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. 

Video: Niall Ferguson Interviews Peter Thiel

Prediction #1: U.S. Dollar Bears Will Remain On the Run in 2012

Since its March 2008 low the U.S. Dollar is up 13% against a basket of the world's most widely held currencies, including the yen, sterling, franc, loonie, krona, and of course the beleaguered euro.

How is this a problem for portfolio manager Axel Merk, the self described "Authority on Currencies"? After all, according to Merk's written after-the-fact letters he claims to have traded out of and back into the euro just in time to surf its wild gyrations.

Merk moved his fund management business to California a number of years ago, where he has been beating a steady 'demise of the U.S. dollar' drumbeat ever since. This past year Merk Funds even took to deploying amusing anti-Dollar cartoon propaganda while routinely touting the superiority of the euro over the U.S. dollar.

Continue reading the full article at Seeking Alpha here.

Recapping The PolyCapitalist's 2011 Predictions

For those keeping score three topics I made 2011 forecasts on were:

1. Rise of Android
2. China's bubble
3. U.S. Housing

On Android, the verdict is in:

The U.S. housing market officially double dipped in May and then continued to fall, so that call looks correct as well.

The China prediction is a bit murkier, but here are some points worth noting:

• The Hang Seng and Shanghai stock markets are in a bear market and down roughly 20% for the year, or 30% since May. From its peak in 2008 Shanghai is off 60%.
• Housing prices are softening quickly; in Beijing new home prices dropped 35% in November alone.
• Coastal cities such as Wenzhou and Ordos appear to be experiencing a credit crisis with reports of businessmen leaping off rooftops.
• Hot money appears to be flowing out of the country: China's $3.2 trillion in foreign reserves have been falling for three months despite a trade surplus.

Things aren't shaping up too well for China or trade relations with the U.S. in 2012 either. For more on this see here, here, here and here.

Overall, does 2.5 out of 3 predictions sound about right?

Two more quick ones: bullishness on gold has been a steady theme since starting this blog in May 2010. And how did gold do in 2011? Despite the autumn selloff gold priced in U.S. dollars has returned around 10%. Not too shabby given that the S&P500 is flat YTD. I also managed a correct mid-year bearish call on the euro.

Check back later for The PolyCapitalist's 2012 predictions.

My $0.02 on Krugman's and Delong's Inflationista Potshots

Here's Delong's OH BOY: NIALL FERGUSON PRACTICING ECONOMICS WITHOUT A LICENSE DEPARTMENT

And my comment (which for some reason won't load onto Brad's blog so I'm posting it here):

I'll readily admit that I'm not an expert on CPI methodologies, and I am inclined to believe that the BLS has many well intentioned and highly educated professionals using defendable methodological practices. However, I share Ezra's feeling that something doesn't smell right on inflation numbers.  

Over the past decade how can official cost of living figures have gone up so little when they supposedly take into account the following items: 

-Housing
-Medical
-Fuel
-Food
-Education 

These are some of the largest cost items for most consumers, and in the last decade up to the financial crisis many saw double digit price increases (in some cases in a single year). 

The BLS's CPI calculator says that $1 in 2001 has the same buying power as a $1.17 in 2007, so yes, the BLS is picking up at least some of the perceived inflation in these categories. However, do the BLS number capture the full picture? 

One thing is for certain: the CPI was utterly useless with respect to the housing bubble as it does not include housing prices, only rent. This despite the fact that nearly 70% of all American homes are owner occupied.

It's convenient to dismiss anyone questioning official government statistics as a conspiracy crank. However, under reporting of inflation by a government bureaucracy would be useful in terms of reducing that same government's expenses in the form of lower cost of living adjustments for government workers and TIPs expense. Under reporting inflation also provides ammunition for the Greenspan-Bernanke Fed to not have to raise interest rates and thereby dampen exuberance. 

In other words, many stand to benefit from the under reporting of inflation. It is therefore reasonable to cast a skeptical eye on these numbers, especially when they fly in the face of everyday experience.

