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: Mervyn King on Twenty Years of Inflation Targeting

A very accessible, excellent talk from the Governor of the Bank of England on the past two decades of financial and central bank history, and the need to rethink the policy of inflation targeting. 

Podcast with better audio quality here.

Speaker(s): Professor Sir Mervyn King

Chair: Professor Craig Calhoun

Recorded on 9 October 2012 in Old Theatre, Old Building.

Since 2008, we have experienced the worst financial crisis and recession since the 1930's. What challenges does this pose to the intellectual foundations of monetary policy? Do we need a new approach?

Mervyn King is the Governor of the Bank of England. Before joining the Bank he was Professor of Economics at the LSE, and a founder of the Financial Markets Group.

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.

Ben Bernanke Cannot Print a New Steve Jobs

Gold bulls rejoice, for open-ended QE is here!

Yesterday's Fed announcement wasn't the long rumored 'QE3', as a '3' implies a beginning and an end like the two prior rounds of quantitative easing.

The Fed has instead committed to not stop printing new money until the economy improves.

What then will the Fed do if the economy never improves, meaning unemployment never gets back below 5%? Will the Fed go on printing forever? We shall have to wait and see.

In the meantime anyone who believes that printing money ad infinitum will fix what ails the U.S. economy, or the global economy for that matter, is living in macroeconomic Willy Wonkaland.

Monetary policy in the form of printing new money and changing interest rates does very little if anything to improve the foundational competitiveness of an economy. The most dynamic economies are the ones which are the most productive and most innovative, and monetary policy has very little if any impact on these two areas.

The kind of GDP growth driven by purchases of products like Apple's iPhone reflects real economic growth. The kind of GDP growth derived from nominal GDP targeting (aka inflation) is fake.

In short, Ben Bernanke cannot create new real jobs. Real jobs are created by the Steve Jobs of the world.

However, it's much easier for central planners to punch a few buttons on a keyboard and print more money than to make the long-term adjustments necessary for fundamental economic improvement.

On the Topic of Financial Collapse Fear Mongering

"Ireland is in a death spiral" -FT

"After the November President election the U.S. is facing a fiscal cliff" -Federal Reserve staff

"Eurogeddon!" -The PolyCapitalist

On and on go the warnings of cataclysm and pending financial doom. Technical jargon and existential risks are bandied about in frightening fashion, leaving the general, less-economically literate with very little ability to understand what's actually happening or just how bad things could really get if say Greece leaves the Eurozone, or another country defaults, or something like this occurs.

This blog is not entirely innocent of this criticism, and this post is a brief attempt to quickly address the question of whether our global financial system is on the precipice of a financial collapse if say something 'really bad' happens in Europe?

The short answer is no.

Now before I expand on that answer I would like to clarify something very important: this post is about financial collapse and not about the extremely high levels of unemployment, which have reached approximately 50% for young people in countries such as Greece and Spain. The youth and general unemployment problems today are serious and something to be very concerned about. But this post is not about that but instead about whether another Lehman-style event could occur where the world's financial system risks implosion if say a country like Greece pulls out of the euro, the current 'bank jog' in Spain accelerates, etc.

So why isn't the risk of financial collapse as bad as some would have use believe?

For starters, we have to keep in mind that our financial world is a virtual world. Today, money is largely a set of numbers on a computer. This means that even in the most extreme scenario of financial disorder, where policymakers completely blow it and the ATMs stopped working and the stock market tanked, that everything that is real and tangible - the houses, the food that is farmed, the physical assets - none of this goes away and will all be here the next day when you wake up in the morning.

Now having said that, a financial implosion would definitely have a major impact on our lives, particularly for those with fewer resources or who are unprepared. But life will go on for nearly everyone and could actually rebound quite quickly given other historical cases. For example, Argentina began recovering within months following its utterly complete financial meltdown in 2001 even though the country achieved the relatively rare trifecta of a currency collapse, a banking crisis, and a sovereign default all at once. Iceland has had a relatively quick turnaround following its 2008 financial implosion. And other Asian countries in the late-90s also turned the corner pretty quickly following major financial crises.

