From a recent speech by Mark Carney, Governor of the Bank of Canada entitled ‘Growth in the Age of Deleveraging.’   The following is a summery inside the speech.  Read the entire speech because it gives a common sense description of where we are in the debt deleveraging cycle and it warns against exacting too much austerity as well as encouraging too much inflation in efforts to delever without economic collapse.

The market cannot be solely relied upon to discipline leverage. It is not just the stock of debt that matters, but rather, who holds it. Heavy reliance on cross-border flows, particularly when they fund consumption, usually proves unsustainable. As a consequence of these errors, advanced economies are entering a prolonged period of deleveraging. Central bank policy should be guided by a symmetric commitment to the inflation target. Central banks can only bridge real adjustments; they can’t make the adjustments themselves. Rebalancing global growth is the best option to smooth deleveraging, but its prospects seem distant.

Beezer here.  The speech is easy to understand and accurately, in our opinion, weights the problems we all face now.  From balance of payment issues in Europe, to currency manipulation in global markets, to private debt becoming public debt in the US and in Europe, Carney hits all the issues.  Underlying Carney’s understanding is not just the debt problem, but the demand problem deleveraging creates.  It’s a high wire act to produce an orderly debt restructuring so political actors need to understand the issues and explain them fairly and honestly to the public that’s being asked to sacrifice.  Unfortunately, this isn’t being done well in Europe, and not at all in the US where politics almost totally unhinged from reality dominates.

If you want to know why liberal economist Paul Krugman constantly harps on raising inflation (reflation) in our current mess and not obsessing about deficits or debt levels as the austerity folks do, you need to read economist Irving Fisher’s seminal paper on debt deflation, published in 1933.

A few selection from this paper, which takes about 45 minutes to read.

Assuming, accordingly, that, at some point of time, a state of over-indebtedness exists, this will tend to lead to liquidation, through the alarm either of debtors or creditors or both. Then we may deduce the following chain of consequences in nine links: (1) Debt liquidation leads to distress selling and to (2) Contraction of deposit currency, as bank loans are paid off, and to a slowing down of velocity of circulation. This contraction of deposits and of their velocity, precipitated by distress selling, causes (3) A fall in the level of prices, in other words, a swelling of the dollar. Assuming, as above stated, that this fall of prices is not interfered with by reflation or otherwise, there must be (4) A still greater fall in the net worths of business, precipitating bankruptcies and (5) A like fall in profits, which in a ” capitalistic,” that is, a private-profit society, leads the concerns which are running at a loss to make (6) A reduction in output, in trade and in employment of labor. These losses, bankruptcies, and unemployment, lead to (7) Pessimism and loss of confidence, which in turn lead to (8) Hoarding and slowing down still more the velocity of circulation. The above eight changes cause (9) Complicated disturbances in the rates of interest, in particular, a fall in the nominal, or money, rates and a rise in the real, or commodity, rates of interest……

And, vice versa, deflation caused by the debt reacts on the debt. Each dollar of debt still unpaid becomes a bigger dollar, and if the over-indebtedness with which we started was great enough, the liquidation of debts cannot keep up with the fall of prices which it causes. In that case, the liquidation defeats itself. While it diminishes the number of dollars owed, it may not do so as fast as it increases the value of each dollar owed. Then, the very effort of individuals to lessen their burden of debts increases it, because of the mass effect of the stampede to liquidate in swelling each dollar owed. Then we have the great paradox which, I submit, is the chief secret of most, if not all, great depressions: The more the debtors pay, the more they owe. The more the economic boat tips, the more it tends to tip. It is not tending to right itself, but is capsizing……

Unless some counteracting cause comes along to prevent the fall in the price level, such a depression as that of 1929-33 (namely when the more the debtors pay the more they owe) tends to continue, going deeper, in a vicious spiral, for many years. There is then no tendency of the boat to stop tipping until it has capsized. Ultimately, of course, but only after almost universal bankruptcy, the indebtedness must cease to grow greater and begin to grow less. Then comes recovery and a tendency for a new boom-depression sequence. This is the so-called “natural” way out of a depression, via needless and cruel bankruptcy, unemployment, and starvation.  On the other hand, if the foregoing analysis is correct, it is always economically possible to stop or prevent such a depression simply by reflating the price level up to the average level at which outstanding debts were contracted by existing debtors and assumed by existing creditors, and then maintaining that level unchanged. 

