Krugman Perpetuates Myth of the Zero Lower Bound

Professor Paul Krugman

Professor Krugman just published a column where he deserves kudos for sticking his neck on the line and predicting that the Bernanke Fed is not creating a bubble in bonds, and "probably not" in stocks either.

While the argument on whether or not Bernanke is blowing bubbles is interesting and worthy of discussion (although only time will tell for sure), that's not what this post is about.

In the column Krugman makes a somewhat tangential comment about what economists often refer to as the 'zero lower bound problem' on where a central bank can set interest rates. Here's Krugman's quote:

"True, it (the Fed) can’t cut rates any further because they’re already near zero and can’t go lower. (Otherwise investors would just sit on cash.)"

Krugman's statement is problematic for several reasons:

First, it's misleading and patently false of Dr. K to say that the Fed "can’t cut rates any further" when in fact it can. There is no economic or natural law which prevents the Fed from setting nominal rates at exactly zero, or at a negative rate.

Whether they should be set at zero or negative is another question. In short, Dr. K needs to replace "can't" with something like "could but shouldn't because...".

Second, I suggest that it would be helpful if Dr. K was a little more precise so that people understand why the Fed "can't" (shouldn't) set zero or negative rates but Denmark's central bank can set a negative deposit rate, and now Drahgi at the ECB is openly discussing this as well.

To be clear, I'm not endorsing negative rates. I'm only saying that negative rates are possible and that some central banks are experimenting with negative rates as a policy tool.

And finally, yes, perhaps if the Fed were the only central bank to pursue a negative rate policy then investors may sit on cash, move their money elsewhere, etc. But if enough central banks around the world kept driving rates further and further into negative territory then it would be very surprising if this didn't help generate inflation, in which case people would probably not be sitting on cash as Dr. K suggests but rather spending it before money lost its purchasing power.

The long perpetuated myth of the zero lower bound is starting to be challenged more and more, and for a more detailed academic discussion of the zero lower bound myth see here. 

Why Italy Isn't In Such Bad Shape, But the U.S. and UK Are

Bill Gross runs PIMCO's huge flagship bond fund which, having engaged in an untimely shorting of U.S. Treasuries, has hit a bit of a rough patch in recent times. Some have suggested that the 69-year old might be a few years past the recommended portfolio manager retirement age and that it's no longer as useful as it once was to read his monthly investment newsletters.

Think again.

While Gross's timing on shorting U.S. treasuries has been poor, and his revealing in this month's column of memory issues is a little unnerving, his analysis of the fundamentals and medium to long-term sovereign fiscal picture remains sound.

Take his updated 'Ring of Fire II' chart, the first version of which he first published a few years back. The chart (below) plots countries by both their annual public sector deficit (y-axis), which is the difference between government spending and taxes, and what is termed a 'fiscal gap' (x-axis). The fiscal gap takes into account future expenditures, which in the U.S.'s case include entitlements such as Social Security, Medicare, and Medicaid.

As you can see from the chart Italy appears to be in better fiscal shape than several 'Ring of Fire' members like the U.S., Japan and the UK.  How is this possible? Italy has been experiencing what economists refer to as a 'speculative attack' from the sovereign bond market, while the three Ring of Fire countries are currently enjoying record low yields on their government debt. 

Continue reading the full article here.

Video: El-Erian, Buiter, Warsh, etc. on Economic Growth

This is another excellent panel from the Milken Institute Conference. It has a somewhat more investment focus than the previous one posted with discussion/predictions on the Eurozone (Greece in or out), elections, interes rates, etc.

Video: Simon Johnson's White House Burning

Podcast: Philip Coggan's Paper Promises - Money, Debt and the New World Order

Below is the podcast of Coggan's book talk, and here is a good review of Paper Promises.

Speaker(s): Philip Coggan

Chair: Professor Christopher Polk

Recorded on 19 January 2012 in Sheikh Zayed Theatre, New Academic Building.

The world is drowning in debt. Greece is on the verge of default. In Britain, the coalition government is pushing through an austerity programme in the face of economic weakness. The US government almost shut down in August because of a dispute over the size of government debt.

Our latest crisis may seem to have started in 2007, with the collapse of the American housing market. But as Philip Coggan shows in this new book, Paper Promises: Money, Debt and the new World Order which he will talk about in this lecture, the crisis is part of an age-old battle between creditors and borrowers. And that battle has been fought over the nature of money. Creditors always want sound money to ensure that they are paid back in full; borrowers want easy money to reduce the burden of repaying their debts. Money was once linked to gold, a commodity in limited supply; now central banks can create it with the click of a computer mouse.