In the case of Argentina, dozens of people died in Dec. 2001 riots, so I don't want to minimize the very real suffering and dislocation which comes with a financial collapse. But Argentina's experience is a far cry from the level of suffering of say a war or severe natural disaster. In short, a 'cataclysm', it was not.

A further point needs to be made about the above examples, which is that they were all relatively isolated, contained crises that did not threaten a systemic collapse in arguably the same way as the current crisis. But this leads me to point number two, which is that a systemic collapse is extremely unlikely, particularly given two facts:

1. what was learned from the recent Lehman-experience in 2008 by the current crop of policymakers.
2. the world's central banks, especially the Federal Reserve, still have loads of financial ammunition.

Regarding the first point, current policymakers got a first-hand glimpse of just how interconnected the world's financial system is and how the failure of a seemingly small cog in the wheel could threaten to topple the whole system. So while yes, Greece's financial implosion could lead to a chain reaction that threatens the entire global financial system, it is utterly inconceivable in the wake of the Lehman crisis that policymakers would sit back and let that happen given what they learned and how they responded in 2008-2009.

So I hear you asking whether all our problems are solved then because central banks like the Federal Reserve are all powerful, financially speaking, and able to contain any crisis which comes its way? Over the long-term, I would say no, they are not all powerful financially. But in the short-term, meaning right now and over the next few months at least, they are all powerful financially, and here's why.

Central banks like the Fed, ECB, Bank of Japan, and Bank of England which operate fiat currencies have an extraordinary power, which is that they can create an unlimited amount of money.

'Unlimited', meaning a truly infinite amount of money? Yes

What this means is that even if, for example, all the depositors in Spain and Greece withdrew every last euro from their local banks the ECB can supply all the notes that citizens want to hide under their bed mattresses. In short, the ATMs should never, ever run out of money in a fiat money system which is being managed by competent professionals.

But earlier I alluded to the fact that even though central banks can print an unlimited amount of money that they were not in fact financially omnipotent over the long-term, so what did I mean by that?

With the magic that is the computer a central bank could literally go and create and infinite amount of money. But there are side effects with central banks creating a lot of money, namely inflation. Without getting technical, simply put inflation is a rise in prices. Hyperinflation is a very large, sudden rise in prices.

But here is the crucial point to remember: rising inflation acts as a brake on a central bank's ability to create money. In other words, a rise in inflation is perhaps the key to understanding when central banks would be constrained in any effort to bail out the financial system.

Today, most of the world's advanced economies (North America, Europe) have relatively modest inflation, meaning low single digit annual percentage increases in official measures of core inflation. And even though they would say otherwise, the central banks in these advanced countries would be more than willing to trade an increase in inflation to stem the risk of a systemic financial collapse.

So how much more inflation would central banks be willing to tolerate as a tradeoff for not risking financial collapse? As the Bank of England has demonstrated in the past couple years, inflation creeping up towards 5% is not enough of a concern to prompt a significant deviation in policy. So my guess (it is a guess) is that at the extreme central banks like the Fed could tolerate up to 10% if they perceived the risks of collapse to be great enough before they would think twice about pulling another post-Lehman style bailout of the world's financial system. And since we're still in low single digit inflation this gives the Fed a decent amount of runway to maneuver.

This room to maneuver is what is meant when it is said that the Fed, which controls the world's most important reserve currency, and other central banks still have lots of ammunition.

The existence of this ammunition is likely a factor behind why given all the current distress in Europe that the stock markets haven't fallen further. In other words, the markets expect central banks to step in and flood the financial system with money if Greece leaves the euro or a banking run accelerates. Even the supposedly hemmed in by the Germans/hard-money crowd ECB. After LTRO and all the sovereign bond debt purchases, anyone who still thinks the ECB won't step in to save the system if things go completely pear shaped by creating a lot money is living in a fantasy. And this flood of central bank money would likely be very bullish for stocks in the short-term.