A final point I'd add is that economics is too important to be left to economists, particularly with most of the 'license' holders (econ PhDs) having completely failed to identify in advance the biggest economic event since the Great Depression.

Video: Carmen Reinhart vs. Paul Krugman

This event occurred back in June but the video just surfaced.

Watch live streaming video from nytimesopinion at livestream.com

Steve Keen on How He Saw "It" Coming and Why We're in a Depression

A must watch interview with Economist Steven Keen, the first part of which is embedded below (remaining parts can be found here).

Reinhart and Rogoff on Why Heavily Indebted Economies Can't Grow

Coinciding with Moody's placing the U.S. debt rating on negative review, Carmen Reinhart and Ken Rogofff remind us that country's will high debt levels often struggle to grow (attention Paul Krugman, they're talking to you!):

Our empirical research on the history of financial crises and the relationship between growth and public liabilities supports the view that current debt trajectories are a risk to long-term growth and stability, with many advanced economies already reaching or exceeding the important marker of 90 percent of GDP. Nevertheless, many prominent public intellectuals continue to argue that debt phobia is wildly overblown. Countries such as the U.S., Japan and the U.K. aren’t like Greece, nor does the market treat them as such. 

Indeed, there is a growing perception that today’s low interest rates for the debt of advanced economies offer a compelling reason to begin another round of massive fiscal stimulus. If Asian nations are spinning off huge excess savings partly as a byproduct of measures that effectively force low- income savers to put their money in bank accounts with low government-imposed interest-rate ceilings -- why not take advantage of the cheap money? 

Although we agree that governments must exercise caution in gradually reducing crisis-response spending, we think it would be folly to take comfort in today’s low borrowing costs, much less to interpret them as an “all clear” signal for a further explosion of debt. 

Several studies of financial crises show that interest rates seldom indicate problems long in advance. In fact, we should probably be particularly concerned today because a growing share of advanced country debt is held by official creditors whose current willingness to forego short-term returns doesn’t guarantee there will be a captive audience for debt in perpetuity. 

Those who would point to low servicing costs should remember that market interest rates can change like the weather. Debt levels, by contrast, can’t be brought down quickly. Even though politicians everywhere like to argue that their country will expand its way out of debt, our historical research suggests that growth alone is rarely enough to achieve that with the debt levels we are experiencing today. 

The full Reinhart and Rogoff article can be found here.

Rogoff: 'Sovereignty and currency co-habitation do not mix'

Reflecting on the latest twists and turns in the Eurozone debt crisis here are some other choice quotes from Professor Rogoff's FT editorial:

• the euro is looking very much like a system that amplifies shocks rather than absorbs them
• even if the euro system was not at the heart of the crisis, it needs to be able to withstand two standard deviation shocks
• markets are more worried about the US’s lack of a plan A than Europe’s lack of plan B
• It is sometimes said that the euro is a creature of politics that would never be justified by economics. The present episode could well turn this statement on its head.

Full editorial here, and here is a recent Charlie Rose panel discussion he participated in with Paul Krugman and others.

“We’re not Greece!” “We’re not Ireland!” “We’re not Portugal!”

While the name of the country changes, the "We're not _____!" plea from a revolving panoply of European officials has become all too familiar.

Can any of Europe's politicians -- or anyone at all -- definitively state at which country's doorstep the rolling European debt crisis will ultimately stop? The short answer is no.

Europe's Two Big Challenges

The Economist has a comprehensive summary of the latest developments in this sad saga; the violence, which first turned deadly in Greece this spring, unfortunately shows no sign of abating in Ireland. From the article:

"[Germany's] Mrs Merkel and Mr Schäuble are continuing to insist on two proposals.

One is that the EU treaties must be amended to give permanent status to the European Financial Stability Facility. Without this, they say, the rescue fund will expire in 2013. But investors know from experience that treaty amendment is neither simple nor quick (it took years to push through the Lisbon treaty). Insistence on treaty change makes them nervous.

