Economics

Dec. 11, 2011

Keywords: European Crisis, Debt Crisis, Financial Crisis

As always at year end I am reading through the "cacophony" of forecasts for the next year.

Menzie Chinn has put together some "fantastical pseudo economics" for the past year:

Econbrowser: The Year in Review: Fantastical Pseudo Economics, Dec. 29, 2011

here is some reading about "big thing forecasters":

About predictors of "big things"

Keywords: Economic Reasoning, Economic Forecasts, Pseudo Economics (not the same as Voodoo Economics....)

Keywords: Global Wealth, Global Development, Prosperity

Related:

"Niall Ferguson Killer Apps" on MarketObservation

Income distribution in various world regions

We had yesterday a fireplace discussion on how highly indebted governments could reduce their debt.

Reinhart and Belen give good insights on this topic.

Here is some more reading about the topic from other researchers:

Ali Abbas, S. M., Belhocine, Nazim, ElGanainy, Asmaa A and Horton, Mark, Historical Patterns and Dynamics of Public Debt - Evidence from a New Database (November 2011). IMF Economic Review, Vol. 59, Issue 4, pp. 717-742, 2011. Available at SSRN: http://ssrn.com/abstract=1970140 or doi:10.1057/imfer.2011.24

Keywords: Government Debt, Government Debt Reduction

Keywords: Currency Reserves, Exchange Rates

Interesting 1982 article of Paul M. Sweezy on business cycles and the stagnation of that time.

Monthly Review: Why Stagnation? Paul M. Sweezy, 1982

Sweezys thoughts have become relevant again. The big question is what could bring us back on an upward trend.

answers.com has extracts from Gale Encyclopedia on business cycle theory. For the current state we are facing in Western economies the excerpt "Factors That Shape Business Cycles" is of particular interest:

"For centuries, economists in both the United States and Europe regarded economic downturns as "diseases" that had to be treated; it followed, then, that economies characterized by growth and affluence were regarded as "healthy" economies. By the end of the 19th century, however, many economists had begun to recognize that economies were cyclical by their very nature, and studies increasingly turned to determining which factors were primarily responsible for shaping the direction and disposition of national, regional, and industry-specific economies. Today, economists, corporate executives, and business owners cite several factors as particularly important in shaping the complexion of business environments.

VOLATILITY OF INVESTMENT SPENDING. Variations in investment spending is one of the important factors in business cycles. Investment spending is considered the most volatile component of the aggregate or total demand (it varies much more from year to year than the largest component of the aggregate demand, the consumption spending), and empirical studies by economists have revealed that the volatility of the investment component is an important factor in explaining business cycles in the United States. According to these studies, increases in investment spur a subsequent increase in aggregate demand, leading to economic expansion. Decreases in investment have the opposite effect. Indeed, economists can point to several points in American history in which the importance of investment spending was made quite evident. The Great Depression, for instance, was caused by a collapse in investment spending in the aftermath of the stock market crash of 1929. Similarly, prosperity of the late 1950s was attributed to a capital goods boom.

There are several reasons for the volatility that can often be seen in investment spending. One generic reason is the pace at which investment accelerates in response to upward trends in sales. This linkage, which is called the acceleration principle by economists, can be briefly explained as follows. Suppose a firm is operating at full capacity. When sales of its goods increase, output will have to be increased by increasing plant capacity through further investment. As a result, changes in sales result in magnified percentage changes in investment expenditures. This accelerates the pace of economic expansion, which generates greater income in the economy, leading to further increases in sales. Thus, once the expansion starts, the pace of investment spending accelerates. In more concrete terms, the response of the investment spending is related to the rate at which sales are increasing. In general, if an increase in sales is expanding, investment spending rises, and if an increase in sales has peaked and is beginning to slow, investment spending falls. Thus, the pace of investment spending is influenced by changes in the rate of sales.

MOMENTUM. Many economists cite a certain "follow-the-leader" mentality in consumer spending. In situations where consumer confidence is high and people adopt more free-spending habits, other customers are deemed to be more likely to increase their spending as well. Conversely, downturns in spending tend to be imitated as well.