Should inflation increase significantly, then the ability of central banks to rush in and save the day could be diminished. But for now, they have the power to act, and that's why (for now) a general financial collapse is not on the immediate horizon.

So in sum, if you want to understand when it might be time to get worried, keep an eye on official measures of core inflation, particularly if it starts creeping up near the 5% level as that is about the time a proper central banker will begin to twitch over fears of runaway inflation.

Now, in terms of how you want to position your investment portfolio given the above, the very first post on this blog just over two years ago argued for allocating some of your portfolio into gold, which is arguably the best hedge against excessive central bank money printing. Even though the price of gold has gone up significantly in the last two years this blog still stands by that recommendation for long-term investors.

Naked Capitalism Uses a Single Data Point to Disprove Financial Repression

A post over at Naked Capitalism titled 'Why Is The Term “Financial Repression” Being Sold?' by the Roosevelt Institute's Matt Stoler purports to "fact check" a statement about the negative effects of financial repression.

That sounds useful, for as Stoler points out financial repression is much in the news these days. However, there's just one big problem: Stoler's fact checking consists of looking at just one country, the U.S.

Never mind that the Reinhart and Sbrancia paper about financial repression which Stoler references includes a 10-country data sample (and information about dozens of other countries), or that other studies on the effects of financial repression have looked at data from 20 or more countries. And Stoler clearly couldn't be bothered with checking to see that most of the research on financial repression has in fact focussed on its impact on economic growth in developing countries, and not advanced economies like the U.S.

Following Stoler's breathtakingly brief analysis of the single U.S. data point he concludes:

"So we see that the financial repression meme is at heart an aristocratic concept."

Sorry, Matt, but it's not quite that simple.

Who exactly are financial repression's winners and losers? As some of the commenters on Stoler's post note the not insignificant dose of inflation which accompanies financial repression hits everyone who saves money. Also, the large rentier may have additional means at his/her disposal to mitigate the effects of financial repression. However, the small rentier (aka 401K holders, pensioners, retirees on fixed incomes) may not easily be able to, for example, shift assets to Lichtenstein.

But there may be a more simple answer to this question of winners and losers. To work as intended financial repression depends on government rules and regulation. In short, this means that under a system of financial repression those who follow the law are the ones who are punished by the law. Sound like a place you'd like to live?

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: Pimco's El-Erian Explains Financial Repression

Video: Jim Rogers on Greek Default, Operation Twist, SNB Intervention & Why He's Shorting Equities

Rogers on how "Bernanke has been lying to us again" and other thoughts on what's happening right now and where he's investing.

End Game: Greece to Default This Weekend?

While the Greek government is publicly denying it (I suppose they have to until the banks close) the game appears to be up (further confirmation from Spiegel here).

The timing of the default would come roughly in line with my prediction. We're also seeing a softening in the euro, now down to $1.36, also as predicted.

In terms of what happens next, the first step following default would likely be a bank holiday in Greece. This would then be followed by some type of devaluation (rumoured to be around 50%) of the reintroduced drachma.

As I posted yesterday, anyone in Greece who still has their euros in a Greek bank may want to move swiftly.

Here is Professor Eichengreen with some deeper perspective and why its likely the ECB is going to be doing a lot of Ctrl+P.

Video: Robert Shiller on Why Housing Has Not Bottomed

Keynes on Printing Money, and Do Loss-Suffering Central Banks (i.e., ECB, SNB) Need Capital?

Weimar Germany during the early-1920s hyperinflation

A 1924 quote from John Maynard Keynes reflecting on events in Weimar Germany and Lenin's Russia:

"A government can live for a long time, even the German Government or the Russian Government, by printing paper money." 

