Archive for June, 2010

Like I Said

Once again Glenn Beck is right behind me.  I think I should have a show.  It’s kind of long so if you don’t want to watch the whole thing just skip to 14:20 and listen for about 20 seconds.

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One of the main tests of a model is how useful it is for predicting the future.  I believe my model explains events such as the great depression and the collapse of ’08.  I will probably write more about these in the future.  However, without further adieu, I want to get on record using my model to do some predictions so that I can say “I told you so” when they happen (the signs are already popping up so there is no time to waste). 

First a couple of notes about forecasting.  It’s hard and it might be wrong.  Especially when the government is monkeying with things all the time.  I will try to predict what they will do.  In broad terms, they are pretty predictable but who knows what details they wll add.  If they do something different, something else will happen and by the way, this would not be a poor reflection on the model, just on my ability to guess what the government will do.  Second, the timing is tough to pin down.  These things might happen in a year or ten years, it’s hard to say, especially when, again, the government is doing its best to postpone them as long as possible.  Also, other events may intervene. 

We have had artificially low interest rates for a long time and consequently we have built up a lot of potential deflation.  Also, interest rates are already near zero so there is no way to inflate prices any further with monetary policy.  This means we will see deflation in the near future.  The signs are already appearing (try going to and searching for consumer prices falling, the article I was looking for from a few days ago doesn’t even come up but plenty of other evidence does).  In spite of these signals, the thing that will make this apparent to most people will be when the following two things happen (probably in this order but it could go either way).  Asset bubbles including housing (again) will collapse and the stock market will fall dramatically.  This will probably happen before the end of the year (but remember timing is difficult).  Notice that this is what they are trying to stave off by getting the Chinese to inflate their currency and begging European governments to spend more.

Now the political predictions come into play.  The reaction by the government and their Keynesian economists will be to say that monetary policy is not capable of fixing the depression because interest rates are already near zero.  This will be true but they won’t mention that the reason we are in a recession is because of their monetary policy.  Therefore the only solution will be for the government to “stimulate demand” by increasing spending. 

At this point, recall why unexpected deflation is a problem.  It causes everyone to simultaneously default on their loans and all their property to be seized by creditors.  So the Fed will suddenly own much of the real wealth in the economy and nobody will have the money to buy it from them….except the federal government.  So the government will start spending like crazy but there will be nobody to tax so they will have to borrow the money.  But there will be two problems.  First, nobody will have any money to lend because it will have been sucked back in by the Fed and second, those who do have money will become nervous about lending to the government because they will begin to see where it is headed.

Luckily (for them) there will be one place left where they can get the money–the Fed.  The Fed will start buying government debt at a rapid pace.  This will cause dollars to flow into the economy in a different way from when the Fed loans it out in the sense that it will cause real assets to flow out of the economy at the same time (remember they paid farmers to destroy crops to keep prices high while people were starving during the great depression).  This will bid prices up and counteract the deflation but it won’t undo any of the harm caused by the deflation.  In fact it will do more harm because people will still be broke but they won’t even get the benefit of lower prices and the process of adjustment back to efficiency will be disrupted. 

When people notice that prices are rising again, government debt is going through the roof, and the economy is not recovering, they will notice that we are heading full steam ahead toward a sovereign debt default.  If anyone is still holding bonds at this point, they will try to get out.  There will be lots of money floating around and nothing to buy with it and every day there will be more money and less to buy.  This will mean that people will be reluctant to hold cash and they will have few other attractive investments.  They will try to find other ways to store wealth.  The prices of gold and silver will shoot up.  Other asset prices will follow.  This inflation will make people even less willing to hold money and velocity will start to accelerate rapidly leading to very high levels of inflation (possibly Weimar-style inflation).

When it becomes apparent that neither monetary nor fiscal policy are capable of fixing the economy, drastic changes will be called for….. By the way, did you know that in the IS-LM model, if taxes are 100%, output becomes infinitely large?  That would be nice huh?  Then we could all sit around and look at art all day.

Are We There Yet?

“In an unsucessful effort to educate people to uniform views, ‘planners’ establish a giant propaganda machine.”

Note especially this tidbit: “Weiner is accusing Beck of maintaining an “unholy alliance” with Goldline, one of Beck’s television and radio sponsors,
and suggests that Beck talks about America’s dangerous levels of debt only to try and scare people into purchasing gold.”

Our current economic paradigm is one which relies heavily on the “animal spirits” explanation to describe economic fluctuations.  This sort of reasoning allows them to create an unstable system who’s sucess is dependent on nobody noticing its flaws and then blame the people who notice its flaws for its eventual collapse.  They will be accused of yelling fire in a crowded theatre.  The fact that the theatre is actually on fire will be ignored.  People like this will of course have to be silenced.  It’s for the good of society…

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Are We There Yet?

