Asymmetrical Information

On the other hand, the oil shock could be worse now, because in the 1970s most oil consumed in the U.S. was also produced in the U.S., so for every $1 that one American had to pay for higher oil prices, another American made $0.90.

Today something like two thirds of our oil is imported from other countries, so higher oil prices are closer to a pure drain on the economoy.

@Half Sigma

Easy does it with lack of understanding how international trade works. Put it down and back away.

Remedial course here:

http://arnoldkling.com/econ/markets/trade.html

Wait, STAGflation? Just a few years ago, Paul Krugman et al were warning me about DEflation! There's too many -flations, and no one seems to be predicting them well.

The sky is falling! Everyone is doing everything wrong! It's getting colder! It's getting hotter! Your money's worth too much! It's not worth enough! Oh no! Grab your guns and run for the hills!

Hmm, life goes on....

I think Jane's questions are certainly the right ones to ask. Stagflation, as we think of it, is a definite possibility. If one removes inflation (via increased liquidity from the Fed and foreign central banks) plus all the pyramid "money" & credit generated via derivatives, the question becomes, "Have we actually experienced any real GDP growth since the 2001 recession ended?"

To me, Al's (probably) facetious comment speaks volumes: who the hell knows what "flation" is in play, when all "flations" are the result of governmental jiggering. It seems to be more of a fellation than anything else, and the American consumer's the one who's doing the kneeling.

Seriously though, the "goods in the basket" used to calculate CPI and other indeces are arbitrary. The Easter Bunny might as well fill the basket. Inflation is an increase in money + credit. Period. More money & credit chasing a static amount of goods and services? Price up.

http://mikesneighborhood.blogspot.com/2006/04/dont-believe-hype.html

As I recall, Milton Friedman taught us that inflation is, at all times and in all places, a monetary phenomenon. The cure is, as it was in 1980, tighter money. It was painful, but it worked.

I think stagflation of the 1970's came from a combination of four things:

1) Huge federal deficits of the 60's (from expanding domestic programs in the middle of a war!) caused high inflation before the oil prices hit.

2) War spending began tapering off in 1973. The end of a war is always a difficult time for the economy...

3) OPEC managed to force oil prices much higher for a while, which raised the price of everything higher.

4) Ill-thought government responses to both the original and the oil-caused inflation - Nixon's wage/price freeze, petroleum regulation that penalized companies that found oil at below OPEC prices, ...

Mark-

All four phenomena certainly had a negative effect on the overall health of the economy. They surely helped drive the "stag" part of Stagflation.

But as for the "in," inflation, I'd look to (a) Nixon's closing of the gold window in 1971 & the subsequent dollar float and (b) Arthur Burns's disastrous tenure as Fed Chair from 1970-1978, which saw floods of liquidity and, therefore, runaway inflation.

Nothing's ever as simple as a two-prong explanation, but them's two pretty sharp prongs.

I have correlated question: If inflation is a monetary phenomena -- too much money chasing too few goods, then how does it help to raise the price of money (the only tool the Fed has) in the face of higher commodity prices (OIL!)

It seems to me that rising petroleum and petroleum derived product prices is already taking "excess" money out of circulation. So how does it help to raise the price of money?

On a related note, I'm convinced that what Volker did to kill inflation was to kill the economy. Effective, you say? Well, it worked. But consumption taxes would have worked quicker and with far less pain and lasting damage.

Of course, Volker wasn't in charge of fiscal policy and when the only tool on your belt is a hammer ...

Paradoxically, the softness in the housing market is likely to have an upward effect on the CPI. When people are nervous about buying (or simply can't afford to buy) they rent...and the CPI is calculated using an "equivalent rent" for owned properties. These equivalent rents for people who do own are likely to go up, along with actual rents for peple who don't.

Norm-

I"m not sure I follow your question, but I'll take a stab.

"how does it help to raise the price of money (the only tool the Fed has) in the face of higher commodity prices (OIL!)?"

First off, the Fed isn't raising the price of money, it's lowering it! By "printing" more money & extending extra credit, money becomes cheaper, not more expensive. It's this devalued, cheap money that's chasing goods. You can look at it this way, inverting the formula: less crude buys more money.

