Friday, June 26, 2009

The Output Gap - A false and Dangerous Theory

Please click on image to see details.

In my last post, I talked about the likelihood of inflation in the U.S. in the near future and I was trying to debunk some of the theories that claim the opposite. I will continue on that note today and talk about one issue that is supposed to make inflation an impossibility during an economic downturn: the output gap.

The “output gap” is a measure of the difference between economic activity in an economy when times are sustainably good, and when there is a downturn. A lot less goods and services are produced during an economic crisis, for obvious reasons, and that is what accounts for the output gap.

Most economists who are currently advising the Obama administration or who are given time in the media are pointing to this output gap. They are saying that the current level of production in the U.S. economy is “unnaturally low”, and hence there is a lot of “slack” in the economy.

This slack, it is thought, can simply be filled in by printing more money, in order to save the economy. Because of the slack, inflation will not be created because the money printing is simply making up for the consumption which has disappeared, but should still be there, it is thought.

In other words, they are saying that the level of production today in the U.S. is not as high as it’s “supposed to be”.

In reality, they are saying that factories are “supposed to” produce more cars, TVs and clothes, and that people are “supposed to” get more haircuts and eat out more often.

But why should this be? Who says that there’s a “natural level” at which consumption should be? Definitely not me…

Please take a look at the model that I drew up in the beginning. This is an illustration of the U.S. economy. The important thing to see in the model is that both consumption and economic output will very likely be lower in 2009 compared to what they were in 2006. My model explains the very simplest of economic linkages: output follows consumption, or put in other words: supply follows demand.

Since the crisis started, demand has gone down rapidly all across the economy. Demand for houses, labor, haircuts and basically everything else has gone down. Naturally, there would be no point in producing any of those things if nobody wants to pay for them, so production goes down.

In order to find out what happened to the demand, what made it go down, one must look at what was fueling it, where the money was coming from.

Maybe the country had an export good, the price of which suddenly dropped like a rock. This recently happened to Russia and its oil. Consumption in Russia consequently went down because a lot of money disappeared.

Maybe the country had a brain drain of people which made key industries less productive. This happened in Zimbabwe when the country expelled its white farmers. A lot of money disappeared, and, incidentally, the Zimbabwean government tried the trusty method of printing money, with less than fabulous results.

There are many ways in which an economy can get in trouble, but no matter what, during times of crises, consumption and output will go down. Where was the money coming from in the U.S.? The answer is: credit.

Wages in the U.S. have been stagnant for over 30 years, and in order to make up for that, Americans have been taking loans to fuel consumption. Credit is the very thing that disappeared in this crisis, and that is what is decreasing demand.

In order for the output gap to be closed without anything radically changing in the economy, credit would have to come back as an economic force just as strong or stronger than before. We all know that that is not going to happen, so where does that leave us?

If there are no prospects of this gap being closed by new credit, then there is no slack in the economy, and money printing will simply be the futile and devastating activity it was in Germany and Zimbabwe.

The gap would have to be closed by something else, such as a more successful export industry. If, by some miracle, the U.S. export industry were to become extremely successful within a matter of months, so that the trade gap could be closed and turned into a surplus, then maybe the theory of the output gap could be relevant. The U.S. would have to stage an unprecedented economic miracle. Somehow I don’t see that as very likely.

The theory of the output gap can be relevant in normal economic times, when simply analyzing small ups and downs. But this theory is wholly irrelevant in a structural crisis or a depression.

In conclusion: the theory of the output gap is false and irrelevant because it is based on a notion of the imminent return of the credit-fueled good times. Using this theory as a justification to print money has been done before, with disastrous inflation as a result.

The economy is not "supposed to be" anything. It is only what you make it in to!

Moreover, I advise that the winner-takes-all voting system should be destroyed.

Saturday, June 20, 2009

A Regulatory System as a Competitive Advantage

One of the most central themes in how I think about the interaction between economics and politics is the importance of the rules governing capitalism, in order for capitalism to reach its full potential and serve society in the best way it can.

The case for a well regulated economy is quite simple when you look at the alternatives:

Socialism does not work because no one can ever know enough about human economic behavior in order to plan everything in advance, and an unregulated economy does not work because that leads to monopolies, oligarchies and crime, and makes a democratic process impossible.