So, even more, does the second German demand: that future bail-outs must include debt-restructuring provisions to impose some losses (“haircuts”) on investors."

With respect to challenge #1, it is quite clear that Eurozone popularity is waning in certain quarters. Any treaty change could prove problematic, particularly in Ireland where such changes must be put to a referendum vote.

Europe's Web of Debt

On #2, haircuts to bondholders, it is worth taking another look at the complex edifice of european debt. The interlocking nature and size of cross-border debt holdings explains why European leaders fear allowing any one domino (Greece in May, Ireland this week) to fall.

Germany is the biggest checkbook in the EU and, quite understandably, is insisting that the private sector share in the cost of any future sovereign debt defaults. Otherwise what is the point of distinguishing between the debt of different countries?

But can Europe's delicately interwoven debt and banking market cope with haircuts, particularly to senior debt? The current Irish crisis was sparked by discussion of losses on subordinated debt (80% in the case of Allied Irish Bank). Tellingly, Irish debt costs have continued rising even after its bailout was confirmed. This is in part due to rumors that senior debt holders may also be forced to take losses.

As former chief IMF economist Simon Johnson and LSE's Peter Boone recently wrote "market participants are good at thinking backwards: if they can see where a Ponzi-type scheme ends, everything unravels". In other words, the market for troubled sovereign debt depends on the ability of countries like Ireland and Spain to 'roll over' their borrowings until their economies begin growing again. (Ireland's economy began shrinking again earlier this year, and Spain's is projected to shrink for 2010.) Without economic growth the odds that troubled sovereign debts will ever be repaid in full (without outside help) is almost certainly nil.

In the months since the spring Greek crisis, the quasi-explicit bailout guarantee by the "troika" (EU, IMF, and ECB) has been the Eurozone debt market's linchpin. Now the bond market is calculating that Germany's insistence on private sector loss sharing by 2013 means than holders of certainly Greek, Irish, Portuguese debt, and perhaps the debt of other nations, will be forced to incur losses. Instead of waiting  around to find out the precise haircut percentage, investors are exiting risky pan-european sovereign debt positions post-haste.

China to the Rescue?

Ultimately, the answer to the question of where the Euro-debt unmerry-go-round stops depends on how far the ECB, IMF and German taxpayers are willing to go.

Simon Johnson thinks the ECB and Germans neither can or will, respectively, step up to the plate. He also questions whether the IMF has enough resources to bailout a country the size of Spain, let alone Italy or France. He goes on to speculate that if one of the large Eurozone nations needs a bailout that China, with its $2.6 trillion in reserves, may be asked to recapitalize the IMF. The attraction for China: increased global standing and leverage on contentious issues, such as its policy of maintaining an artificially low currency.

I believe that China may expand its existing role in Europe's debt crisis. However, European and U.S. officials will be reluctant to surrender center stage to China and will minimize Beijing's participation. While the exact form of the ultimate resolution is unclear, it will be a European-U.S. led solution.

Looking Ahead

The question of whether membership in the euro currency union is a good idea has taken root. Iceland's President has recently been talking up his country's relatively quick bounce back from bankruptcy abyss. Part of Iceland's rebound can be explained by the fact that it was able to devalue its own currency, which helped its export sector. In contrast to Ireland, Iceland also chose not to bail out its insolvent banks. The Czech Republic, slated to become part of the currency bloc, recently demurred on whether it would follow Sweden's path of never adopting the euro.

On the subject of whether any countries will abandon the euro currency all together, the consensus view popularized by Professor Barry Eichengreen was that joining the euro was irreversible due to the risk of sparking a bank run. But as NY Times columnist Paul Krugman states, this incentive to keep the euro vanishes when a bank run (like the one currently underway in Ireland) has already taken place.

Many questions remain, but one thing is certain: even with Ireland's bailout (the specifics are expected to be announced on Sunday before Asian markets open) the Eurzone crisis is far from over. Investors looking to insulate themselves from events may want to consider hedging currency risk through various inverse Euro ETFs, or by investing in precious metals.