And I'd argue that this money + credit doesn't fly out of Central Banks and derivative schemes to "face" higher commodity prices, but quite to the contrary, it's this excess liquidity that raises the commodity prices.

Obviously there are a million other variables in the equation (e.g., falling supply due to peaking oil yield; refinery limitations resulting from Katrina and more "dirty" crude; massive increases in demand from China & India), but to speak econowonk for a sec, "let's assume static supply & demand for a moment." If more liquidity floods the markets here & abroad, that will raise prices.

That's as far as I can go before I start talking out my ass (if I haven't begun doing so already).

Mike,

What you would say would be true if the fed was in fact printing more money (following an expansionary policy). But as I understand it, the Fed has just gone through 17 consecutive increases of the discount rate, a contractionary monetary policy, that should slow growth and crimp inflation.

As for derivatives, you must be more specific. Given the near infinite variety of derivatives available for sale I don't understand how as a group they affect inflation (what do call options on equity have to do with monetary policy) or even which specific instruments you are talking about.

As for stagflation, we should be very careful with terminology. It may be true that growth will slow and inflation will rise, but an inflation rate of 3.5-4% with real GDP growth of say 2.5%, is a far cry from the disaster of the 1970's, which saw double digit inflation and much lower GDP growth.

As for how oil's impact on the US economy, it is true that the US imports more oil now, but you oil accounts for a far smaller fraction of the US economy. In the 1970's, oil inputs were about 20% of the cost of raw materials into the US economy, now they are under 5-6$, so sustained upward oil shocks will have to be far greater to adversly affect the economy to the affect happened 30 years ago.

It would have been nice if Greenspan and the obvious inflationists appointed to join him on the FOMC during the Clinton era had been scolded at least a little bit for their policy of credit expansion. It was especially harmful (inflation-causing) when the demand for money was decreased by the tax hikes of 1993-1994.

For some reason too many didn't wake up to what was happening until the last few years. Central banks selling gold in the mid-to-late 1990s helped hide it, perhaps, but in general people just don't seem to want to know that fiat money is always debauched money, eventually.

Saudi Arabia's oil fields are quite spread out and terrorist attacks aren't likely to curtail production to any great extent. The pipelines are quite vulnerable, but any damage can be repaired quickly. That's the good news. The bad news is that if terrorists managed to destroy one or more of the three main pipeline pumping stations, Saudi Arabia's exports would be severely limited, and quite likely for a prolonged period of time.
The Saudis claim that the pumping facilities are heavily guarded, but I find it rather difficult to have much confidence in that claim.

So what data should Helicopter Ben Bernanke pay attention to, I wonder? Wednesday's unpleasant inflation numbers, suggesting another interest rate hike, or the more recent bad employment numbers & leading indicator drop? Scylla of higher inflation, or Charybdis of a big recession? Y'know, if'n we'd had a real recession back in 2001, with all the unpleasant things that go along with it, the balance sheet of the United States would look a whole lot better than it does right now.

I remember stagflation, I served with stagflation...no, wait, stagflation served me up. Like a blue plate special...

But this time, all the major stock markets of the world seem to be in synch...

have correlated question: If inflation is a monetary phenomena -- too much money chasing too few goods, then how does it help to raise the price of money (the only tool the Fed has) in the face of higher commodity prices (OIL!)

the simple answer is this: by raising the price of money, the Fed raises the opportunity cost of using money - you are better off leaving your dollars in the bank than purchasing petrol - hence reducing the amount of cash chasing too few goods and reinstating the eqm...

however, as Big Ben (as he goes these days) & co. will tell you - it's a far more complex issue than this. What the Fed targets is not the price of petrol - but is more the smoothed cost of living (the PCE index in the US case) and the core PCE or CPI does not take into account volatile components such as oil.

So what the Fed is quite wary about is any pass through that could occur - they name these 2nd round effects - between the headline and the core indices. And this pass-through generally occurs through the wage bargaining chanel and the inflation expectation chanel. The latter is easily understadable - if the Fed loses it's credibility on Wall Street and inflation expectaions increased - then you will be seeing a pass-through and that would be bad for the economy. Hence, it's critiical that at anytime Bernanke ensures traders of his inflation fighting crudentials.

