Sky High Oil....

So the oil price is at all time high levels- as the following graph shows (although this data series stops in March 2007: the price is now over $80/Barrel).




But is it really? First, here's the real price of oil- still significantly below the level attained in 1980, shortly after the Iranian Revolution.




But there's another reason to downplay the massive growth in the price of oil. It just happens to be reported in US dollars, which have been losing value against almost all other currencies in recent months.

Here is the real price of oil faced by consumers in the United Kingdom, by comparison. Yes, the price of oil is up, but hardly by the spectacular levels we'd imagine when we read the headline figures- especially for countries with exchange rates that have appreciated against the USD. in fact, because oil happens to be priced in USD, a fall in the value of the greenback will naturally increase the price of oil irrespective of the supply and demand for "black gold."

Hong Kong's Money...

Want to know how monetary policy is really set in Hong Kong, and the intricacies of the Currency Board system? Look no further than "Hong Kong's Money," a new book written by Tony Latter and Published by Hong Kong University Press. Mr Latter is a former Deputy Chief Execuative of the Hong Kong Monetary Authority, and his association with monetary policy stretches back to the formation of the currency board in 1983. But his understanding of Hong Kong's monetary history stretches back a long way before then....

How Does a Central Bank Create Money?

James Hamilton of UC San Diego and prolific blogger at Econbrowser provides an excellent explanation of the process by which the Federal Reserve creates money here. While the labels and details vary, any economy with an independent central bank follows a similar process.

The Maestro

Alan Greenspan is the former Chairman of the Federal Reserve Board, the US Central Bank. He was widely hailed as an excellent Chairman throughout his tenure, but some cracks are starting to appear in his reputation.

For one, he continued with an expansionary monetary policy even when most analysts expected interest rates to rise. At the time, this appeared to be a masterstroke- the economy continued growing at a fast rate without the resulting inflation that economists feared.

But now there is an alternative interpretation given to this expansionary policy, and one that implies that he was less than the maestro many had thought. Maybe Greenspan's expansionary policy fueled increased inflation afterall- just not in the prices of consumer goods and services that we track so carefully.

I'm talking about asset prices, of course. Low interest rates encouraged US households to over-invest in real estate, driving up property prices, and creating a property market bubble that is now in the process of deflating. The bubble, and the consequent bust, would most likely have been less severe without the active help of the Greenspan Fed.

We could go further. Indeed, one insightful journalist - Caroline Baum at Bloomberg- has listed a range of excellent questions that she'd like to pose to Greenspan, that together read like an attempt to bring the Maestro from his pedistall back down to earth. Read her article here.

The Canadian Dollar

Further to my earlier post, the Canadian dollar was worth more than the US dollar last night for the first time in 31 years. As I write, $1CDN will buy $1.0014USD!

As this Bloomberg story notes, the Canadian dollar has appreciated by more than 62% since 2002. This has also largely been a real (as opposed to nominal) exchange rate change, as the inflation experiences of the US and Canada have been similar over this period.

There's a warning implicit in the there for all international transactions: exchange rate fluctuations are huge, and can easily dwarf all other risks faced by businesses.

Arbitraging the HKD

"What is the role of arbitrage in HK's exchange rate arrangement?" - Vincent

Arbitrage plays an important role in ensuring that the interest rate in Hong Kong remains close to the value in the United States. To illustrate this point, suppose interest rates in Hong Kong were significantly higher than in the United States. It would then be profitable to borrow large sums of money in the United States, convert them into Hong Kong dollars, and deposit them in the Hong Kong banking system- because the interest income earned on your HKD deposits would exceed the interest that must be repaid on your US dollar loan. When the loan comes due, you would withdraw your HKD deposit, convert it back to USD, repay your USD loan, and have money left over!

Of course there are more efficient ways of taking highly leveraged positions to benefit from any interest rate mis-match. Using currency futures markets, you could take a long position in HKD and a short position in USD- if the exchange rate remains fixed, your profits would be approximately equal to the difference between the interest rates in the two economies, multiplied by the size of your position held.