Time and again, this cycle has resulted in financial and economic crises. In the 1930s, countries abandoned the gold standard in the face of the Great Depression. In the 1970s, they abandoned the system of fixed exchange rates and ushered in a period of paper money. The results have been a long series of asset bubbles, from dotcom stocks to housing, and the elevation of the financial sector to economic dominance.

The current crisis not only pits creditors against debtors, but taxpayers against public sector workers, young against old and the western world against Asia. As in the 1930s and 1970s, a new monetary system will emerge; the rules for which will likely be set by the world's rising economic power, China.

Philip Coggan was a Financial Times journalist for over twenty years, including spells as a Lex columnist, personal finance editor and investment editor, and is now the Buttonwood columnist of The Economist. In 2009, he was awarded the title of Senior Financial Journalist in the Harold Wincott awards and was voted Best Communicator at the Business Journalist of the Year Awards. Philip Coggan is the author of the business classic, The Money Machine.

Jeremy Grantham's Full December 2011 Quarterly Letter

JGLetter_ShortestLetterEver_3Q112

Quote of the Day: On the Megabank-Government-Central Bank Axis

Portuguese President Anibal Cavaco Silva is calling for the ECB to go beyond just being a lender of last resort to banks and to become one for his and other European governments. Specifically, he's calling on the ECB to make "unlimited" purchases of EU sovereign debt. This may be the first time one of Europe's leaders has publicly asked the ECB to take this step.

Would such a move by the ECB be a sound one? From a recent editorial in the FT:

"If governments stand behind banks and banks stand behind governments and the central bank lends freely to both and also underwrites financial markets, then financial asset prices become completely detached from economic reality. In this “system”, the central bank implementing more quantitative easing is no different, in economic terms, from Bernie Madoff marking up his client accounts every month."

From 'Circular commitments lead to a Ponzi economy'.

More on the distinction between what is meant by being a lender of last resort to banks versus the governments here and why lender of last resort to sovereign countries is the proper role for the IMF.

Guest Post: Investing Simplified for Senior Citizens

Investments for senior citizens are no different than those made by a person of any age; however, it may be in their best interest to make investments with low risks since many are retired and are on a fixed income.  Here are some typical investments:

Stock Investments- You buy an equity ownership interest in a publicly traded companies. The price of a stock can fluctuates; as it fluctuates investors either make or lose money on their initial investment.  Stock prices can be unpredictable and risky but has the potential for very high returns if you invest smartly. Some stocks also pay dividends, although the amount of the dividend can be changed by the company.

Stock Mutual Fund Investments- You choose a manger and they invest your money into diversified set of assets. Mutual funds are available for stocks, bonds, short-term money market instruments, and other securities. A mutual fund can less risky than investing in a single or small number of companies due to diversification. However, fund fees can reduce the total investment return.

Savings Deposit Investments- Deposits you make into your savings account with your bank.  Money must be moved into your checking account for use.  While in your savings account, your bank pays you interest based on current interest rates and your money is insured by the FDIC up to $250,000 per despositor, per insured bank.

Certificate of Deposit Investments (CD)- You deposit a fixed amount of money for a fixed amount of time into account with a bank or thrift institution.  Once the maturity date is met, your bank pays you back your initial investment plus any interest you accrued. Bank CDs are also often covered by FDIC insurance.

Treasury Bill Investments (T-Bills)- Short-term debt sold by the U.S. Treasury, usually at a discount from the par amount, i.e. amount the bill will be worth upon maturity. For example, you might buy multiple bills for $98 and get $100 for each when the bills mature at a later date; the lowest bill you can buy is worth $100 upon maturity. Treasury Bonds are longer-term debt sold by the U.S. Treasury for periods up to 30 years. The Treasury also sells Treasury Inflation Protected Securities (TIPS) which have feature and adjustable coupon payment based on the changes to Consumer Price Index.

Money Market Account (MMA) or Money Market Deposit Account (MMDA) Investments- A deposit account offered by banks.  Upon deposit, your bank will invest your money into government and corporate securities. You will be paid interest based on current money market rates of interest.

Money Market Mutual Fund Investments- A deposit fund offered by brokers who invest your money in short-term government and corporate debt securities. This investment is very similar to MMAs except that they are through a broker and not insured; they are more risky than MMAs, but you may receive a higher rate of return on your investment.

Below is an easy to read chart for senior citizens; it lists general details about these investment types.

Shannon Paley is a guest post and article writer bringing to us her simplified explanations on investments for senior citizens. She writes about nursing home abuse for nursinghomeabuse.net.