The economic crisis has now reached a stage where the role of regulation is becoming apparent for the U.S. financial system. More specifically, I argue that U.S. financial companies are now doomed to failure in competition with foreign financial companies because they have not, and will not, be adequately regulated.

A recent article in the New York Times highlights this problem. The article explains that, as a result of the crisis, the influence of British, German, Swiss and Japanese banks is growing on Wall Street and in the U.S. in general. As Eugene A. Ludwig explains, this could have something to do with regulation:

“What worries me is the competitive edge that non-U.S. banks have vis à vis U.S. banks,” said Eugene A. Ludwig, the comptroller of the currency under President Bill Clinton, who now runs the Promontory Financial Group, a Washington bank consultant group. “Non-U.S. banks generally operate under more coherent regulatory structures than U.S. banks do, which creates imbalances that non-U.S. banks can exploit, especially at a time when their U.S. counterparts are operating under extraordinary constraints.”

In short, the U.S. economy has again reached a stage where it is a wild west-style economic system that is essentially unregulated. The little regulation that exists is highly fragmented, where different financial regulators oppose each other and where financial companies can choose their own regulator, invariably picking the one that enforces the least amount of regulation.

By contrast, financial institutions in the EU operate in a much more comprehensive economic framework in general. A lot of this has to do with the work that was done in anticipation of the introduction of the Euro as the common currency. More specifically, Germany refused to go along with the project unless the German brand of stable capitalism became central to the operation of the Euro zone.

Some of the best examples of this are:

- The European Central Bank has a single mandate: to fight inflation ONLY, and not concern itself with economic growth, and to be wholly independent from politicians. A very helpful international comparison of central banks can be accessed here:

- Antitrust laws and fierce enforcements of those laws are meant to ensure that the “too-big-to-fail” problem does not occur.

- Bank capital requirements are higher, and additional credit rating standards are imposed on complex financial products such as mortgage-backed securities.

In addition to these rules, several countries in the EU have other regulatory advantages over those that U.S. companies have, such as:

- A single financial regulator with clear, often internationally harmonized rules (such as Basel I and II, and multiple EU agreements)

- Unlimited liability instead of limited liability. In many countries in the EU, financial executives are personally liable for what happens in their companies. This obviously creates a different risk-taking climate.

- The right of the government to take over non-banking institutions such as mutual fund companies and hedge funds in order to protect investors, much like the FDIC takeover authority in the U.S..

What I have listed above under the heading of “regulatory advantages” may seem like a not so coherent list of issues, but what these things lead to in terms of the role of financial institutions in the economy is one central thing:

A focus on long-term profits instead of short-term profits

It would be very hard to argue that a focus on short-term profits is a good thing from a societal economic perspective, or indeed from any perspective other than that of the individual financiers.

A focus on short-term profits, I argue, leads to large-scale “looting”, which I explained in
this blog post on circular looting.

Needless to say, the focus that American financial institutions have on short-term profits, as a result of the inadequate regulatory framework, is the explanation as to why U.S. companies are being challenged by foreign ones now. U.S. companies are simply not equipped to compete in the long term. When the looting is done, the companies have nothing to show for.

What we are seeing right now is a failure of the central functions of capitalism. Because the system has been under-regulated, if not unregulated, the good dynamics of capitalism where efficiency, choice, competition and innovation are central components have been shoved aside, in favor of outright looting.

Presently, U.S. financial companies appear to be doing better, but make no mistake, this is only an illusion. The suspension of the mark-to-market rule has enabled them to grab numbers out of thin air and make it look like they’re profitable again. Also, because the federal government is lending money to them extremely cheaply, on a highly unsustainable level I might add, these companies are currently experiencing some short-term gains.

As soon as the government realizes that the enormous subsidies cannot go on anymore, U.S. financial companies will start to tumble once again. My guess is that that will happen within 1-2 years.

The New York Times article gives the example of the U.S. auto industry not being able to compete with the Japanese auto industry, which I think is an excellent example. Because the U.S. government failed to implement proper standards for automobiles there was seemingly no need to change anything, you just keep churning out new cars for quick profits.

One day, though, the confidence of the public was used up, and the U.S. auto industry as we knew it died. In a not so distant future, Bank of America will be the new GM, and Deutsche Bank will be the new Volkswagen.

Moreover, I advise that the winner-takes-all voting system should be destroyed.