Beezer here.  Today we call the bold print above the ‘paradox of thrift.’  But the original concept was Fisher’s,  who iconic economist Milton Friedman considered America’s greatest economist.   Fisher said reflation of the currency, or looked at another way something that keeps nominal wages from spiraling downward, was the proper way to keep a recession caused by over-indebtedness from a deflationary spiral and a devastating Depression.  Austerity measures, both in the US and in the European Union, are capable of turning a severe recession caused by over-indebtedness into another Great Depression.  Read the entire article, which also lists what ‘starts’ periods of over-indebtedness.   At any rate, if you do read the entire article you will understand why Krugman counsels as he does.

Economics professor Robert Reich, Secretary of Labor under President Bill Clinton describes our real problems and calls for Obama to reverse course and aggressively fight the great recession.

Before I turn to the President, though, let’s be clear: The lousy economy is due to insufficient demand. Consumers – who are 70 percent of the economy — can’t and won’t buy because they’re running out of cash. They can’t borrow against homes that are worth a third less than they were five years ago, and most consumers are bad credit risks anyway because they’re losing their jobs and their wages are dropping.  They also have to start saving for the kids’ college or for retirement, which will cut their spending even more.

 Without enough consumers, businesses won’t hire enough people and pay them enough to reverse the vicious cycle. So we’re dead in the water. Even the stock market has caught on to the truth.

Unfortunately for the economy, Reich hears President Obama has thrown in the towel and decided doing much about jobs is a non-starter given the Tea Party controlled House of Representatives.

Which gets me to the President. Even though the President’s two former top economic advisers (Larry Summers and Christy Roemer) have called for a major fiscal boost to the economy, the President has remained mum. Why?

I’m told White House political operatives are against a bold jobs plan. They believe the only jobs plan that could get through Congress would be so watered down as to have almost no impact by Election Day. They also worry the public wouldn’t understand how more government spending in the near term can be consistent with long-term deficit reduction. And they fear Republicans would use any such initiative to further bash Obama as a big spender.

So rather than fight for a bold jobs plan, the White House has apparently decided it’s politically wiser to continue fighting about the deficit. The idea is to keep the public focused on the deficit drama – to convince them their current economic woes have something to do with it, decry Washington’s paralysis over fixing it, and then claim victory over whatever outcome emerges from the process recently negotiated to fix it. They hope all this will distract the public’s attention from the President’s failure to do anything about continuing high unemployment and economic anemia…..

There’s still time for political operatives in the White House – and the person they work for – to change their minds. If economic stresses increase, Americans may insist on government doing more. A CNN poll released Monday found 60% believe the nation remains in an economic downturn and conditions are worsening. Only 36% believed that in April.

But for now the President is being badly advised. The magnitude of the current jobs and growth crisis demands a boldness and urgency that’s utterly lacking. As the President continues to wallow in the quagmire of long-term debt reduction, Congress is on summer recess and the rest of Washington is asleep.

The President should present a bold plan, summon lawmakers back to Washington to pass it, and, if they don’t, vow to fight for it right up through Election Day.

Beezer here.  Incredibly, those who have predicted runaway inflation and counseled austerity as the cure, both in the US and Europe, are still being listened to by politicians.  Everything these people predicted has been totally wrong.  Interest rates have never been lower.  Inflation is subdued to the point of indicating disinflation, even deflation, could be lurking ahead.  Equity markets are struggling to regain their footing because investors know that government austerity and the total lack of any real jobs programs is bad for the economy, not good.    They know that this approach will make debts harder to pay down, not easier.  Bank analysts are busy marking down their predictions for future growth.  Paul Krugman, a leading proponent of larger stimulus and aggressive jobs programs, complains that even though his and Reich’s predictions (among many others including Nobel laureate Joe Stiglitz) have all been correct, political leaders still listen to those who have been wrong all along.