However, "In the last phase, when the use of the legal tender money has been discarded for all purposes except trifling out-of-pocket expenditure, inflationary taxation has at last defeated itself."

The above quote was excerpted from a 1997 paper by the IMF's Peter Stella titled 'Do Central Banks Need Capital?'

Can Central Banks Go Bust?

Technically speaking, the answer according to Stella is no, central banks do not require a capital buffer to absorb losses in the same sense that a commercial bank does. However, Stella states:

"Weak central bank balance sheets invariably lead to chronic losses, the abandonment of price stability as a primary policy goal, a decline in central bank operational independence, and the imposition of inefficient restrictions on the financial system to suppress inflation. 

...if society values an operationally independent central bank capable of attaining price stability without resorting to financial repression, the transfer of real resources to recapitalize the central bank becomes necessary when chronic losses are sizeable."

In other words, the overarching reason for central banks to hold sufficient capital is that it helps maintain confidence in the soundness of the central bank and the value of the currency it issues.

Has the ECB Become Europe's 'Bad' Bank?

As the European debt crisis has spread and intensified, central banks in Europe have been suffering heavy losses for over a year now.

The Swiss National Bank has reported losses in the tens of billions of swiss francs on its euro purchases over the past 12+ months. Whether or not the Swiss government will move to recapitalize the bank is unclear. So far as I know the Swiss central bank is unique among major world central banks in that it is publicly-traded with both government and private shareholders.

There has also recently been speculation that the relatively thinly-capitalized European Central Bank will need to be recapitalized again if it were to continue to suffer heavy losses on its purchase of European sovereign debt. The ECB recently began purchasing tens of billions in Italian and Spanish debt, which comes on top of the tens of billions in Greek, Irish and Portuguese debt it already holds. The prospect of the ECB needing additional funding is not sitting well with Germany and other rich European nations which will have to foot the bulk of the bill.

Interesting times in the world of central banking.

Gold Price: Full Steam Ahead to $2,000/oz.

Over a year ago, on May 6, 2010, this blog launched with a first post on the attractiveness of gold as an investment. On that day the price of gold was just under $1200/oz, and as it became clear that the Federal Reserve was about to embark on another large round of money printing, which later came to be known as QE2, I felt compelled to grab the keyboard and start typing (see articles tagged 'Gold' both here and on SeekingAlpha for further reference).

During this time it has been amusing to watch the professional punditry drone on about a  "gold bubble" and observe various blogger bets about how gold's run couldn't last. The biggest amusement of all, however, has been the disparaging remarks from those such as Berkshire Hathaway's Charlie Munger, who belongs to a group I've taken to calling the 'gold haters'.

Suggestions from credible policymakers, such as the World Bank's Robert Zoellick advocating a return to the gold standard, have lit a fire under the barbarous relic's price this past year. Today, with gold pressing above $1700, or nearly 50% higher in just over a year, I can't help but comment on how we've heard nary a peep of late from the anti-gold crowd.

Where to from here? As long as three key fundamental forces persist then the rise in the price of gold will continue unabated. Those forces are:

1. Low interest rates, a hallmark of the current program of financial repression, which is only just getting started and should extend for many years to come.
2. Continued central bank purchases of gold by countries such as South Korea, Thailand, Russia, etc.
3. More money printing, which we've seen in spades of late with Italian and Spanish bond buying, Bank of Japan and Swiss National Bank currency intervention, and the Fed's rumored QE3.

Continue reading the full article at SeekingAlpha here.

Video: Jim Grant - 'We Traded the Gold Standard for the PhD Standard'

Interview with Jim Grant on Bernanke's press conference today, the coming of QE3, and why the Federal Reserve should "be run by someone with a degree in unintended consequences" after the break.

Financial Repression Redux

The latest from Carmen Reinhart and Co. on the return of financial repression has been published on the IMF's website here. If you're a little turned off by academic papers then you'll find this latest short, magazine-style piece much more appealing.