TECHNOLOGICAL INNOVATIONS. Technological innovations can have an acute impact on business cycles. Indeed, technological breakthroughs in communication, transportation, manufacturing, and other operational areas can have a ripple effect throughout an industry or an economy. Technological innovations may relate to production and use of a new product or production of an existing product using a new process. The video imaging and personal computer industries, for instance, have undergone immense technological innovations in recent years, and the latter industry in particular has had a pronounced impact on the business operations of countless organizations. However, technological innovations—and consequent increases in investment—take place at irregular intervals. Fluctuating investments, due to variations in the pace of technological innovations, lead to business fluctuations in the economy.

There are many reasons why the pace of technological innovations varies. Major innovations do not occur every day. Nor do they take place at a constant rate. Chance factors greatly influence the timing of major innovations, as well as the number of innovations in a particular year. Economists consider the variations in technological innovations as random (with no systematic pattern). Thus, irregularity in the pace of innovations in new products or processes becomes a source of business fluctuations.

VARIATIONS IN INVENTORIES. Variations in inventories—expansion and contraction in the level of inventories of goods kept by businesses—also contribute to business cycles. Inventories are the stocks of goods firms keep on hand to meet demand for their products. How do variations in the level of inventories trigger changes in a business cycle? Usually, during a business downturn, firms let their inventories decline. As inventories dwindle, businesses ultimately find themselves short of inventories. As a result, they start increasing inventory levels by producing output greater than sales, leading to an economic expansion. This expansion continues as long as the rate of increase in sales holds up and producers continue to increase inventories at the preceding rate. However, as the rate of increase in sales slows, firms begin to cut back on their inventory accumulation. The subsequent reduction in inventory investment dampens the economic expansion, and eventually causes an economic downturn. The process then repeats itself all over again. It should be noted that while variations in inventory levels impact overall rates of economic growth, the resulting business cycles are not really long. The business cycles generated by fluctuations in inventories are called minor or short business cycles. These periods, which usually last about two to four years, are sometimes also called inventory cycles.

FLUCTUATIONS IN GOVERNMENT SPENDING.
Variations in government spending are yet another source of business fluctuations. This may appear to be an unlikely source, as the government is widely considered to be a stabilizing force in the economy rather than a source of economic fluctuations or instability. Nevertheless, government spending has been a major destabilizing force on several occasions, especially during and after wars. Government spending increased by an enormous amount during World War II, leading to an economic expansion that continued for several years after the war. Government spending also increased, though to a smaller extent compared to World War II, during the Korean and Vietnam wars. These also led to economic expansions. However, government spending not only contributes to economic expansions, but economic contractions as well. In fact, the recession of 1953-54 was caused by the reduction in government spending after the Korean War ended. More recently, the end of the Cold War resulted in a reduction in defense spending by the United States that had a pronounced impact on certain defense-dependent industries and geographic regions.

POLITICALLY GENERATED BUSINESS CYCLES.
Many economists have hypothesized that business cycles are the result of the politically motivated use of macroeconomic policies (monetary and fiscal policies) that are designed to serve the interest of politicians running for re-election. The theory of political business cycles is predicated on the belief that elected officials (the president, members of congress, governors, etc.) have a tendency to engineer expansionary macroeconomic policies in order to aid their re-election efforts.

MONETARY POLICIES. Variations in the nation's monetary policies, independent of changes induced by political pressures, are an important influence in business cycles as well. Use of fiscal policy—increased government spending and/or tax cuts—is the most common way of boosting aggregate demand, causing an economic expansion. Moreover, the decisions of the Federal Reserve, which controls interest rates, can have a dramatic impact on consumer and investor confidence as well.

FLUCTUATIONS IN EXPORTS AND IMPORTS. The difference between exports and imports is the net foreign demand for goods and services, also called net exports. Because net exports are a component of the aggregate demand in the economy, variations in exports and imports can lead to business fluctuations as well. There are many reasons for variations in exports and imports over time. Growth in the gross domestic product of an economy is the most important determinant of its demand for imported goods—as people's incomes grow, their appetite for additional goods and services, including goods produced abroad, increases. The opposite holds when foreign economies are growing—growth in incomes in foreign countries also leads to an increased demand for imported goods by the residents of these countries. This, in turn, causes U.S. exports to grow. Currency exchange rates can also have a dramatic impact on international trade—and hence, domestic business cycles—as well."

