Friday, March 28, 2008

Pandora gets worse

I had the pleasure of meeting Pandora co-founder, Tim Westergreen, at Stanford a year or so ago, and learning how he and his team struggled through the internet bust before finally making it big. Unfortunately, I'm not sure that VC money is helping Pandora as much as it could. They have a new feature, stations organized by Genre, which I think is a nice idea. Here's what that part of the site looks like:

Hmmm. Just 7 genres? Surely there must be more. Suppose you want to listen to some obscure, niche genre, like "rock" -- where might that be? Well, you need to click on that little left arrow 4 times before you see it as an option. Displaying the available genres in such a restricted way is a bad idea, but having "rock" be the least important (last) selection boggles my mind.

Thursday, March 27, 2008

Tug of war

I recently described the tension between the Fed's attempt to print money, and thus increase the money supply, and the financial system's attempt to de-lever in the face of (now obviously) bad loans as two opposing armies. One side is stoking inflation through all means possible, while the other is shedding bad debt, risky loans, and unsustainable consumption on the grounds that it's, well, unsustainable, and so deflating the overall money supply.

The massive money printing by the Fed over the past 10-20 years has resulted in a US economy that is too small for its clothes, and the question is will it grow into a comfortable fit through getting bigger, or can we shrink the clothing itself? In this analogy, I'm not sure which of the two approaches corresponds to the inflationary or deflationary scenario, although as a net saver personally, I prefer deflation.

Cassandra also sees this situation as a tension between inflationary and deflationary forces, describing it as a "a liquidity tug of war". But whatever happens in the markets on a given day, we are still in the early period of a significant financial realignment.

Monday, March 24, 2008

Urbanist in Dubai

City Comforts visits Dubai, and is appalled by the poor urban planning he finds there.
Dubai is doing an absolutely brilliant job of creating itself using the very worst urban model possible: USA 1975. The new part of Dubai is not even remotely a walkable city and gives no promise of being so. (I put it that way because there is so much construction going on that without local knowledge or access to plans it is not totally clear what it will be like.) But none of the real estate advertising I saw, for example, gives any indication that there is more to life than "prestige" and "exclusivity" and "luxury" and nothing to urban charm or walkability etc etc.
All of this is quite true. Dubai is very hot most of the year, so old Dubai, built when it was poorer, has dense shops with individual air conditioners in each shop, and no parking.

The moved some of the old Dubai feel into a rather lovely souk in Sharjah, where tall towers help funnel in breezes and keep the whole thing quite cool, even though it is also not air conditioned.

But the air conditioned mall was a clear favorite, beginning with the now run down Al Ghurair center and continuing on to the ever larger projects being built today.

Dubai's currency is pegged to the dollar, and so it has been experiencing dramatic inflation over the past few years. In a high inflationary environment, you want to take on as much debt as possible, and the best way for individuals to take on debt is to buy mortgaged property . Dubai combines dramatically increasing housing stock with dramatically higher prices, in what is either the largest property bubble since the Ostrich Palaces of Oudtshoorn or the birth of a new Singapore. Or both.

City Comfort is correct to note that urban planning in Dubai is non-existent. The folks advising the Sheik on this stuff are the same people who planned the US and UK in the 60s-80s, so it's unsurprising that the new development is so awful. But once the Sheik learns about smarter urban planning he can change his ship-of-state on a dime. There is a lot to be said of the "government=property developer" model of politics.

(Thanks William!)

Dept of Pomposity

For the policymaker as for the investor, the challenge is to find a way between the Scylla of outdated wisdom and the Charybdis of nihilistic cleverness
Avoid the whole thing.

Friday, March 21, 2008

Less is more

I love the Flip digital camcorder, which is a camcorder, but just barely.

It reminds me of the iPod, which was an mp3 player (but just barely -- no radio, no games, no FM tuner, no voice recorder, no Outlook compatibility, etc.)

(Another aside)

I loved this line in the Economist:
As a result, Mr Reade, who reckons that the fundamentals justify a gold price of only $700-750 an ounce, has “thrown in the towel” and now expects bullion to reach $1,025 within a month and $1,075 within three.
The fundamentals? I would love to see any discounted cash flow for gold, an inert, industrially useless metal, whose only savings graces are 1) Bernanke cannot make more of it, 2) neither can anyone else, 3) people have agreed it's money for ten billions years.

Thursday, March 20, 2008

Opposing armies

In my last post I wrote about how, in the current US financial system, credit is money. It stands to reason, then, that when institutions that used to give out credit start to reign it in, the supply of money shrinks.