Wednesday, June 10, 2009

The Inflation Riddle

The single most important discussion in economics at the moment is whether or not there will be inflation in the U.S., and if so, when that will happen. The Bush and Obama administrations along with the Fed and the Treasury have made their positions crystal clear: they believe that inflation is a near impossibility in this economic environment.

The government, the Fed and the Treasury have for months now been trying to tell the world that things are getting better and that the measures they have taken to ease the crisis are working. Geithner even went to China and gave speeches telling everyone how much confidence the Chinese still had in the U.S. economy, even as the Chinese sold long-term U.S. Treasuries and bought short-term U.S. Treasuries instead (which is a clear sign of a loss of confidence).

Governments around the world are currently engaging in what they call “quantitative easing”, otherwise known as money printing. The most famous example of this is probably Germany after World War I. Germany had a huge war debt to pay, and that debt was strangling the German economy. The Germans decided to simply print more money and be done with it. After that policy was implemented, people started using money to light fires in their furnaces because it was worth so little.

Nowadays, even the Bank of Switzerland is printing money. The U.S. government is the worst offender, and is currently flooding the U.S. economy with money. In a matter of months, the Fed has suddenly expanded its balance sheet 40 times, after having stuck to a policy of stability for six decades. This is truly revolutionary and truly disturbing.

Take a look at the recent expansion in the Fed's monetary base:

Why are governments doing this? It has to do with the theoretical approach to the creation of inflation.

For people who are unfamiliar with a range of theories in economics, such as the entire economic team of the Bush and Obama administrations, there is a dogma concerning inflation:

Inflation can only be created by a wage and price spiral

This is what the government believes, or at least is strongly hoping for. In other words, for inflation to start growing, people would have to start demanding higher salaries (which is not exactly easy in a country essentially without unions or labor laws) and people would have to start consuming goods and services to a much higher degree. So, all of a sudden, we would have higher salaries, more consumption and the good times would again start to roll. The government sees this as an unlikely scenario. On that point, I absolutely agree.

So, if you believe that the preceding scenario is the only scenario under which inflation can be created, printing money might make sense for a while. However, I, and many others, do not believe that this is the only scenario under which inflation can occur.

You can look at the problem of what inflation actually is in 2 ways:

1. inflation is ONLY a wage and price spiral where too much money is chasing too few goods and services, OR

2. inflation is an excess of money in the economy

In order to find out which of these two statements is true, a simple theoretical model can be constructed. If statement 1 were true, there would be no examples in history where inflation was created without a wage and price spiral. Is that so? The answer is unequivocally: NO.

Inflation has been created without a wage and price spiral countless times in economies around the world. Some examples are: Argentina at the end of the 90:s, Zimbabwe currently, Germany in the 1920:s and 1930:s, and so on and so on.

However, what these countries do have in common during the abovementioned crises is money printing. For different reasons, these countries have been printing money in order to get out of a crisis, and that has created massive inflation. This is exactly what the U.S. is doing today, so why should the U.S. be different?

The statement that inflation can only be created by a wage and price spiral is most certainly untrue. It has no basis in empirical evidence, and in fact, much evidence to the contrary exists.

I believe that inflation is simply an excess of money in the economy. Is an excess of money being created by the Fed right now? You would have to be some sort of lunatic to answer "no" to that question.

People tend to focus too much on microeconomics when thinking about inflation, which is what makes them believe in the wage and price spiral theory. They believe that consumers tend to steer the economy with their spending. This does not have to be true in many cases, though.

If a central bank such as the Fed starts printing money and flooding the economy with it, that money is going to go somewhere. It does not have to go to consumption of goods and services, it can go to the financial markets and spur speculation.

That this happened in the last few months would be a good bet, because the recent attempts to save the economy has mainly been a huge bailout of financial companies, transferring massive amounts of wealth over to them.

If all this money had been transferred to American citizens in the form of living allowances or something like that, we might have had some sort of price spiral, but that didn’t happen. When Wall Street got all the bailout money, it started to push up prices of stocks again in the early spring, and a massive stock rally occurred.

So, I believe that the rise of the stock market has to do with an inflation of prices brought on by the financial bailout. This will most likely put additional upwards pressure on inflation. This is a kind of price spiral too, and this taken together with the excess of money in the economy makes inflation even more likely.

To sum up: the U.S. will experience massive inflation soon as a result of the money printing activities and the recent stock rally is an illusion brought on by the financial bailout.

Moreover, I advise that the winner-takes-all voting system should be destroyed.