End of Year Reading

• Zerohedge summarizes a Bank of America study on the past and upcoming decades of Asian economics and how they impact the US.

  The financial crisis delivered a clear verdict, in our view, on the limits to the Asian growth model. It no longer makes sense to pursue double-digit growth by lending cheaply to the US consumer.
  Yet change would require less reserve accumulation or – put another way – allowing the currency to appreciate against the US dollar, to which it is now effectively pegged. China needs to manage this “exit” carefully. Moving too fast risks a dollar crisis, with a disorderly drop in the US dollar and a spike in US bond yields. Moving too slow risks a boom-bust cycle in China, with capital inflows and strong monetary growth rates putting upward pressure on asset prices and inflation.

• This is an amazing read on China, written by Christopher Hayes at The Nation. One of the summary paragraphs is particularly interesting, and I quote it below, but I strongly recommend you read the entire article.
  

  We tend to view China as posing an alternative and threatening model for the future, one that's by turns seductive and repulsive, the source of envy and contempt. But after a while I wondered if we aren't in some way converging with our supposed rival. China has managed the transition from a repressive, authoritarian, impoverished country to an industrial, corporatist oligarchy by allowing a loud and raucous debate while also holding tightly onto power. Perhaps we are moving toward the same end from a democratic direction, the roiling public debate and political polarization obscuring the fact that power and money continue to collect and pool among an elite that increasingly views itself as besieged on all sides by a restive and ungrateful populace.

• The title says it all: Why market sentiment has no credibility. Good read at FT.
  
• I don't know who John Kozy is, but I like this paragraph he wrote in his article titled, "The Long Decline of the American Economy":
  

  Ideally, companies exist to provide products and services to people. If the products and services are good, the companies prosper; if they aren't, the companies fail. That's risky, so American companies inverted this model. They fed the public the notion, which has rarely been questioned, that a company's responsibility is solely the financial welfare of its stockholders. Products and services are no longer the goal of business; they are merely means to profit. That reducing quality leads to greater profits quickly became evident. One fewer olive in each jar, one flimsy part in a complex device, one inefficient procedure in a manufacturing process, built-in obsolescence, built-in short product life-cycles, engineered high failure rates. The American quality standard became, "Junk"!

• An excellent argument for a surtax on millionaires, which does a good job of countering an argument I myself believe: that unlimited income potential (where a surtax limits said income potential) is a great motivator for innovation, entrepreneurship, and general hard work. Also, I really like the reasons behind the title of the blog.
  

  The third thing it also might change is the pay that CEOs get. For example, if the top tax bracket were 99%, for all income over $5 million, tax opponents always describe this case as having the effect that people will just stop working after they get to $5 million. That's just not an option for the likes of Peyton Manning, however. What Peyton Manning (or any corporate CEO in the same position) would likely do, however, is settle for just $5 million a year, since all income after that goes to the state. Then, once you get a Republican in office, and they cut that 99% top bracket from $5 million-plus to $25 million plus, Peyton Manning will renegotiate his salary up to $25 million, even though he's still playing 16 NFL games a year...
  So, in this case, tax rates down implies total taxes collected from Peyton Manning up but total "production" from Peyton unchanged, but worsening inequality for the economy and less taxes paid for someone else. So, we'd need to look at whether the consumption spending of people like Tiger Woods, CEOs with their corporate jets, and investment bankers is better for long-run economic growth than the spending of the poor, who spend a large chunk of their disposable income on things such as education and health care...
  This is essentially what has happened in the US, and that is why you shouldn't believe it when economists tell you we shouldn't tax millionaires.
  

Accusations Against the Fed

To be honest, I don't quite understand this one. Can someone explain to me whether the conclusion in this article is true (namely, that the Fed is acting in violation of the Constitution)?

It had generally been assumed that the AIG payouts of 100% on credit swaps (when the insurer was under water and bankrupt companies do not satisfy their obligations in full) was the result of some gap in oversight plus traders at AIG exercising discretion (they were unhappy about bonus rows and had reason to curry favor with dealers, who were potential employers).

The article makes clear that AIG had been negotiating to settle on the swaps prior to getting aid from the government, and was seeking a 40% discount. The Fed might not have gotten that much of a discount, but there was clearly no need to pay out at par.
...
After less than a week of private negotiations with the banks, the New York Fed instructed AIG to pay them par, or 100 cents on the dollar. The content of its deliberations has never been made public.
...
As Vickrey indicates, the fact that this was a backdoor rescue means the Fed is acting as an extra budgetary vehicle of the Treasury. This is a violation of the Constitution and shows how patently false the Fed’s claims of independence are.

Onto other reading...

