Wednesday, December 29, 2010

From comments: Krugman is part of the problem

Thanks to winterspeak reader Peter for drawing my attention to this Krugman quote in the comments:
β€œThe key thing to bear in mind is that for the world as a whole, spending equals income. If one group of people β€” those with excessive debts β€” is forced to cut spending to pay down its debts, one of two things must happen: either someone else must spend more, or world income will fall.”
Please look at your paycheck and see if what your employer spends on you equals your income. If the two are not the same, what accounts for the difference? Why did Krugman not notice this rather obvious elephant in the room and write something so obviously false? Why did Peter not catch it? What bearing (if any) does this have on thinking about aggregate demand in our current economic state? Does understanding MMT have anything to offer in this context?

So many questions!

Where inflations expectation is not nonsense

In a recent post where I detailed why I thought the "inflation expectations" model used by orthodox macro was nonsense, I promised to outline the one exception. Well, here it is.

The reason I reject the inflation expectations model is because it handles savings as an inter-temporal consumption decision. This fails to capture the essence of the actual savings dynamic, leading to comical predictions as proffered by Nick Rowe. While economists take a year's vacation and buy luxury items on the eve of their life savings evaporating, the rest of the species merely shift into other savings vehicles -- forex, gold, and real assets, particularly land.

That last category, however, is an exception to the rule, and here I believe inflations expectations really do alter consumption decisions on the margin. Someone who has decided to buy a house may very well decide to take on more leverage, and buy more house than they otherwise would, if they expected inflation. Real estate is about the only highly leveraged position a household can take, and I can see it being very interest rate sensitive. Our friend in Sao Paolo may very well take his cruz while he has them, and plow it into as much real estate as he can leverage himself into.

This may be part of the dynamic in an old paper I've currently mislaid that looked at historic data and concluded that real estate is the business cycle. I'll poke around for it, but if anyone know what I'm referring to, please do post it in the comments.

While ultimately, real estate may be the trigger for private sector credit expansion again, signaling the true end to this recession, it may take a while to get there. House prices are still higher than historic norms on average, although in practice this means some areas are fairly priced (or cheap) while other areas remain at bubble levels. I also think the recent bubble has taken some of the gloss of real estate, although I don't think this factor is particularly strong. I think continued labor market weakness is discouraging household formation, and there is still an overhang of homes, all of which will keep prices down. And of course there is the big backlog of shadow inventory which banks will keep dribbling into the market whenever prices start to show material appreciation.

Japan is now about 30 years into their post-bubble economy, and have yet to recover. I don't think the US will take as long, but if the Government gets serious about deficit reduction I may be proved wrong.

Friday, December 24, 2010

Merry Christmas!

Happy Holidays to all winterspeak readers!

Wednesday, December 22, 2010

Don't blame the savers

Steve Waldman blames savers for the housing bubble and financial crises. You heard me right -- Steve thinks that people who refused to take out massive NINJA loans to buy houses they could not afford at crazy prices are the guilty ones. Is he Lloyd Blankfein's puppet? Did Geithner slip him extra-special cookies when Steve flew over to meet the great man? Read through the comments and decide for yourself.

Tuesday, December 14, 2010

Why the inflations expectation model is nonsense

Thanks to all who commented on my challenge. Big thanks to Nick Rowe especially.

A brief recap: economic models treat the savings decision as a case of inter-temporal substitution -- either I buy now or I buy later. The discount rate governs exactly how this decision is made, and the discount rate includes an inflation term. If inflation expectations increases, then future consumption is discounted more heavily, and inter-temporal substitution begins to favor the present. Or, as Nick says "the increase in expected inflation reduces the real interest rate for any given nominal interest rate"

I don't reject this model because it abstracts reality to illuminate a particular mechanic. That is the point of models. I reject this model because it fails to capture the essential economic dynamic at work here. The inflation expectations story is simply a weak one.

Take this scenario (slightly tweaked, as Nick, while long on generosity was a little short on imagination. Still, all is forgiven, and I do thank him for this list): You're living in Brazil, it's 1970s, you have a stash of cruzieros (your and your family's life savings!!) and you think the value of your nest egg is about to be blow to smithereens via a vicious bout of hyperinflation. In this case, Nick would:
- Buy a variety of luxuries
- Buy some financial assets tied to commodities
- Quit his job (take unpaid leave)

In case you think I'm joking, here's the list, verbatim:
1. A new, lighter weight canoe. Swift Mattawa, in carbon fusion. Better buy it now, before prices rise, rather than waiting till I'm too old to lift my heavier one. (Do you really want the exact model and manufacturer?)

2. Better cookware.

3. Many crates of Scotch.

4. A new field drain under the back yard.

5. New laptop for one daughter.

6. New stereo for the other daughter.

7. Small farm 30 minutes north.

8. shares in oil/gas drilling company.

9. equity mutual funds (have to ask my broker which).

10. One year's leisure (unpaid leave from work, since the money won't be worth as much, and it would be better to take the leisure now and retire a year later).
See, I was not kidding! I think the number of people who, on the eve of having their hard earned life savings obliterated, would blow it on kayaks and scotch is small.

Vivianne Vilar, who it seems has personal experience, nails it:

My mum (and all family) used to buy dollars. I can't tell you about 1979, because I was only born 2 years later, but that is what she did from when I was a kid until 1994, when the Plano Real was implemented.
Primarily, people save for things:
1. They cannot afford currently (and don't want to buy on credit)
2. Unexpected emergencies
3. Old age
4. Bequests for their kids

2-4 cannot be moved forward and so are not inter temporal decisions the way the models treat them. Therefore, if savings are threatened, people will substitute into other stores of value such as fx or gold. They will not move consumption forward, as they cannot. This is not about consumption.

1 is an interesting case. If there's something you cannot afford now, you will not go out and buy it because you'll be able to afford even less of it in the future. There is one big exception to this, which I'll write about in a future post.

Ultimately, you need to decide for yourself whether, if your nest egg is going to be hyper inflated away, you'll spend it on a fiber glass kayak or move your savings to another currency. Economists are betting on the kayak.


Monday, December 06, 2010

Obama makes the right move

The Obama administration's latest stimulus is very good. Keeping income tax rates where they are, extending unemployment, and a payroll tax cut boosts aggregate demand without the Government picking winners and losers, and without red tape.

More please