To be an economist of my stripe these days — basically a Keynes-via-Hicks type, who concluded as soon as Lehman fell that we were in a classic liquidity trap with all that implied — is a bittersweet experience, with the bitter vastly greater than the sweet.

The good news, such as it is, is that our underlying model has performed very well. Interest rates have stayed low despite large government borrowing; crowding out has been totally absent; huge increases in the monetary base have not been highly inflationary.

The bad news is that policy makers almost everywhere have failed dismally, and seem determined not to take on board the lessons of experience, either historical or what we’ve learned the past few years. As Joe Stiglitz says,

When the recession began there were many wise words about having learnt the lessons of both the Great Depression and Japan’s long malaise. Now we know we didn’t learn a thing. Our stimulus was too weak, too short and not well designed. The banks weren’t forced to return to lending. Our leaders tried papering over the economy’s weaknesses – perhaps out of fear that if we were honest about them, already fragile confidence would erode. But that was a gamble we have now lost. Now the scale of the problem is apparent, a new confidence has emerged: confidence that matters will get worse, whatever action we take. A long malaise now seems like the optimistic scenario.

Robert Reich, talking to people in the administration, says that there has been a deliberate decision to focus on the wrong issues, knowing that they’re the wrong issues:

So rather than fight for a bold jobs plan, the White House has apparently decided it’s politically wiser to continue fighting about the deficit. The idea is to keep the public focused on the deficit drama – to convince them their current economic woes have something to do with it, decry Washington’s paralysis over fixing it, and then claim victory over whatever outcome emerges from the process recently negotiated to fix it. They hope all this will distract the public’s attention from the President’s failure to do anything about continuing high unemployment and economic anemia.

And in Europe, says Kantoos Economics, a low inflation target has become a sacred icon even though all evidence – including the experience under the gold standard! — says that this will be fatal:

I sincerely do hope that I read the wrong newspapers and missed all those European economists and commentators screaming all these things (or even better: that I am wrong). But whenever I try to hear something, there is just silence – or Axel Weber lashing out at Olivier Blanchard. Meanwhile, European policy makers and central bankers are wrecking one of the most fascinating projects in human history, the unity and friendship among the countries of Europe. This is beyond depressing. Way beyond.

I’m still trying to make sense of this global intellectual failure. But the results are not in question: we are making a total mess of a solvable problem, with consequences that will haunt us for decades to come.

Beezer here.  Hat tip once again to economics professor Mark Thoma’s economist’s view blogsite.  Everyday Thoma’s site scours the internet landscape culling the best economic thinking and highlighting it at economist’s view.  A first must-read for anyone seriously interested in understanding our nation’s economy, and the politics of it all.

Investment advisor, popular blogger and regular contributor to CNBC, Barry Ritholtz points out an inconvenient fact  to all those gnashing their teeth about today’s weak dollar.

“The hand-wringing about the US dollar is rather late to the party.

Where were all you concerned dollar bulls earlier in the decade? It strikes me that like the late-to-discover inflation, you folks cannot spot a trend until it bites you in your collective asses.

While the WSJ is upset that the dollar has been range bound between 72-87 the past 3 years, I strongly urge them to look at the 7 years before that.

Consider the following charts: The one at right was in today’s WSJ, and shows the US currency off by less than 20% over the past few years.

That’s not a dollar collapse; A fall from 121.02 in July 2001 to 70.69 in March 2008 — Now THATS a dollar collapse:

Source: Barchart.com

Beezer here.  Facts are just so yesterday.  Who are these people that keep reminding us of the truth and provide some perspective?

Beezernotes is basically a series of narratives comprised from writings across the internet, selected by Beezer.  The point is that very few of these posts are original to Beezer, who’s basic training is print journalism.  It’s reporting, not academic.

Due to the recession, most of the posts deal with the financial world.  This has been the primary narrative of Beezernotes, but not the only one.    This preface is entered just as a reminder about what Beezernotes is, and is not.