When investors take advantage of interest rate differentials like this, the very act of arbitraging will move interest rates closer together- borrowing USD will raise the US interest rate, and lending HKD will lower the HK interest rate. So interest rates in HK will remain close to those in the US- adjusted for relevant risks between the two markets.

The above argument only applies to currencies with fixed exchange rates. For most currency pairs, there may be large and persistent differences between interest rates, as taking leveraged positions across currencies is very risky due to exchange rate volatility. Exchange rate movements are often large, and may more than cancel out any gains from trying to arbitrage away interest rate differentials- see the previous story about the volatility of the Canadian dollar. But the presence of exchange rate volatility doesn't stop people trying to profit from interest rate differentials. Strategies designed to take advantage of this are typically referred to as the "Carry Trade." For an earlier discussion about this, see the comments here.

Controlling China's Inflation

China's inflation rate has increasing, and recently hit 6.5%- the highest level in 10 years. The mainland Government has responded to inflation in the past by gradually increasing interest rates in small increments, with limited success. But now it's bringing out the big guns. From today's South China Morning Post....

"Beijing has issued price-control measures for consumer products, which include a freeze on prices.... the government would not change any of the prices of products and services it controlled for the rest of the year. The government administers a vast array of prices, including those for land, transport, utilities and fuel."

It then goes on, more ominously, to reccommend....

".... price-monitoring systems for food, electricity and medicine, and an emergency response system to address any big price fluctuations..... [L]ocal governments should increase minimum wages as soon as possible to make up for inflation."

Let's boil down the problem of increasing inflation to its elementary economic components. Ultimately, any increase in prices is due to a mis-match between supply and demand. At existing prices, demand exceeds supply across a wide range of goods and services, so producers respond by raising their prices, to maximise their profits. But price increases will likely lead to demands for higher wages, as workers seek to maintain their real wages, which firms will in turn pass on to consumers via higher prices, causing a wage-price spiral.

The government's solution to this problem is to try to limit this process by preventing price rises across the range of goods and services whose prices they control. By definition, they may be able to control these prices, but this is a small front in the overall battle against inflation. And ultimately price controls are futile in this battle.

Price controls are nothing new, but they have never been very successful. Even the United States had price controls over the 1971-1973 period, and while the inflation rate fell from 6% to 3-4% over during the freeze, it shot up to 11% in 1974 when the price controls were removed. That's because the fundamental source of inflation had not been addressed.

So that's one black mark against price controls: they fail to work, except in the short run. But there's another more fundamental reasons to dislike price controls. They cause the price system to break down.

When we as consumers decide what we'd like to consume, the price provides an important input into our decision making process. We tend to skimp on high priced goods, but consume relatively more of low priced goods. Because the prices reflect the resource costs of providing the goods, this is efficient. Our consumption decisions reflect the fundamental cost of providing goods and services, reducing resource wastage in the economy.

Now the Government decides to delink the price from the cost of provision across a range of goods and services. Rational consumers will respond by consuming more of these relatively cheap goods and services. The government will need to respond to this increase in demand by stepping up supply- even though it may be making a loss on each unit of output that it is now providing. Thus valuable resources will need to be diverted from some alternative use to increasing the supply of the price controlled goods.

The alternative is that the goverment fails to increase the supply of price-controlled goods, and instead allows demand to outstrip supply. The end result of this would be shortages, and the likely establishment of black markets where the goods are sold at their true economic value, away from government control.

So if price controls are futile, what can the Government do to try to lower the inflation rate in Mainland China? Ultimately they need to lower the demand for goods in the economy. That requires that the economy cool off, and the break-neck rate of economic growth slow.

The appropriate channels for achieving the required economic slowdown are what we would label a "contractionary monetary policy"- for example, raising interest rates abruptly, by more than the increase in inflation, to ensure that real interest rates rise. Or allowing the currency to appreciate more quickly, so that foreign demand for domestic goods slows, and and domestic demand for foreign goods (which are now cheaper) increases. These steps would deal with the fundamental imblance in the Mainland economy, and ensure that demand moves back into line with supply.