• David Brooks with some more criticism of the idiotic government decision to police pay and whatnot:
  
  

  Now in disgrace, Wall Street firms are rewriting their rules, but the Obama administration has decided it should take control of compensation reform. Nobody seriously believes high pay caused the financial meltdown; it was bubblicious groupthink. But cutting executive pay just polls so well. ...
  Treasury officials are now making individual pay-package decisions across an array of different companies — and they must have really big brains to understand the motivational psychology of all those different people. The Federal Reserve, meanwhile, has decided to police banks and veto pay deals that lead to excessive risk. Those experts must have absolutely gigantic brains if they can define excessive risk years before investments pay off.
  ...
  The best and the brightest in government are now rewriting existing pay contracts and determining that certain firms will be compelled to pay much less than their competitors. They’re not leveling the playing field, as a humble government would do. They’re making it less level in complicated ways.
  
  

• A case for big banks, and a rebuttal.
• A really interesting read on the dollar.
• On the new tools of monetary policy:
  
  

  Participants in this session were asked to address two basic questions. The first is whether the Fed's targeted liquidity operations were necessary and effective. My answer is probably yes, though I would have a hard time persuading someone if they were not already convinced of that. The second question is whether such operations should be considered an important part of central banks' arsenal of tools in the future. To that my answer is categorically no. From virtually any perspective of our current problems, it would have made far more sense to address these problems with proper regulatory supervision prior to the crisis instead of targeted liquidity operations after the crisis unfolds.
  

  
  
  
  

Quick Links

Sorry for the lack of posts recently - been quite busy. Here are a few articles I think are worth reading:

• The Baseline Scenario writes about monetary policy, taking a look at hawks vs. doves in the Fed. I never quite thought of hawks or doves in monetary policy, but it's a neat take.
  
  

  Hawks also like to talk a lot about “credibility,” which means a reputation for being willing to fight inflation. People use the word credibility in this context because the conventional wisdom used to be that national governments would not be willing to take tough steps (raising interest rates) against inflation because that would cost jobs, and hence votes in the next election. So central banks had to prove that they were willing to raise interest rates and put people out of work, even though that might be politically unpopular. Now that our Fed governors and bank presidents are accountable to just about no one, beating on their chests and proclaiming how willing they are to be tough in the face of the political winds rings a little hollow to me — especially in a “middle-class” country that considers inflation to be a greater evil than unemployment. Arguably, the situation has reversed; it has become so accepted that the primary job of a central bank is to fight inflation, despite the Fed’s dual mandate (to both fight inflation and promote stable economic growth), that fighting inflation has become the politically safe thing to do.
  

• This is interesting, and for Americans, potentially alarming: China, Russia, Japan, France, and some Middle Eastern countries are planning to "end dollar dealings for oil." There's been quite a bit of noise over the past months about shifting away from the dollar as the main international currency, but (at least in articles I read, which I must note tend to be written by Americans) such talk has been largely dismissed. Apparently, we shouldn't dismiss so easily. The dollar is already weak in value, and such a move only further hurts its reputation. If this is actually going to happen, it will increase tension between China and America. It is also interesting that Japan, who has been a pretty close trade partner and ally since WWII, is part of this non-dollar alliance.
• A profile of Larry Summers and his team.
  
• Mish arguing that deflation is no longer a looming threat, it is here. Furthermore, he argues that it's a good thing! Take a look:
  
  

  Deflation is not a threat because deflation is here by any practical measurement. Deflation is also here by impractical measurements such as falling prices. See Humpty Dumpty On Inflation and Daniel Amerman vs. Mish: Reflections on the Great Inflation/Deflation Debate for a further discussion of a practical definition of deflation, a contraction of money supply and credit marked to market, not falling prices.
  
  Moreover, deflation is not a threat in a second sense. Deflation is needed to purge the excesses of the last credit cycle. Attempts to defeat deflation by force will only prolong the agony while accumulating government debt, just as happened in Japan's two lost decades.
  
  Finally, deflation is not a threat in a third sense. Falling prices are a natural state of affairs because of rising productivity over time.
  

  
  
  
  
  

Inflation? Deflation? Both?

Of course, not at the same time. However, this question has been on my mind recently.