Read more: http://www.answers.com/topic/business-cycle#ixzz1hzz7GdmX

Think yourself about options politicians, central bankers and business leaders currenty have...

Even more government spending?
Further monetary expansion?
Re-establishing trust in governments through consistend and efficient action (e.g. EU politicians)?
Creation of favorable investment climate, e.g. through tax benefits?
Constant improvement of free trade?
Constant improvement of labor mobility?
Constant improvement of industrial productivity?
Investment in education, particularly engineering?
Financial innovation which improves access to investment capital?
etc. etc.

There still seem to be many ways to improve the economy. The sky will not fall. However, politicians in Europe and the US should now act decisively towards creating an environment which re-establishes trust in public finances and which is more predictable for businesses and investors.

Must read reflections of Jesus Huerta de Soto on money, bank, credit and economic cycles:

Some Additional Reflections on the Economic Crisis and the Theory of the Cycle, by Jesus Huerta de Soto, Dec. 29, 2011

Issues and questions tackled are:

1. The Relationship between Credit Expansion and Environmental Damage
2. Then Is Credit Expansion Really Necessary to Boost Economic Growth?
3. Is It True that Banks Caused the Crisis by Incurring Risks Disproportionate to Their Capital?
4. So the Problem with the Banking System Is that Bankers Did Not Manage to Properly Harmonize the Deadlines of Loans Granted with Those of Deposits Received?
5. Can an Isolated Bank Escape Unscathed in the Case of Widespread Credit Expansion?
6. Savings as a "Flow" Magnitude versus Cash Balances in the Form of Deposits as a "Stock" Magnitude
7. Does Leland Yeager Offer a Sound Argument when He Asserts that It Is Impossible to Distinguish between Demand Deposits and Very Short-Term Loans?
8. What Are the Possible Scenarios in the Event of a Crisis like the Present One?
9. What Measures in the Right Direction Could Now Be Adopted to Bring Us Closer, Even If Timidly, to the Ideal Financial System of a True Free-Market Economy?
10. Conclusion: Bewilderment among Theorists and Citizens

Keywords: Economic Theory, Business Cycle, Financial Crisis

Great column by Harvard's Martin Feldstein on Project Syndicate, pointing out that French politicians should not continue to palaver but start to put their country in order:

..."Looking ahead, stopping the eurozone financial crisis does not require political union or a commitment of German financial support. It depends on individual eurozone countries – especially Italy, Spain, and France – making the changes in their domestic spending and taxation that will convince global financial investors that they are moving toward budget surpluses and putting their debt-to-GDP ratios on a downward path.".... Source: Martin Feldstein

Project Syndicate: The French Don’t Get It, by Martin Feldstein, Dec. 28, 2011

Keywords: European Crisis, French Politics, French Economy

..."One big factor is that presidential ratings can be, in part, a mirror of how people feel about the economy and their own prospects. And on that front, the consumer outlook is that the economy is weak but improving."

CNBC: Obama Sees Approval Rating Rise: Is It the Economy? Dec. 28, 2011

Keywords: Economic Cycle, Presidential Election

Good article by Tyler Cowen on bank borrowing, regulation and more:

NYT: From the Fed, a Shield Against Europe, Dec. 24, 2011

Keywords: US Economy, European Economy, Bank Regulation, Fed Policy

Blackstone's Byron Wien on the Macro Environment, Nov. 2011

Keywords: US Economy, Global Economy

J.H. Cochrane thinks that sovereigns should be able to default and that banks should treat sovereign debt just as other debt. He shows that so far Europe has gone a different way:

"Banking misregulation was the euro’s fatal flaw. Sovereign debt, which can always avoid explicit default when countries print money, doesn’t remain risk-free in a currency union. Yet banking regulators and ECB rules continue to pretend otherwise.