The alternative- a partial price freeze- is like a partial stop bank in the path of a swollen river. Yes it might keep the water out for a while, but ultimately it just won't work.

For my earlier take on price level targeting in China, see here.

See also this column by Thomas Palley in the Guardian.

Fed Rates and Exchange Rates....

One effect of the Fed rate cut has been a further fall in the value of the US dollar against most other currencies, as a direct result of the drop in relative returns on US fixed income assets.


To focus on just one currency pair, for the first time in 30 years, the Canadian Dollar looks set to surpass the US dollar (see graph above).

Given the increasing importance of oil and other commodity prices in driving the appreciation of the Canadian dollar, I think an abrupt fall in commodity prices is the only possibility of the Canadian dollar not surpassing the value of the US dollar in short order. (According to http://www.xe.com/, the Canadian dollar is currently trading at 0.9904 US Dollars).

The Fed Finally Cuts....

So the US Federal Reserve Board have finally cut interest rates by 50 basis points (that's half a percent). Despite increasing evidence of a coming recession from many fronts- falling house prices, increasing housing foreclosures, decreasing demand for durable goods including cars, weak labour market data, and dropping wholesale inflation rates- the Fed held off on interest rate cuts due to concerns that inflation was uncomfortably high.

Now that they have cut, economists are divided, with some believing that the fed has not done enough, and others believing that they've done too much, and inflation will now increase.

For my part, I'm in the "not enough" camp. The melt-down of the housing sector is gaining momentum, and I expect to see increasing evidence of the fall in house prices feeding into lower consumption figures. As demand falls back further, I think the inflationary concerns will take care of themselves.

(For further insights on the Fed rate cut, check out Nouriel Roubini and James Hamilton).

China's Air Pollution...

Two brilliant minds, Adam Posner and Gary Backer, weigh in on China's air pollution, here and here.

Thanks to Freakonomics for the link.

China Trade is Changing....

According to this story, the structure of Mainland China trade is changing. In the past, China imported intermediate goods from the rest of Asia, assembled them into final goods, and exported the final goods to the Western world. Thus China ran a massive trade surplus with the US, while running a trade deficit with most of Asia.

This appears to be changing, with China importing more raw materials and constructing the intermediate goods within its borders. If this process continues, China's continued growth will increasingly come at the expense of the rest of Asia, who will no longer assured of a large market for their intermediate goods.

However, an exploding trade surplus is neither efficient nor optimal for China in the long run. If China continues on its current development trajectory, I expect Mainland demand for finished goods imports to grow rapidly, as consumers demand access to the vast range of goods and services available elsewhere. The beneficiaries from this process will be final goods producers (such as Japan, Korea, and Europe), rather than the less developed intermediate goods producers who have done so well off China's growth to date.

See the full story here.

HK and US inflation....

"Why Must the HK inflation rate stay close to the US inflation rate in the long run?" - Ronnie

In the long run, the inflation rate must be similar across any countries with a fixed exchange rate. Consider the alternative: suppose prices in HK were to increase at a much faster rate than in the US? Given enough time, it would be profitable to buy goods in the US, export them to HK, and sell them at a profit. The act of such arbitraging would put upward pressure on prices in the US (since demand in the US would rise), and downward pressure on prices in HK (since supply would increase), thus pushing their inflation rates closer together.

This argument strictly only holds for tradeable goods- for non-tradeables (for example haircuts and apartment rentals), it's impossible to arbitrage away price differences, since there's no gain from renting an apartment in the US if you live in HK, no matter how much cheaper it is! But tradeables are a large enough portion of the total consumption bundble (about 40%-70% of goods in the CPI) that HK and US inflation rates will always tend together in the long run- provided the exchange rate remains fixed.

Lecturing for Profit....

How could a Professor make money off rational students, and what lessons does it hold for Iraq?

See here for more details.

When the US has a cold, the rest of the world catches... ?