Note: please see the Disclaimer on the right side of this website. Before considering any investment you are encouraged to consult with a professional investment advisor.

Recommended links

1. Why is Greece turning down the “bailout” (Tyler Cowen)

2. Circular commitments lead to a Ponzi economy (Letter to the FT). Here's the key quote:

If governments stand behind banks and banks stand behind governments and the central bank lends freely to both and also underwrites financial markets, then financial asset prices become completely detached from economic reality. In this “system”, the central bank implementing more quantitative easing is no different, in economic terms, from Bernie Madoff marking up his client accounts every month.

3. The Bailout That Busted China's Banks (WSJ)

4. Mr. Hoenig Goes to Washington (Simon Johnson)

5. Bond Dealers See Fed Holding Rate Near 0% at Least Through First Half of 2013 (WSJ)

6. Papandreou Is Right to Let the Greeks Decide (Spiegel)

7. Live European debt crisis coverage (BBC) and (Telegraph)

The Italian Job: An 'Explosion in Slow Motion'

While much of the damage control attention in the rapidly escalating Italian crisis has fallen on the ECB's purchases of Italian debt, German Profressor Hans-Werner Sinn points out how the Bundesbank (and other European central banks) have been conscripted into lending a neighborly hand:

The ECB directed the central banks of all Eurozone members to buy huge quantities of Italian government bonds during the crisis. While the national central banks have not revealed how much they bought, the aggregate stock of all government bonds purchased rose from €74 billion ($102 billion) on August 4, to €165 billion this month. Most of this increase was probably used to purchase Italian government bonds. 

The German Bundesbank, which was forced to buy most of the bonds, strongly opposed the program, but was unable to stop it. In response, ECB Chief Economist Jürgen Stark resigned. He followed Bundesbank President Axel Weber, who had resigned in February because of the earlier bond repurchases. Meanwhile, the new Bundesbank president, Jens Weidmann, openly objects to the program, while German President Christian Wulff has publicly accused the ECB of circumventing the Maastricht Treaty.

Not to be outdone the Banca d’Italia has started printing money:

But the bond purchases are just the tip of the iceberg. Equally important, but largely unknown, is the fact that the Banca d’Italia has resorted to the printing press to cover Italy’s gigantic balance of payments deficit. The extra money printing and lending, as measured by the so-called Target deficit, effectively means drawing a credit from the ECB. 

This credit replaces the private capital imports that had hitherto financed the country’s net purchases of foreign goods, but which dried up because of the crisis, and it finances a capital flight, i.e. the purchase of foreign assets. The ECB in turn draws the Target credit from the respective national central bank to which the money is flowing and which therefore has to accept a reduction in its scope for issuing refinancing credit. 

Until July, only Greece, Ireland, Portugal, and Spain had drawn Target credit, for a combined total of €330 billion. Italy was stable and did not seem to need the printing press to solve its financial problems. No longer. 

In August alone, Italy’s central bank drew €40 billion in Target credit, and it probably drew roughly another €50 billion in September, when the Bundesbank’s Target loans to the ECB system increased by €59 billion (after a €47-billion hike in August). This is the highest Target loan ever drawn from the Bundesbank in a single month, and in all likelihood it went primarily to Italy.

Full commentary here. 

What If We Paid Off The Debt? The Secret U.S. Government 'Life After Debt' Report

This secret report was obtained through a Freedom-of-Information request by NPR:

The copy of Life After Debt we obtained reads "PRELIMINARY AND CLOSE HOLD OFFICIAL USE ONLY." 

The report was intended to be included in the official "Economic Report of the President" — the final one of the Clinton administration. But in the end, people above Jason Seligman decided it was too speculative, too politically sensitive. So it was never published.

Here's more:

The report is called "Life After Debt". It was written in the year 2000, when the U.S. was running a budget surplus, taking in more than it was spending every year. Economists were projecting that the entire national debt could be paid off by 2012. 

This was seen in many ways as good thing. But it also posed risks. If the U.S. paid off its debt there would be no more U.S. Treasury bonds in the world. 

"It was a huge issue.. for not just the U.S. economy, but the global economy," says Diane Lim Rogers, an economist in the Clinton administration.

The U.S. borrows money by selling bonds. So the end of debt would mean the end of Treasury bonds. 

But the U.S. has been issuing bonds for so long, and the bonds are seen as so safe, that much of the world has come to depend on them. The U.S. Treasury bond is a pillar of the global economy.

Banks buy hundreds of billions of dollars' worth, because they're a safe place to park money. 

Mortgage rates are tied to the interest rate on U.S. treasury bonds. 

