, said Seiji Adachi, a senior economist at Deutsche Securities.

”I’m still expecting a double dip,” he said.

”After the bounce in industrial output is over, the economy will slow again due to weak consumption and a severe labour market. Capex will also be a problem for any V-shaped recovery.”

Japanese firms’ recurring profits in January-March fell 69 per cent from a year earlier while sales dropped 20.4 per cent, both record falls and underlining the severity of the recession.

Economists expect Japan’s GDP to grow a modest 0.1 per cent in the second quarter and 0.5 per cent in the third quarter as overseas demand stabilises after a collapse in global trade last year, according to a Reuters survey last month.

External demand probably won’t be strong enough to support a faster recovery in Japan’s economy as companies are under pressure to cut costs by reducing wages and the unemployment rate is expected to rise from its current 5 1/2-year high of 5.0 per cent, weighing on domestic demand.