Common Ground in Krugman vs. Ferguson

Paul Krugman & Niall Ferguson

Hard as it may seem to believe in today's world, there was a time when not all bankers were reviled.

Equally shocking, perhaps, is that prior to the 1980s the U.S. financial system really didn't experience a major financial crisis for the previous half century. This also was an era of significant economic progress for America as a whole.

For several months now Professors Paul Krugman and Niall Ferguson have been squaring off on camera and in print over whether the U.S. needs a second government stimulus to kickstart the economy. You can check out videos of their their respective arguments on CNN here and here.

While there is a large gap on where they stand in the fiscal debate, there is a topic where they appear to share common ground, and that is the need to fix banking.

Thoughts on Krugman's "Myths of Austerity"

An interesting and lively discussion is taking place over at zerohedge.com in response to Professor Paul Krugman's most recent article titled "Myths of Austerity".

I highly recommend perusing the comments that follow Leo Kolivakis's response to both Krugman and Niall Ferguson's alternative view expressed in a video interview on CNN (Krugman also is interviewed on the same program).

Some of the opinions I agree with:

1. Massive government stimulus spending is inefficient in terms of the economic bang for the buck.
2. I would prefer if Krugman spent more time discussing the 'quality' of government stimulus spending vs. always focussing on the 'quantity'.
3. Government investment and support in new technology development (e.g., sustainable energy) and public works (e.g., street lamps) can add economic value.
4. Japan is not necessarily in as bad of shape as the U.S. because, unlike the U.S., it is a surplus country (it produces more than it consumes) and its astronomical debt level (over 2x larger than the U.S.'s Debt/GDP ratio) is owed almost entirely to itself.
5. Most bond investors aren't interested in playing the role of 'vigilante' -- they simply want to earn an appropriate rate of return on their capital and see their principal returned.
6. While in the near-term it may be true that "the big, bad bond vigilantes are simply no match for the Federal Reserve and they know it. Bernanke can squash them like a bug". However, over a longer-term horizon there is not a central bank on earth -- not even the mighty Federal Reserve -- that can win if confidence in that country's scrip is lost.
7. Always framing the economic conversation around 'growth' or 'inflation' distracts from the very worthwhile economic goals of 'stability' and 'sustainability'.
8. "When we are unable to borrow money to buy new crap we will put more effort into maintenance of what we have" -Paul E. Math
9. It is likely that the U.S., unfortunately, will not make the necessary political decisions and take action until another crisis hits due to the short-term outlook and a lack of public pressure and political will.

And if you haven't already read it The Zero Hedge Conflicts/"Full Disclosure" Policy is pretty entertaining.

Is a U.S.- China Economic War On Its Way?

The tone of U.S.-China relations, as evidenced by General Electric CEO Jeff Immelt's provocative “colonization” remarks, are deteriorating rapidly and signaling trouble ahead. Given the importance of this relationship it is important to understand what's at stake and how events may play out.

Sizing Up the Sino-American Relationship

The U.S. has the world's largest economy and the U.S. Dollar is the world’s reserve currency. China has the world’s fastest growing large economy, and it has proven comparatively resilient in the wake of the ‘Great Recession’. China recently passed Japan to become the world's second largest economy, and Goldman Sachs has forecasted that China will overtake the U.S. by 2027.

While the export of manufactured goods to countries such as the United States has been a key driver of China’s growth story, benefits have accrued on both sides of the Pacific. Large U.S. government deficits have been underwritten in part by the thrifty Chinese, and U.S. consumers have snatched up voluminous quantities of low cost Chinese imports.

This seemingly symbiotic relationship, which Harvard Professor Niall Ferguson has termed ‘Chimerica’, avoided close scrutiny during the credit boom years. But amid high U.S. unemployment and a mounting public debt Chimerica is now under a microscope.