First, a quick Econ 101 review (I had to look this stuff up, I swear) courtesy Wikipedia:
Inflation: "In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time. ... A chief measure of price inflation is the inflation rate, the annualized percentage change in a general price index (normally the Consumer Price Index) over time."
Naturally then, Deflation: "In economics, deflation is a decrease in the general price level of goods and services. Deflation occurs when the annual inflation rate falls below zero percent, resulting in an increase in the real value of money — a negative inflation rate. This should not be confused with disinflation, a slow-down in the inflation rate (i.e. when the inflation decreases, but still remains positive). Inflation reduces the real value of money over time, conversely, deflation increases the real value of money." (here's another good explanation article on deflation from Inflationdata.com)

One further important point: headline vs. core inflation. Core inflation uses a CPI that excludes food and energy prices. This has, in recent times, been controversially viewed as a more accurate measure of inflation. The argument for it is that food and energy prices are too volatile to be considered as part of CPI. It's important to note that the Fed tends to use core inflation as it's guide, though they've recently had to review that policy. The controversy stems from the fact that, one, consumers *do* need to pay for food and energy, and two, there are more volatile aspects to CPI than food anyway, according to research from the Philly Fed.
Yikes, eh? Makes things pretty complicated. And to make things even more fun, headline inflation is negative while core is slightly positive.

It's important to note that what needs to be avoided is hyper-inflation and deflation (this also is arguable, but let's go with conventional thinking for now). As far as I know, it's generally accepted that moderate inflation is considered the most healthy scenario for an economy. I draw heavily from the SF Fed for the following analysis:

• High inflation is dangerous and prevents economic growth: for example, price change in a product could no longer be easily define by supply and demand if inflation could just as easily be the cause. Also, high inflation tends to have higher fluctuation, which causes consumer and investment uncertainty.
• Zero inflation is dangerous because this usually implies lending rates close to 0, which leaves the Fed very little room for stimulus if necessary.
  
• Thus, you're left with moderate inflation as the safest path. Kinda roundabout, but hey - that's what I've gathered so far.

We also need to address why deflation is generally considered dangerous (again, from SF Fed):

• In deflation, prices are falling throughout the economy - and that actually sounds kinda nice at first glance, from a consumer's perspective. However, keep in mind that deflation increases the burden on borrowers (read: consumers) in the case of a fixed-rate loan, and prolonged deflation can reduce the value of collateral, again making borrowing (credit) more difficult to come by. Lastly, again, the Fed would probably be stuck at 0% interest rates and would be unable to properly stimulate the economy.

Ok. All that's out of the way. I think we have a very rudimentary understanding of what we want, and what we don't. So, what might be coming?

It's good to get a review of what can actually cause inflation and deflation.

What can cause inflation:

• Increasing supply of money
  
• Decreasing supply of goods
  
• Increasing demand for goods
• Decreasing demand for money

Deflation is the opposite:

• Decreasing supply of money
  
• Increasing supply of goods
  
• Decreasing demand for goods
• Increasing demand for money

The inflation-is-coming faction bases their claims on the Fed's liberal pumping of money into the economy (first bullet for inflation). Though CPI has been falling, many attribute this to dramatic falls in food and energy prices, as well as dramatic falls in rental and property prices - and despite all this, notice Core CPI never went negative!. When these factors begin to recover, inflation will jump with it.
The deflation-is-coming camp, however, notes that there has indeed been negative Headline CPI, and that there is no guarantee prices will recover. Even despite the recovery in energy prices, which will force headline CPI back up, rent and wages are still falling and will be much more serious components of the measure.

I'm leaning towards the deflation camp in the short term. Layoffs are on-going, and though they're slowing, they're still happening! This means lots of people with less purchasing power, which will force rents down and the price of goods down, based on decreasing demand. The Fed already has interest rates at 0 - if things go bad, they won't be able to easily stimulate things again, which is further danger of deflation. And yes, I believe we're not out of the woods and that we are likely in line for a U- or W-shape recovery.
In the long-term, however, the picture is more murky. The Fed has pumped a LOT of money into the system (take a look at their balance sheet! I link to that in the Econbrowser article below) and if/when recovery occurs, that increased supply could make for serious inflation.

Here are some good reads on the topic:

• Krugman (deflation-oriented)
  
• David Rosenberg (deflation-oriented)
  
• Seeking Alpha (inflation-oriented)
• Econbrowser (inflation-oriented, very very good read)
  

Lastly, I'm no expert on ANY of this stuff. I hardly know monetary policy. Please, if anyone has more insight, feel free to comment and criticize. I would love to understand this better.

A few follow-up points I think are important:
1. It's unclear that deflation is necessarily bad. Many tend to use the Great Depression or Japanese experience as examples of why deflation is bad; in fact, it can be argued deflation occurred during the Industrial Revolution (supply of goods increased dramatically) and this was a good thing. So, deflation could be good or bad depending on the situation. This is taken from the Inflationdata.com article linked earlier in this post.
2. There are many debatable measures of inflation. I tried to stay with mainstream analysis for this post.
3. This is all based on the conventional definition of money supply where money is currency. I didn't discuss money supply enough in this post, but it is very important in understanding inflation.

**UPDATE** The market and the Fed seem to disagree on where interest rates are headed, which implies differing views on coming inflation (the market seems to think it's more likely than economists do).