The second one (which is a HUGE worry in europe) is more subtle. By increasing the base rate, you shift your supply curves in such a way that employees have less bargaining power in wage negociations - because investing is more costly to firms - putting downward pressure on employment. The same argument could be made via the Philips curve.

if'n we'd had a real recession back in 2001, with all the unpleasant things that go along with it, the balance sheet of the United States would look a whole lot better than it does right now.

this is a somehow incorrect view - not that it's wrong to say that a recession would have left the US with a smaller c/a deficit or budget deficit - but rather it doe not answer the question of how did we end up there correctly.

my point is: do you really think Japan / China would not be having billions of US treasuries for breakfast had the US undergone a recession? this would be equivalent of saying that China would have floated its Yuan had the recession materialise.

which brings us to: why on earth did they issue so much treasuries in first instance? now, i'm no politician, but could a watershed of tax cuts or increased government spending have anything to do with that? And then you can ask yourself whether having a recession would have curtailed the huge defense budget, ect ect,... well you get by point by now ;)

"Paradoxically, the softness in the housing market is likely to have an upward effect on the CPI. When people are nervous about buying (or simply can't afford to buy) they rent...and the CPI is calculated using an "equivalent rent" for owned properties. These equivalent rents for people who do own are likely to go up, along with actual rents for peple who don't."

This is plain wrong! Yes the CPI and the PCE are based on a rental yield index. And yes more people will intend to rent than buy property. But it is not a simple demand and supply issue here. The rational argument is to say that rental yields are the opportunity cost of buying - so people make educated decisions as to which one is economically in their interest. Now that many are facing too high house prices, they will look back to renting. But if renting was to go way up, then it would make buying property attractive again. So there is an equilibrium point which does not have to be necessarily increased rents.

For instance, the construction market is well-known too be a lagigng one - after all you don't just build a house in a couple of days. So all properties that are not finding buyers (note inventory gone up to 5.5 months in April!), could ultimately be up for rental as soon as renting becomes more favourable. And this represents the counter-balance to the supply-demand argument.

I wrote:
"if'n we'd had a real recession back in 2001, with all the unpleasant things that go along with it, the balance sheet of the United States would look a whole lot better than it does right now."

Markov1427 replied:

this is a somehow incorrect view - not that it's wrong to say that a recession would have left the US with a smaller c/a deficit or budget deficit - but rather it doe not answer the question of how did we end up there correctly.

Short answer: no.
Longer answer: the 2001 recession never happened because Easy Al Greenspan chose to drown it in an ocean of liquidity. So the mis-investments and mal-investments that would have been eliminated, the bad debt that would have been paid off one way or t'other (possibly pennies on the dollar, mind you), and all the other distortions in the economy created by the easy-money 90's...did not happen. Instead we got more of the same; more debt both public and private, a stock market bubble that morphed into a building bubble that even now is beginning to deflate in the UK, in Australia, in the US and even in China. As the Fed continues to hike interest rates, all those nifty interest-only adjustable rate mortgages that were so neato 2 or 3 years ago will begin to reset to higher payments. Since the only people who bought such things were folks that couldn't buy a house any other way, we'll see more defaults, and as the bubble deflates, and the price of houses goes down , we'll see more inverted mortgages, leading to more people walking away from their houses. Banks do not like to own houses, so they'll sell them as fast as possible, and if that means lowering the price to a moderate loss, so be it...but that will further drive the market price down, leading to more inverted mortgages...

The iceberg of debt that the good ship American Economy is about to hit wasn't created by God, it was created by the Federal Reserve Bank's policies.

my point is: do you really think Japan / China would not be having billions of US treasuries for breakfast had the US undergone a recession?

I don't know, nor do I understand why I should care. Why should I expect foreigners to prop up the dollar, anyway? Shouldn't the central bank created in 1913 specifically to preserve the value of that dollar be working on that project?

this would be equivalent of saying that China would have floated its Yuan had the recession materialise.

I do not think that is the case, but it's a hypothetical anyway.

which brings us to: why on earth did they issue so much treasuries in first instance?

To stave off recession, IMO.

now, i'm no politician, but could a watershed of tax cuts or increased government spending have anything to do with that?