If the US has a recession, what will be the effect on the rest of the world? This question has bounced around for some time now.

In one corner are the optimists. The lack of demand from the US will be largely replaced by an increase in demand from Asia, they argue, so that the world economy will continue to grow unabated. It's a nice story, but seems a little optimistic in my view. For a start, the largest Asian economies- Japan and China- look unlikely to take up any slack from the US. The latest macro news from Japan was weak- GDP decreased 1.2% last quarter.

For China's part, a substantial increase in domestic consumption would be required for it to provide much imputus to global growth. Increased consumption is the flip-side of decreased savings.... and China's disproportionate savings rate is due to deeper structural problems, which show no likelihood of abating any time soon. In an economy with poor quality, expensive, inadequate health care, rational consumers will always tend to oversave... the alternative is the possibility of premature death, for want of effective health care.

So if Asia can't replace a lack of demand from the US, what about Europe? Europe is already running on all cylinders, and significantly outperforming the US economy at the moment- despite a much lower population growth rate that would normally result in lower economic growth on average. To expect more from Europe may be to expect too much.

The bigger concern is that a recession in the United States might have serious negative consequences for Asia, leading to a further slowdown in world growth. Both Japan and China depend heavily on exports to the US for their own domestic economic health, lending credence to this argument. If so, hang on for a rollercoaster ride of an economy for the next couple of years!

For a related viewpoint, see Menzie Chinn's analysis here.

Labour Market Data

Some excellent anaylsis on the latest labour market data in the US from Econobrowser.....

Exporting Junk

Mainland China has been in the international headlines recently, for some of the wrong reasons. Some goods exported from China are of poor quality, an in some cases are dangerous for their intended purpose. The media has focuses on the resulting dead pets and recalled toys.

Clearly there are quality issues with Mainland exports, but the response in the US in particular has indicated that maybe all trade with China should be subject to restrictions, as part of a popular move towards growing protectionism across the board. If China exports junk, then maybe it should be stopped!

Let's turn the tables on this argument for a moment. Yes, some of what China exports to the US may be junk. But China is not alone in this behaviour. As Daniel Gross of Slate points out, much of what the United States exports to China is also junk! See this story for more....

Interest Rates and Recessions....

"Why do bond prices increase in a recession?" - Catherine

That's an excellent question! First not all bond prices necessarily increase.... it depends in part on the conduct of monetary policy, as we'll see.

But first lets step back and think about how bonds work. A bond is a financial asset that will pay out a fixed sum of money at some point in the future, along with a stream of interest payments until then. Without loss of generality, we'll ignore the interest payments, since they can be accounted for by appropriately adjusting the bond price. So we'll focus on a bond that pays only at maturity.

Suppose you hold such a bond. For the purpose of our example, we'll suppose that the amount paid at maturity is $1. Further, suppose that the bond has a market price today of $B. The return (or interest rate) on that bond until maturity can be easily computed as Int = (1-B)/B. That is, the return less what you paid for the bond, divided by what you paid. The point to notice is that the interest rate is inversely related to the bond price: an increase in B causes Int to fall, and vice versa.

So we've established that the bond price and the interest rate that the bond pays are inversely related. Now, in a recession bond prices may increase significantly, for at least two reasons:

1) "flight to quality." Uncertainty about the state of the economy may lead investors to be worried about holding too many equities or other risky assets, and instead wish to hold relatively low risk assets like bonds instead. If investors start buying bonds in large numbers, the demand for bonds rises, driving up the price of bonds. The increased price of bonds provides a windfall for existing bond holders, and results in interest rates falling (as per our formula above).

2) monetary policy. In many countries, the central bank sets monetary policy to try to stabilise the economy in response to shocks. In a recession, they seek to reduce the severity of the economy by cutting interest rates and stimulating demand. But if interest rates for some classes of assets start to fall, investors will re-allocate their investment portfolios to take advantage of the new lower interest rates. The end result will be that interest rates tend to fall across most classes of assets. Again, a fall in interest rates on bonds implies an increase in bond prices, and therefore a gain for existing bond holders.