People now feel–rightly– that “planners” can’t get things done.

It’s the first half of this that is interesting for my purposes.  Note especially that his assertion that the founders wanted 51 to 49 to be good enough is flat out wrong.  The federal government was designed carefully to guard against “tyranny of the majority.”

It’s a Trap! A Liquidity Trap…

June 24, 2010 3 comments

Before I get deeper into this macro model, recall two main points from previous posts.  First, unexpected deflation is bad for the economy.  Second, an increase in the market interest rate causes the price of a durable asset to fall and the rate of change of that price to increase

Now a technical note on Fed policy.  Some people say that the Fed sets interest rates and some refer to this as changing the money supply.  I will imagine a model where the Fed chooses an interest rate and then people can borrow as much money as they want at that rate.  Thus if they lower the interest rate, the money supply will increase.  This is not different in any important way from imagining that they choose a quantity of money and this implies an interest rate (as in, for example, IS-LM) but it is a little easier to think of policy in these terms for this model and I would argue that it more closely approximates what the Fed actually does.

Begin by recalling how an economy with a fixed quantity of money (and flexible interest rate) would function.  The real rate of interest would be determined by real factors (intertemporal consumption preferences and investment opportunities), liquidity preference would cause the value of money to increase at a slower rate than other investments.  This would probably mean moderate deflation though inflation cannot be ruled out.  The difference between these two rates would be the nominal interest rate.  It is important to point out that all of these rates would be determined in the market.

Alternatively, consider an economy where some central authority chooses the nominal interest rate and the quantity of money is flexible (it expands/contracts to the point where that rate is an equilibrium in the market).  In this case, the real interest rate should still be determined by real factors.  This means that there will be an arbitrary fixed difference between the real and nominal interest rates.  In order for this to constitute an equilibrium in financial markets something else will have to adjust.  The natural variable that would resolve this is the inflation rate.  Let’s take a look at how that would happen.

Imagine an economy that produces one good which can either be consumed or invested to produce in the future.  And imagine it faces a number of investment opportunities for the production of that good with varying rates of return.  Naturally, they will participate in the most profitable investments first.  An efficient capital allocation would occur in an equilibrium where the marginal rate of substitution between consumption now and consumption in the future is equal to the rate of return on the marginal investment opportunity.  This rate would be the real interest rate.  All projects with a rate of return higher than this would be undertaken and all projects with rates of return below this would not. 

If a central authority set the interest rate at a level below the natural (nominal) rate. there would at first appear to be a bit of a paradox.  This is because investors, when faced with a lower interest rate would want to borrow more and invest in more projects until the marginal rate of return fell to that rate.  Meanwhile, consumers would want to borrow more (or lend less) until their marginal rate of substitution between consumption now and in the future fell to that level. 

If actors had perfect information, the market would still sort this out in an efficient way.  This is because the competing interests of investors and consumers would bid the price of the good in the present up through borrowing and inflating the money supply.  But in the future these loans would have to be paid back.  This will cause a contraction of the money supply in the future and if people can forsee this, they will expect prices to fall in the future.  In other words they will expect deflation and this deflation will pick up the slack between the real and nominal interest rates bringing the market into equilibrium with consumption and investment unchanged. 

The important thing to notice here is that the lower the nominal interest rate is set, the more deflation is required to bring the market into equilibrium.  This is contrary to the conventional wisdom which is that lowering the interest rate increases the money supply and therefore causes inflation in the long run but not in the short run because prices are sticky.  I suggest that this is only half the story.  In a frictionless economy with perfect information, prices would jump upward when interest rates are lowered.  Undoubtedly, this process takes some time in reality.  But it is premature to call the length of time that it takes for prices to adjust upward due to an increase in the money supply (from a lower interest rate) the “long run.”  In fact the period of inflation should be considered the medium run at best.  In the long run, this lowering of interest rates should actually cause deflation (or at least lower inflation). 

Now the problem is that the Fed tells us that it’s job is to simultaneously encourage growth with low interest rates and maintain a low but positive level of inflation.  Unfortunately, these are inherently incompatible.  Keeping the interest rate below its natural level causes pent-up deflationary pressure.  It does, however, cause inflation in the short run.  So as long as you have room left, when the inflation starts to turn to deflation you can lower rates more and the short run inflationary effects will offset the deflationary pressure that has been building up from previous low interest rates.  The rub is that you can’t lower interest rates below zero.  This is known as a liquidity trap.  Interestingly, this is the justification used by Keynes for advocating aggressive fiscal policy in a recession.  But to Keynesians, liquidity traps just sort of happen randomly.  I am arguing that they are a necessary effect of artificially low interest rates. 