So, by artful application of bad ideas, Europe has taken a plain-vanilla sovereign restructuring and turned it into a banking crisis, a currency crisis, a fiscal crisis, and now a political crisis."

Bloomberg: How Bad Ideas Worsen Europe’s Debt Meltdown: John H. Cochrane, Chicago Booth School of Business and an adjunct scholar of the Cato Institute, Dec. 22, 2011

Keywords: European Crisis, Sovereign Debt Crisis, European Fiscal Union, European Monetary Union

Great graph on the origins of the financial crisis. Showing clearly a combination of easy money, de-regulation, reckless leveraging and market failure.

Source: Ritholtz, The Big Picture

Keywords: Financial Crisis, Origins of the Financial Crisis

Morgan Stanley: Global Economic Forum, 2012 Outlook

..."Our base case assumes that European governments make a big step towards fiscal integration soon that stabilises confidence, and that US Congress extends most of this year's stimulus"....

"We also construct a ‘reasonable' bull case, which assumes a swift and convincing solution of Europe's sovereign crisis and a balanced US medium-term deficit-reduction plan combined with extension of fiscal stimulus into next year. Confidence and domestic demand would pick up and world trade would grow by 2 percentage points more than in the base case. In this scenario, global GDP expands by 4.2% in 2012, against 3.5% in the base case and 1.9% in the bear case"...

go here to read the analysis

Keywords: Global Economy, European Economy, US Economy

Keywords: BRICs, Global Economy

CNBC: Mark Mobius Sees End to Euro Crisis by June: Report, Dec. 21, 2011

Mark Mobius, Franklin Templeton executive, believes that

• Investors are overstating the European crisis. Negotiations among nations take time. Major improvement of the situation can be seen mid 2012
• Size of derivatives tied to European sovereign debt offered real risks to investors
• Brazil "is in a very good situation"; has a big consumer market and a diversified economy
• Chinese economy expansion will likey to continue at elevated rates, but risks are in real estate markets

go to CNBC to read the article

Keywords: European Crisis, Global Economy, Chinese Economy, Brazilian Economy

IMF direct: 2011 In Review: Four Hard Truths, Dec. 21, 2011

First, post the 2008-09 crisis, the world economy is pregnant with multiple equilibria—self-fulfilling outcomes of pessimism or optimism, with major macroeconomic implications.

Second, incomplete or partial policy measures can make things worse.

Third, financial investors are schizophrenic about fiscal consolidation and growth.

Fourth, perception molds reality.

read more on the IMF direct homepage

Keywords: Global Economy, Economy in 2011

Related:

The collapsing intellectual case for the government’s economic strategy, Duncan Weldon, Dec. 22, 2011

Good article on the role of entrpreneurs for fixing a sluggish economy:

Project Syndicate: Who Will Fix the US Economy? Henry Mintzberg, Dec. 22, 2011

..."Public support should be shifted from protecting large established corporations to encouraging the growth of newer enterprises. And startups should be discouraged from rushing into the embrace of the stock market’s short-sighted analysts (and many an established corporation should be encouraged to escape that embrace). At the same time, regulation and taxation should be used to rein in disruptive day trading and other exploitative speculation that crowds out sustainable investment and disrupts regular business activities.

Above all, what the American economy needs now are managers who know and care about their businesses. Armies of MBAs who have been trained to manage everything in general but nothing in particular are part of the problem, not the solution. So are economists who study clouds without ever getting wet.

Keywords: Economic Problems, Role of Entrepreneurs

Dec. 18, 2011

Keywords: Euro, Dollar

CNBC: Euro Bonds Would Destroy Euro Zone: Ex-ECB Economist, Dec. 14, 2011

"Euro bonds, giving the EFSF a bank licence – I think this would have destroyed the euro zone in the long run."

"For me, an independent central bank should stay away from being involved in political decisions"

Otmar Issing, former Chief Economist at the European Central Bank

read more on Otmar Issing's thinking in The Washington Post

Keywords: Europe, European Problem, Eurobonds, Central Bank Independence