The Federal Reserve — our central bank — buys and sells Treasury bonds all the time, in an effort to keep the economy on track. 

If Treasury bonds disappeared, would the world unravel? Would it adjust somehow?
"I probably thought about this piece easily 16 hours a day, and it took me a long time to even start writing it," says Jason Seligman, the economist who wrote most of the report.
It was a strange, science-fictiony question. 

Full story and audio clip here.

h/t Barry.

Links to Chapters in Michael Lewis' New Book 'Boomerang'

Besides a new preface, which Zerohedge has done a nice job highlighting here, Michael Lewis' new book Boomerang is a collection of his previously written stories about the financial problems of various European countries and one U.S. state (California).

Below are links to each of those stories in the order of their publication. They're all worthwhile and still very relevant.

 1. Wall St. on the Tundra (Iceland)

2. Beware of Greeks Bearing Bonds (Greece)

3. When Irish Eyes Are Crying (Ireland)

4. It’s the Economy, Dummkopf! (Germany)

5. California and Bust (California)

Video: Kyle Bass on the Worldwide Problem of Too Much Debt

Link to Kyle's video presentation here.

Kyle, btw, is the protagonist in Michael Lewis' latest book, Boomerang. Zerohedge has posted some of the highlights about Kyle from the book here. 

Interactive Global Debt Clock

Courtesy of The Economist

The clock is ticking. Every second, it seems, someone in the world takes on more debt. The idea of a debt clock for an individual nation is familiar to anyone who has been to Times Square in New York, where the American public shortfall is revealed. Our clock shows the global figure for all (or almost all) government debts in dollar terms. 

Does it matter? After all, world governments owe the money to their own citizens, not to the Martians. But the rising total is important for two reasons. First, when debt rises faster than economic output (as it has been doing in recent years), higher government debt implies more state interference in the economy and higher taxes in the future. Second, debt must be rolled over at regular intervals. This creates a recurring popularity test for individual governments, rather as reality TV show contestants face a public phone vote every week. Fail that vote, as the Greek government did in early 2010, and the country can be plunged into imminent crisis. So the higher the global government debt total, the greater the risk of fiscal crisis, and the bigger the economic impact such crises will have.

h/t zerohedge

Video: Pimco's El-Erian Explains Financial Repression

Default Myth Busting: Sorry Simon and James, the U.S. is not a Default Virgin

Professor Simon Johnson and James Kwak of The Baseline Scenario have an article at Vanity Fair about the geopolitical importance of credit in late-18th century France, Great Britain, and (especially) the United States. Their article, however, fails to mention an important detail which also happens to contradict their claim that "the (U.S.) federal government would always honor its debt".

The consolidation/conversion of U.S. revolutionary state debt into federal debt, which took place in the early 1790s, and which the authors refer to in the paragraph prior to the above quote, represented a U.S. sovereign default. (For more on this event see Reinhart and Rogoff (click on the U.S. tab) or Sylla, et al, which describes the 'haircut' bondholders received (6% to 4%).)

The notion that the U.S. has never defaulted has unfortunately been repeated often enough that, like the incorrect claim that TARP was "profitable", otherwise well-informed people have come to believe it.

In terms of other U.S. defaults, Reinhart and Rogoff also count Franklin Roosevelt's 1933 prohibition on owning gold and the subsequent devaluation of the U.S. dollar vs. gold as a default.

It's not very surprising to see Vice President Biden promoting the myth that the U.S. has never defaulted (in his case following a visit to the U.S.'s largest creditor, China). Professor Johnson, however, should know better.

Video: Michael Lewis on the New Third World

Video: Carmen Reinhart on a Decade of Debt

Here is a link to audio only versions of Carmen's presentation and the Q&A.

Podcast: Carmen Reinhart on the Coming Financial Repression

Link to audio stream here.

Graphic: Who Holds Sovereign Debt? 70% of U.S. Debt Held by Government Entities

Courtesy of Global Macro Monitor:

Here’s a great chart just released by the International Monetary Fund. Note that almost half — 47 percent – of the US$14.7 trillion U.S. federal government debt is held by the Federal Reserve and the government itself, such as the Social Security trust fund. Add to that the 22 percent foreign official holdings (mainly central banks) and almost 70 percent of the debt of the U.S. government is held by non-market/non-profit oriented public sector entities. Stunning! 

It’s also interesting to hear Europeans quote the $14.7 trillion (apx. 100% of GDP) figure while U.S. officials like to refer to marketable or debt held by the public, which totals US$10.1 trillion (apx. 75% of GDP).

(click to enlarge)