That said, there are two sub themes in the financial world, deflation/inflation and trade surplus/deficit, that provide a lot of gist for what’s in Beezernotes and in many other blogs on the internet.  Understanding these two themes is important to understanding the recession.

Economist Paul Krugman, of Princeton, the New York Times and the Nobel Prize, addresses in a very succinct way what’s important to remember when considering these two sub themes.  From a NYT blog post by Krugman:

“One Size Doesn’t Fit …

Many of the reactions to my writing, both in comments here and more generally, seem to be along one of the following lines:

(a) You say devaluation/inflation is good — but how did it work out in the 1970s/Zimbabwe? Hah!

(b) You say Germany is being evil by running a trade surplus — but you praise it in Iceland. Inconsistent!

What such comments betray is a mindset that relies on slogans, not models — or, more kindly, a failure to appreciate that economic policy requires that you pay attention to circumstances.

Thus, on the devaluation issue: devaluation is helpful when your problem is one of inadequate demand, so that an improvement in the cost-competitiveness of your industry can help you expand. It’s not good if you’re suffering from an overheating, inflation-prone economy. It depends on the nature of your unhappiness.

On the trade issue: the world’s problem is that it’s facing a deleveraging shock, in which highly indebted players are being forced to cut spending sharply; what we need is for those not deeply in debt to spend more to compensate. Iceland is in the first category, Germany in the second.

I realize that this isn’t how some understand economics; they want it to be stable prices and free markets, hallelujah and amen. But life, and economics, aren’t that simple.”

Beezer here.  Krugman is a talented, award winning economist who just happens to have the gift of sorting out the chaff and thus reducing what are often complicated dynamics into relatively understandable explanations of events.  Beezer often cites Krugman because Krugman’s predictions of what will happen have been spot on.  Will Krugman always be right?  Most probably not. 

But even when he inevitably falls short, a reader will understand where Krugman has gone wrong because Krugman is understandable.  You don’t need a thorough understanding of differential calculus to follow his reasoning.  And no doubt Krugman will explain his failure as well as he explains his successes.

His post today basically asks that readers keep an open mind and always accept the truth that the world is not a simple, predictable place.  Circumstances need to be understood.  Composition needs to be understood.  And thanks to people like Krugman, sorting out both is explained and, if need be, itemized.

Wonderful Thanksgiving at the Beezer household and, it is hoped, at yours too.  Now on to Christmas!

There’s been an intellectual tug of war over whether inflation or deflation is the most likely future for the US economy.  Obviously the Federal Reserve is more concerned, at the moment, about deflation taking hold.  That’s one reason, possibly the primary one, for the Quantitative Easing II (QEII) the Fed is currently executing.  The Fed may buy as many as $600 billion in Treasuries before QEII is over.

That said, the public often doesn’t understand what comprises the CPI index, and more particularly the ‘core’ CPI used by officials to track inflation trends.  Which is why we’re reprinting the following analysis of the most recent CPI figures. 

The analysis at Zacks Investment Research by Dirk van Dijk not only explains the CPI and core CPI, but it also provides historical context and suggests what the CPI figures are predicting right now.  van Dijk has been studying and analyzing securities for more than 25 years. 

“The Consumer Price Index (CPI) rose by just 0.2% in October, up from 0.1% September, but down from increases of 0.3% in August and July. Year over year, it is up just 1.2%. Almost all of the increase was due to energy prices, which rose 2.6% after increases of 0.7% in September and 2.3% in August. Year over year, energy prices are up 5.9%.

Actually the increase is even narrower than that, as energy commodities such as gasoline were up 4.4% after increases of 1.8% in September and a 3.8% increase in August. That is much higher than inflation in the rest of the economy. The relative pricing strength in energy commodities suggests that it would be a good idea to be over weighted in the energy sector.

Energy service prices, like electricity and piped gas service actually rose by just 0.2% after falling by 0.8% in September. In August it increased just 0.2%. Year over year, energy services prices are a very well behaved, rising just 0.9%.