Of course, when the Fed can no longer lower interest rates, they can no longer hold off the inflation that they had been baking in for years.  But if people don’t see this connection and continue to have faith in the Fed’s ability to keep infltion low, then when prices start to fall, firms and consumers will begin to default on their loans and it will cause all the effects noted in the post about deflation.

Are We There Yet?

A student sent me this recently.  As you look at it, ask yourself where we are in this process.  Here is a hint.

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Rule of Law

June 17, 2010 2 comments

I just heard a legislator ask BP’s CEO (whom the president didn’t think was worth speaking with but apparently he is an acceptable sacrificial lamb)  a question which the victim tried to give a very specific scientific answer to.  The inquisitor then cut him off and demanded an aswer to the question “would you define that as a plume?” to which the victim did not know the answer (since this is a purely sobjective question) at which point, the inquisitor declared that he would interpret the victim’s response as a “no” and that this was at odds with all established science.  This offers an almost comical example of how these people operate.  They take “science” and dumb it down into a statement that really doesn’t mean anything–one that is not scientific, then they paint anyone who doesn’t answer the nonsensical question in the way they like as some kind of evil deceptive villain or science-fearing heathen. 

Alright, now what I really wanted to talk about today was the other, even more terrifying thing that Obama said in his speech earlier this week

Tomorrow, I will meet with the chairman of BP and inform him that he is to set asside whatever resources are required to compensate the workers and business owners who have been harmed as a result of this company’s recklessness.  And this fund will not be controlled by BP.  In order to ensure that all legitimate claims are paid out in a fair and timely manner, the account must and will be administerred by an independent third party.

In a rule of law state there is a mechanism in place to act as an “independent third party” for determining fair payments for damages.  It is the courts.  It is not the executive!  Notice the language that he uses.  He doesn’t say “I will ask the chairman to set asside resources.”  He says “I will inform him that he is to set asside resources.”  The president does not have the power to sieze resources.  Not even from a company that has harmed others.  That is the job of the courts.  The “independent third party” of which Obama spoke is his “pay czar” Kenneth Feinberg.  I wonder how much of that money will end up in the pockets of labor unions.

The worst part of this is that there is a law on the books limiting the liability for oil spills to $75 million.  This is a bad law.  I was passed by the government after extensive lobbying by oil companies following the Exon Valdez spill.  Now they are raking BP’s CEO over the coals with questions like “shouldn’t you have drilled a relief well when you first drilled this well?  I understand it would have cost a little more money but wouldn’t that have been better than what we have now?”  (paraphrasing)  Well, yeah that would have been cheaper if you had known that this would happen.  But if there is a small probability of this happening and you know that if it does you will only have to pay $75 million, then the amount you would be willing to spend to avoid it will be very small.  This is something that should be predicted by congress when they pass laws like this.

So they drove BP to this behavior but now they have a situation where everyone is mad at BP and thinks that it would be unfair to stick to the law.  Do they say “wow we shouldn’t have made that law, this is a problem caused by a corrupt legislature that is in bed with big oil companies.  We will change the law, institute term limits and try to restore the integrity of our government?”  Of course not.  They blame it all on BP.  They even criticize BP over rumors that they might be thinking about invoking the law that they had passed.  Then they demand $20 billion.  They are changing the rules after the fact.  Sure they are changing a bad rule to one that would have been better but this is exactly what can’t happen in a rule of law state.  The rule have to be known in advance, even if they are bad rules.  And they need to take responsibility for their bad rules. 

Finally, BP doesn’t realize who they are dealing with.  People are saying that even though they didn’t have to accept this deal, they got off pretty cheap and it was a good public relations move.  But Harry Reid called the agreement “a good start.”  The Wall Street Journal says: …the company hopes thefund can earn it back goodwill.  Earlier this month, Attorney General Eric Holder announced a criminal investigation of the company.  Today they are ripping them appart on the hill.  Every questioner asks him questions which he answers to the best of his ability and then the questioner remarks that they are disappointed by the lack of cooperation.  These people will never let BP go.  They know that their power over them does not come from the law, it comes from BP’s fear of public sentiment.  They more they can demonize BP, the more they can loot.  Thinking that if you just give in a little, they will lay off is sadly misguided. 

Just to be clear, I think that on a moral level, BP should pay for much of this damage (although not for workers layed off by Obama’s moratorium on drilling) but this is not the way things are done in a rule of law society and we need to be concerned about this.

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