So, when mortgage issuers decide to no longer allow zero-down NINJA, neg-am, liar loans, they have reduced the amount of credit in the world and thus shrunk the supply of money. When you have a systematic reduction in credit, because people are trying to decrease the amount of debt they have, then that's called "deleveraging" or a "credit crunch". And just as an increase in the money supply dilutes it ("inflation"), a decrease in the money supply concentrates it ("deflation"). In an inflationary environment, where old dollars are worth less than new dollars, debt is cheap because time will whittle it away. In a deflationary environment, where old dollars are worth more than new dollars, debt is expensive because it grows with time, and cash is king.

As financial institutions reduce their leverage, shrinking the money supply, the Federal Reserve is doing everything it can to counter this by increasing the money supply (diluting the US $). The lower interest rates, the generous lending terms, the swapping crap assets for dollar bills, all increase inflationary pressure. Right now I don't see dramatic inflation or deflation in the US, but I do see extremely powerful forces building for each, and I do not know which will overwhelm the other, or if they will both counterbalance each other perfectly and can both be reduced in sync.

Wednesday, March 19, 2008

Is credit money?

In the current financial system, credit is, without a doubt, money.

Fractional reserve banking enables banks to make loans much larger than their deposits on hand, and these loans act as real live money, buying houses, cars, plasma TVs, etc.

The Austrians certainly have thought longer and harder about this than I have, but it's become clear that credit increases money supply (at least in a fractional reserve system that allows maturity mismatching), and can do it through mechanisms far outside the control of the Fed. One wonders what the point of a Fed is in an environment where so many institutions, many of them not even banks, can create such huge quantities of money through new credit facilities.

One of the primary financial innovations beyond the housing bubble in the US were easier credit facilities for borrowers (the now famous NINJA loans, Opt-ARMs, Neg-Ams, etc.) I don't think that the money these easier credit facilities created show up on M1, M2, M3, or MZM, or M Prime. But they clearly showed up in real estate prices.

So, what does money supply mean in the context where you have the Fed controlling interest rates, and all kinds of other institutions creating and extending credit? More soon.

Tuesday, March 18, 2008

(An aside)

BR is very unimpressed with Alex Tabarrok's piece in the NYTimes. I am too, for it is truly merde, but it's also interesting to see how blogging often, and offering a usefully contrarian view, can get one into the pages of the New York Times, content be damned. And to those who truly want to influence, the Grey Lady beats The Green Bag.

I don't think I'm being unfair when I paraphrase Tabarrok's writing thusly:
- Yes the financial system is a mess because people are worried house prices will fall
- Yes house prices are incredibly high compared to historical norms!
- But house prices could stay high because the US is a great place to live, and don't forget that mortgage tax deduction


Monday, March 17, 2008

Money and dilution

On my last post, I split the general phenomenon of "inflation" (rising prices) into two parts: 1) dilution (creating more money) and 2) price changes. These two effects can work in opposite directions and thus cancel each other out, or they can work in the same direction and magnify each other's effects. I think the story of the last 70 years in America has been rampant dilution of the currency through the banking system masked (to some degree) by rapid reductions in prices thanks to technology. Think about it this way -- we are *much* more efficient and producing bottles of Coca Cola today than we were in 1930, but Coke used to cost 10 cents and now it's a dollar. As per unit production costs have fallen so dramatically, how much more must currency dilution have been to result in a net increase in price by an order of magnitude.

The Fed can create money by low interest rates (which make it cheap to borrow) and by the fractional reserve system that lets banks loan out 9 times their short term deposits in long term loans. In addition, the Fed puts the imprimatur of the US government on all kinds of other paper, including mortgage backed securities through Freddie Mac and Fannie Mae, and OFHEO. If it's backed by the US government, it's dollar currency, whether it's printed on green paper or not. All of this activity has recently increased.

So, given that Bernanke is running the printing presses like there is no tomorrow, does that mean the US is going into an inflationary period? More tomorrow.

Thursday, March 13, 2008

Inflation vs Dilution

In the context of my recent post on inflation I think it's worth thinking more clearly about what this word means.

While I do not agree with the grim prognostications of this essay, I do think that distinguishing different flavors of price movement is useful.

In general, when most people refer to "inflation" they mean "a general increase in prices". This is seen to be a bad thing. By the same token, when most people refer to "deflation" they mean "a general decrease in prices". This is seen to be an even worse thing, although it is not immediately clear why lower prices are bad. I mean, if Apple announced 10% discounts on all their products, no one would be unhappy. If gasoline dropped back to $2/gallon, the politicians would not admonishing Big Oil to be stingier at the spigot. But somehow price declines across a broader span of goods is really bad.

For a moment, let's separate prices and quantity.

Say there is a fixed amount of dollars in the world, $Q. Say the Fed prints 20% more dollars, there are now 1.2$Q in the world. If the number of goods in the world is the same, then these extra dollars will drive up prices until 1.2$Q buys as much as $Q used to. In other words, any idiot holding $Q can now buy less.