Food prices were also relatively well behaved, rising just 0.1% after being up 0.3% in September and 0.2% in August. Year over year, food prices are up 1.4%. Due to poor harvests in several important areas of the world — most notably due to droughts in Russia, and floods in Pakistan — agricultural commodity prices have been rising sharply, although they have recently backed off. So far they have had relatively little impact on Consumers shopping at Kroger’s (KR – Analyst Report).

The actual cost of raw wheat is a very small fraction of the actual cost of a loaf of bread, so one would not want to exaggerate the likely impact of higher prices in the commodity pits on prices at the checkout counter.

Core Inflation

Thus, if one strips out the volatile food and energy prices to get to core inflation, prices were unchanged, the third straight month of being unchanged. Year over year, core prices are up 0.6%. Over the last three months, the increase annualizes to 0.0%.

While everyone consumes food and energy, their prices tend to be extremely volatile, and can be influenced by external events. As such, the Fed tends to focus more on core prices when setting monetary policy. After all, it would not be a good idea to be tightening up on the money supply or raising interest rates simply because there is a drought in a key agricultural area of the world which drives up food prices, or because there is instability in the Middle East which causes energy prices to rise.

Together food and energy make up just 22.3% of the total CPI. The graph below tracks the long-term history of the CPI (year over year change) on both a headline and a core basis. Note that core CPI is at an all-time low for the period on the graph (and I cut out the really high inflation 1970’s so you could get a better sense of the more recent movements). The year-over-year change in core CPI is at a record low level, and records go back to 1957.

Another Report Vindicating QE2

This report is a vindication of the Fed decision to undertake another round of quantitative easing.  The danger of QE2 is that it could set off a round of inflation; many critics say “hyperinflation.” That, however, is not the danger the economy faces, deflation is.

Deflation is a very nasty beast, and one that the Fed must stop from emerging at all costs. At any given level it is far more insidious than inflation; we can and have done reasonably well as an economy with 3 or 4% inflation, but 3 or 4% annual deflation would be an economic nightmare.

For starters, nominal interest rates do not go below 0.0%, which means that real interest rates rise sharply. That will choke off capital investment in the economy. At the same time, if people know that prices are going to be lower in the future than they are now, they will sit on their wallets.  Total demand will fall.

With no customers, since they are all sitting and waiting for prices to go down, businesses will have even less reason to invest and will have need of fewer employees. The resulting layoffs will result in still less aggregate demand. Lather, Rinse, Repeat.

Housing Keeping Core Levels Low

The key reason why the core CPI has been so low of late is the cost of shelter. Housing prices are not measured directly through a housing price index like Case-Schiller. Instead, the government tries to measure just how much it would cost you to rent a house equivalent to the house you own next door to it.

This is known as Owner’s Equivalent Rent (OER). It makes up 25.21% of the CPI, or more than food and energy combined. Regular rent, paid by tenants to landlords, makes up another 5.97% of the overall CPI. The two rent measures tend to move closely together and combined make up 31.2% of the overall CPI, and since you neither eat nor burn your house (unless you are an arsonist committing insurance fraud) they make up an even larger part of the core CPI, 40.1%.

Regular rent rose just 0.1% in both October and September, reversing a 0.1% decline in August. Over the last year it is up just 0.3%. OER was also up just 0.1% after being unchanged in each of the last two months. Year over year, OER — by far the most important single part of the CPI — is unchanged.

The use of OER, rather than directly tracking housing prices, makes for a much more stable CPI. If housing prices were directly measured — using the Case Schiller index, for example — inflation early in the decade would have been running at levels close to what we saw in the 1970’s, and over the past few years as the housing bubble burst, we would be experiencing severe outright deflation in the core CPI.

Deflation Fears Keeping T-Note Yields Low

Right now, the risk of deflation is greater than the risk of run away inflation. We are not in it yet, at least as measured by core prices, but we are uncomfortably close. The threat of deflation is one of the reasons that long term T-note yields are so low. A return of under 2.9% per year is not very enticing for locking up your money for ten years.