I seriously doubt that the tax cuts had anything to do with it.

And then you can ask yourself whether having a recession would have curtailed the huge defense budget, ect ect,... well you get by point by now ;)

Yes, I'm afraid I do. Please note that centrally-planned economies do not have all that great a track record...although the US Senate last week chose to ignore that fact in its immigration bill...

ellipsis: Indeed, the tax cut of 2001 (though a huge wasteful portion of it was a spending bill to give everyone a "rebate" check which is economically as useful as a welfare check), and much more usefully the tax rate cuts in 2003, increased the demand for money, which reduces the rate of inflation, and increases the value of the dollar. The fact that we're still having people not aware of the debased state of the dollar 1993-2002 is a shame. The real purchasing power of the dollar probably declined nearly 60% during that period. But as happened in American politics in 1982, those correcting the situation will get the blame for its cause, rather than credit for fixing it.

I think it's not correct to say that the Fed created the "iceberg" of debt. At least not directly. I do get your first point - but then wasn't Greenspan's argument that you do not lean on bubbles at any rate - wait for it to pop and then loosen dramatically? Is that your point: that this is wrong monetary policy ?

About China and Japan - well I can tell you that I'm definitely right on that. To keep the Yuan artificially weak, China needs to buy a lot of $$ and once it does so it needs something to invest it in - hence buying loads of treasuries and increasing demand dramatically over the past 5 years or so... When China revalued by 2.1%, it wasn't only the $ that took a hit, but the 10yr was up 5-6 bps on the day - because everyone thought that demand was going to plunge..

And I don't think you increase UST to stave off recession. You do this by cutting your base rate. Monetary policy has very little to do with printing notes and bills. Admittedly it does lead to more treasuries - since they are cheaper to issue. But it should be clear that increase in supply of treasuries and having a loose monetary policy are distinguishable things: when the Fed cuts rate, they want to inject liquidity in the system - they want people to get their cash out and boost the economy; but when the US govt. issue treasuries, they are doing the exact opposite: they remove that liquidity from the system (predominant assumption: that UST buyers are mosly domestically based, which as I've said isn't the case)

So yeh, you do have a point! but a huge deficit is only a "buy-product" of an easy monetary policy. There are more factors to it. and one of them resides in government spending..

Markov1427:
You forget the multiplier effect caused by fractional reserve banking. When the Fed and the Treasury do a coupon-pass to create "dollars" out of thin air by issuing debt, those "dollars" are shoveled out the door to banks, who then write a whole lot of loans based on the "dollars". A multiplier of 14 or more to 1 is not an unreasonable guess. Those loans have to be paid back somehow, someway, someday, but of course nobody worries about that because "stocks always go up", or they did until 2001. Nowadays "houses always go up", and thus in some regions up to 1/3 of house buyers had no intention of living in the place, they planned to flip it for a profit. Now we are seeing that houses do not always go up, but the mortgages on them sure don't go away. But wait, it gets worse...

The consumer is the current driver of the US economy. In all previous recoveries that I am aware of, industrial/business capital spending led the way out of the recession, with consumer spending coming on later. Since 2001 it's been the consumer all the way, based on those stupid welfare checks you mentioned as well as cash taken out of mortgage refinancing. The welfare checks were supposed to jump-start the economy, and the stimulus did certainly do a lot of good for Wal-Mart, and thus for the factories of China. But where's the investment in new industrial machinery and other baseline business spending? Nowhere, nowhere ate all. So we have individuals increasing their debt load to the point that savings go negative, and that's the main driver of the US economy?

So the Greenspan notion of drowning deflation in a n ocean of liquidity has had the effect of greatly increasing private debt, which will make the next recession a really interesting one. Prechter, of Elliot Wave fame, points to the 1930's as a model of what he finds likely.

Yes, government spending plays a huge role in the increase in public debt, but it's still the coupon-pass Treasury-to-dollar creation model that was used to reflate the stock market in 1987 I find to be very dangerous in the long run. And who was the Fed chairman that pioneered that technique?

Sure, the Chinese find it to their advantage to collect the whole set of Treasuries, I misunderstood. But why do I care, given that nobody outside of Peking has any real control over that?

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