At the same time, suppose there is some dramatic new technology (such as, say, China) that can produce goods at much lower prices. Maybe 20% cheaper. Thanks to this new technology, someone with $Q in their pocket will now be able to buy more (since what used to cost $P now costs 0.8$P).

Now suppose these two things happen at the same time -- the Fed prints more dollars while, at the same time, new technology makes goods much cheaper. The net effect of all of this may be that, although the currency is being dramatically diluted prices are not rising by all that much. This means that measures of inflation, such as CPI (which has lots of problems all by itself) are totally useless because they do not include the opportunity cost of not having money diluted in the first place.

Looking at inflation this way, as dilution, also makes it really easy to understand the old Milton Friedman (U Chicago) aphorism "inflation is always and everywhere a monetary phenomenon" -- if you substitute "inflation" with "dilution" it reads "dilution is always and everywhere a monetary phenomenon" which is so obvious as to be a tautology.

OK. So we have now separated the fuzzy and confusing term "inflation" into the more precise terms "dilution" (referring to an increase or decrease in the monetary base) and "price changes" (which can happen for a variety of reasons). Since the compound term "inflation" conflates both changes in prices due to "dilution" (monetary only) and other "price changes" (lots of reasons), we find that core measures of inflation (like CPI) are useless because they combine price and quantity. More on this later.

Tuesday, March 11, 2008

What is inflation?

I must admit, I did not understand macroeconomics at all when I studied it in Chicago. I suspect that no-one else really understands it either. For one thing, there seems to be no consensus on what the elasticity of anything is, such as the elasticity of labor supply to wages. Therefore, no one knows what the impact of any policy will be, since that ends up depending on what the supply (or demand) response will be. As for cross-price elasticities, forget it.

I was also told that "money is anything that can extinguish debt". I think this is wrong, because it implies "no debt, no money" which is true in fractional reserve banking, but also does not make much sense. Hmmm, this does not say good things about fractional reserve banking.

I'm also not sure about Bryan Caplan's assertion here that
1. Seigniorage is a trivial fraction of the U.S. federal budget. Contrary to Rothbard's extravagant claims, printing money accounts for only about 1-3% of the federal budget.(pdf). There are some Third World countries where Rothbard's "conspiracy" theory is quite right. But in the First World, the government has much easier - and less unpopular - ways to pay the bills.
Looking at the way the publication from the St Louis Fed he links to calculates "money supply", it's pretty clear that there are instances of money printing that they do not count as seigniorage "officially", but are nonetheless. For example, Fannie Mae is now going to buy $729,750 mortgages. If a green piece of paper, with "$1" written on it, that's backed by the US government counts as money, then shouldn't a white bit of paper, with "$729,750" written on it, that's also backed by the US government, also count as money? I certainly think it should, but the St Louis Fed does not think so as it is not included in its definition of "extended money seigniorage". In fact, I'm not even sure that these brand new $729,750 bills are included in M3. Of course I may be totally wrong -- please email me if you know better.

Good article on microfinance

James Surowiecki has an excellent article on why microloans make individuals in poor countries better off, but not the countries themselves. He argues that the loans smooth consumption (which benefits the individual), but do not support companies larger than single owner-employee proprietorships. Therefore, business never enjoy any economies of scale, and workers stay as (un)productive as before, limiting real income growth.

Monday, March 10, 2008


When I was last posting, the housing market was beginning to slow, and there were slight tremors in the financial markets.

Things have changed.

According to Case-Shiller, home prices are down about 4-5% nationwide with more declines to come (estimates range from 10% to 30%). These numbers do not seem large in % terms, and the havoc they seem to be wreaking on financial markets is a testament, I think, to how bad the current system is at reducing the amount of debt it runs on (de-leveraging). I have thoughts on what it says about a system that can pile on debt to take riskier bets, but cannot reduce debt to become more conservative--more on this later.

Various plans have been bandied about that all focus on propping up house prices. This writer feels that house prices in the US are too high and need to fall, and has thought this since 2002 (which was too early, aka wrong, but it certainly seems to be true now). Harvard's Marty Feldstein has one proposal which Megan likes, but Tanta thinks is ridiculous. I never took Ec 10 and tremble at disagreeing with Marty, but I tremble at disagreeing with Tanta more.

Given the financial and political unwillingness to let house prices fall back to their historical ratios with salaries and rents, the only alternative is to raise the price of everything else, via good old-fashioned inflation. GLD has enjoyed a spectacular run-up, and I'll be interested to see where it heads if it breaches $1000 the way oil has well and truly breached $100.

Saturday, March 08, 2008

Am back

Kind of. Little babies seem to be nocturnal.