If inflation were to average over the next ten years what it has averaged over the last ten years (2.5%) the increased amount of goods and services you could get for delaying your gratification for a decade would be almost nothing. If it were to average what it has since 1983 (the period covered by the graph above — 3.0% for both core and headline) you would actually lose purchasing power by locking up your money.

At the first hint that inflation is picking up, bond yields can be expected to head much higher. Even though I think that deflation is a greater threat right now than a return to the high inflation of the 1970’s, I do not think that the Fed will allow it to happen.

Deflation is the only scenario under which the purchase of long-term treasuries makes sense at these levels. To buy a T-note, you have to be rooting for breadlines and Hoovervilles. A good way to bet on T-note yields rising is the short treasury ETF (TBT).

Where Prices Are Increasing

So what areas are showing price increases? Health care costs always seem to run faster than overall inflation, but even they seem relatively well behaved. Medical commodity prices (i.e. drugs) were up just 0.1% in October after a 0.3% rise in September, and a 0.2% increase in August. Year over year they were up 2.5%.

Part of the reason for that is probably the increasing substitution of generic drugs for name-brand prescriptions. While prices of drugs still on-patent for firms like Pfizer (PFE – Analyst Report) and Merck (MRK – Analyst Report) are still aggressively rising, they are now losing share to their slightly older drugs that are no longer state-enforced monopolies and have to face the free market.

Medical services prices (i.e. a visit to the hospital) rose 0.2% after they jumped 0.8% in September. But that was after a 0.2% rise in August and after being unchanged in July. Year over year, medical service prices are up 3.6%. That is still higher than the inflation rate elsewhere in the economy, but is far below the average rate of medical inflation in recent decades.

The taming of medical inflation is vitally important, as rapidly rising health care costs are the primary factor in the long-term structural budget deficit. It is the long-term structural deficit that we have to be worried about, not the current big deficit that is mostly due to cyclical factors (reduction in tax revenues and higher automatic stabilizer costs due to high unemployment).

The other noteworthy area of inflation is in car prices, particularly used car prices. That finally changed for the better in September, as they fell 0.7%. That continued this month with a 0.9% decline. Still, we are talking about a 8.9% rise over the last year.

The price of new cars fell 0.2% in October after rising just 0.1% in September and 0.3% August. Year over year, new car prices are up 0.4%. In other words, the remarkable resurgence in the Auto industry, as symbolized by the massive GM IPO today, was not simply due to the car companies being able to jack up prices.

The differential between new and used car prices was obviously unsustainable. If it were to continue for a few more years, a 1999 Ford (F – Analyst Report) Escort would cost more than a new Ford Focus. Somehow I don’t see that happening.

The narrowing of the difference is probably bad news for the big used car dealers like CarMax (KMX – Analyst Report). What we were probably seeing is a large “inferior good” effect. In other words, in tough times, people gravitate to buying the cheaper product, even if is of inferior quality. Used cars relative to new cars meet that description.

Fairly Solid Report

Overall this was a fairly solid report. It does not totally put to bed the danger of deflation. However, this is October data from before the Fed started to actually implement QE2 (although the move was well telegraphed). It certainly does not raise the specter of runaway inflation any time soon. It vindicates the Fed’s decision to go ahead with QE2.

QE2 is bullish for stocks and commodities, a mixed bag for bonds (the additional buying pressure from the Fed would reduce yields, but to the extent that QE2 raises expectations for inflation going forward, long-term yields would tend to rise). It should bearish for the dollar (and thus bullish for other currencies), but so far the effect seems to have been swamped by renewed concerns over the Euro due to the Irish (and potentially Portuguese, and Spanish) debt situation(s).

QE2 should end the risk of outright deflation, and at the margin should help the overall economy. Don’t expect it to have a dramatic effect. It is a poor substitute for what the economy really needs — more fiscal stimulus — but that is simply not going to happen in the current political environment. Instead, fiscal policy is likely to head in the completely wrong direction starting in January, and the additional monetary stimulus will likely be offset by fiscal drag.”