For more thoughts on financial repression, including how to protect oneself from it, see here.

Will Central Bankers Have the Same Courage On the Way Out?

Exit interview here with outgoing Fed Governor Kevin Warsh, who openly discusses his skepticism of QE2, how inflation is the cruelest tax of all, and other topics.

On the Fed's long talked about but still distant plan to 'exit', or unwind, its unprecedented monetary stimulus, he states "Central bankers must have the same courage on the way out that they had going in".

But just how likely is that? Given the current unemployment situation, and the Fed's dual mandate of stable prices and low unemployment, the Fed seems destined to remain in neutral or biased towards putting it's foot back on the money printing pedal.

The Fed has now surpassed China as the largest holder of government debt and has made it abundantly clear that its weak U.S. dollar policy, hashed in the interest of kickstarting exports, is not really open to negotiation.

Bottom line: don't expect the Fed to have the same courage when (or if) it belatedly decides to exit its massive monetary stimulus.

Bill Gross Harps on Financial Repression

Picking up right where he left off last month, the Bond King's latest letter sounds-off on how financial repression is a bad deal for U.S. treasury investors.

Video: Bill Gross on U.S. Financial Repression

Econ Myth Busting: Sorry John Carney, the U.S. is Not a Default Virgin

I'm a big fan of American Public Media's Marketplace radio show, but Friday's show featured CNBC's John Carney and Fortune's Leigh Gallagher discussing the U.S. debt situation.

Both John and Leigh stated the oft-repeated myth that the U.S. has *never* defaulted.

If only that were true.

The above summary is from Carmen Reinhart's and Ken Rogoff's research in their superb book This Time is Different, which is available in the Good Books and Films section on the far right column of this blog.

As you can see from their research not only has the U.S. defaulted, but the U.S. has defaulted or 'restructured' (a partial-default) at least once every century since the founding of the republic. Details on each episode can be found in the book and at Carmen's website.

As Reinhart and Rogoff put it, the U.S. is definitely not a "default virgin".

What is Financial Repression and How Investors Can Protect Themselves

Carmen Reinhart

Financial repression, a subject last widely studied in development economics circles in the 1970s-80s, appears to be making a comeback. Bill Gross dedicated his May investment letter to financial repression, and an article by the FT's Gillian Tett describes how both policymakers and investors are having to refamiliarze themselves with its tenets.

Just what exactly is the ominous sounding 'financial repression'? Below is an abridged definition from Reinhart & Rogoff's This Time is Different:

Banks are vehicles that allow governments to squeeze more indirect tax revenue from citizens by monopolizing the entire savings and payment system. Governments force local residents to save in banks by giving them few, if any, other options. 

They then stuff debt into the banks via reserve requirements and other devices. This allows the government to finance a part of its debt at a very low interest rate; financial repression thus constitutes a form oftaxation. Governments frequently can and do make the financial repression tax even larger by maintaining interest rate caps while creating inflation.

The 'Era of Financial Repression'

Carmen Reinhart and M. Belen Sbrancia recently published a paper which analyses the extent of financial repression among advanced economies in the post-World War II period. Here's Reinhart's and Sbrancia's updated definition of financial repression, which now includes pension funds along with banks in their list of domestic captives:

A subtle type of debt restructuring takes the form of “financial repression.” Financial repression includes directed lending to government by captive domestic audiences (such as pension funds), explicit or implicit caps on interest rates, regulation of cross-border capital movements, and (generally) a tighter connection between government and banks.

They studied the post-WWII period:

In the heavily regulated financial markets of the Bretton Woods system, several restrictions facilitated a sharp and rapid reduction in public debt/GDP ratios from the late 1940s to the 1970s. Low nominal interest rates help reduce debt servicing costs while a high incidence of negative real interest rates liquidates or erodes the real value of government debt. 

And their key finding which has PIMCO's Bond King in a tizzy:

Continue reading the full article at SeekingAlpha here.