China’s “Unfair” Currency Policy

China has been accused of manipulating its currency by pegging the renminbi to the U.S. dollar at an artificially low rate, thereby allowing China to gain an unfair trade advantage. Critics point to China’s more than $2 trillion in largely U.S. dollar denominated foreign exchange (forex) reserves as prima facie evidence that the renminbi is grossly undervalued. Market participants have speculated that if the renminbi were allowed to freely float it would appreciate by 20-40% against the U.S. dollar.

Emerging market and EU officials have joined the U.S. in criticizing China's currency policy. Under pressure, China’s recent announcement that the renminbi would be allowed to float was initially greeted with widespread enthusiasm. However, since the announcement the value of the renminbi has moved within a narrow 0.5% range, remaining effectively unchanged. This has led some critics, such as NY Times columnist Paul Krugman, to accuse China of “playing games”.

A U.S.-China Economic War?

One of history’s unfortunate reoccurring themes is the tendency on the part of political leaders to create foreign scapegoats, particularly when faced with challenging economic times and an uncertain electoral environment. From this perspective surging, recalcitrant China makes for a nearly ideal political target.

Candidates for office can blame the U.S. unemployment problem on “unfair” China competition and the undervalued renminbi. China's large U.S. treasury holdings (estimated at up to $1 trillion, or roughly 20% of all foreign holdings) will also make a convenient target for fear mongers pointing at foreigners as the source of the U.S.’s troubles. Expect increasing criticism of China (reminiscent of 1980s Japan bashing) from politicians, labor groups, talk radio, etc. through this November's mid-term elections and through the next presidential election cycle.

What is the likelihood that the U.S. will go beyond rhetoric and take action? Seeing the renminbi revalued upwards is one of the few policy areas with bipartisan support. President Obama may feel pressure to appear strong and stand up to foreign powers to preserve the American economic way of life. Calls to “do something” will only grow louder in the face of the projected slow employment recovery. In short, formal trade action against China cannot be ruled out.

How would China respond to overt moves by the U.S.? The Chinese government detests foreign pressure. At the same time China's leadership, emboldened for example by the failure of The West to prevent the financial crisis and Google's recent blink, is growing more confident. Looking to flex its new economic and geopolitical muscles, China would almost certainly retaliate in some fashion against any U.S. trade action.

Looking Ahead

Both the U.S. and China possess numerous incentives to avoid a serious breakdown in relations. The economic and political consequences would be devastating for both countries and the rest of the world. The central question is will the U.S. and China be able – or willing – to find a path towards compromise which is also congruent with their respective interests?

It is human nature to underestimate the probability of seemingly unlikely, large-scale events like a U.S.-China trade and currency war. However, students of history know this to be an all-too-frequent mistake.

In considering whether such a conflict can be successfully avoided it is important to remember that policymakers often fail to properly diagnose and head-off the really big problems, such as war and financial crisis. Assurances by officials shortly before the near collapse of the financial system that the subprime problem was "contained" is but one recent example.

What could lead to a more serious escalation of tensions? A WTO ruling, U.S. Congressional action, China’s sale (or further purchases) of U.S. Treasuries, or an Asia Pacific geopolitical event (i.e., Taiwan, North Korea, etc.) are just a few of the possible triggers.

With China in the U.S.'s political crosshairs investors would do well to continue to closely monitor the world’s most important bilateral economic and political relationship. And given the stakes, let us hope that the current U.S.-China trade and currency war doesn't escalate further, for even a mild economic war could be devastating.

Why Deflation is Good News for Gold

Today the U.S. Labor Department released its May Consumer Price Index report, considered a key inflation barometer. There was a 0.2% decline in CPI in May, the largest decline since December 2008's 0.7% decline. The May report also comes on the heels of a 0.1% decline in April. Back-to-back monthly declines in CPI may be a warning signal that deflation is gaining a toehold.

Yet today the price of gold, which in theory should tank in a deflationary environment, is rallying up 1.5% to $1250/oz as I write this. What gives? And how could deflation be good news for gold bulls?