Of the two effects outlined above, 2) is the most important, as the case of Hong Kong illustrates. Here the Currency Board mechanism ensures that monetary policy is committed to maintaining the fixed exchange rate, rather than stabilising the economy in response to shocks. So the central bank cannot cut interest rates in response to a recession.

Further, the fixed exchange rate ensures that interest rates remain similar between Hong Kong and the United States; otherwise arbitrage opportunities would open up (borrowing money at low interest rates in one economy to lend at higher interest rates in the other economy). Given the relative sizes of the Hong Kong and US economies, that means our interest rates will tend to fall when the US has a recession, regardless of what is happening in Hong Kong!

So if you think there's going to be a recession in Hong Kong, holding Hong Kong Dollar denominated bonds is unlikely to offer much protection, or prospective profits!

Controlling China's Inflation Rate

"In response to the surging CPI in mainland China, some economists have proposed that the RMB be anchored to the prices of 50-100 goods. The goverment would fix a certain price for the basket (say 100 RMB), and adjust the money supply to try to keep that price fixed, no matter what happens to the economy, so that people can always buy such a basket with 100RMB. Is it feasible? And what are the advantages and shortcomings? Were there any precedence in the history of the world economy?" - Roy

This sounds like a version of price level targeting, which has been tried before- in Sweden, 1931-1937 (see this paper for a discussion). Normally, we would think of price level targeting as focusing on the entire basket of goods and services enjoyed by consumers by targeting the Consumer Price Index, but there's nothing to stop the Government targeting a select basket of goods and/or services.

Provided the central bank is given the automony to focus fully on its target (by adjusting interest rates or, equivalently, the money supply), such a policy target is achievable. If the price level increased above the target, the central bank would need to raise interest rates (decrease the money supply) to slow the economy sufficiently to get the price level to return to its target, and vice versa if the price level was below the target. This may not always be politically popular, but with sufficient autonomy, it can work.

The principle benefit of such a target is that it gives the Central Bank a numerical objective, and individuals can easily see whether or not the objective is being achieved. If indeed the target is achieved, then inflation expectations should remain under control, which should in turn make it easier to maintain stable price levels in future- all in a nice, virtuous circle.

This same benefit can in principle be conferred by any nominal anchor for monetary policy- for example an inflation target (as is common in many countries, starting with New Zealand in 1990), or an exchange rate target (China's official form of monetary policy target until recently), or any other numerical objective for that matter.

There may be some other benefits as well. Some people have argued that one problem with monetary policy is that Central Banks cannot credibly commit to future actions. In modern Macroeconomics models with sticky prices, the policy that the Central Bank should choose today depends on the policy that they will choose in the future. If they cannot commit to the policy that they will follow in the future, then they will be reduced to choosing a sub-optimal policy today.

A price level target can help to reduce the costs imposed by their inability to commit, because of the manner in which it ensures that the policy that the central bank will follow in the future is related to the policy that the central bank follows today.

I've written a couple of papers related to this, published in the Journal of Macroeconomics (see here and here). Personally, I'm sceptical that there are any gains to price level targeting by this mechanism, since the results are very sensitive to assumptions about how believable the central bank is, and how price setters set prices.

The Physics of Economic Growth....

Perhaps, not suprisingly, Physics can help explain why some economies are more likely to develop than others, as this story by Tim Harford explains.

The essentially story is simple. Economic development is the process of replacing the production of relatively low valued goods and services with higher valued ones. Some countries focus on sectors that can easily and smoothly transition up the value chain, while others do not. Guess which ones are likely to develop....

See here for more details....

Timing The Coming US Recession.....

For quite a while now, I've been arguing that the US economy is on the brink of recession (see, for example, here, here and here). I have seen little to change my mind on this one, although I am surprised that the recession is taking so long to arrive! There are two possible responses to this:

1) I am wrong; the US is not on a path to recession
2) I am right; but the recession is still coming

I'll stick with 2) for now, but there is a very important lesson here about the ability of economics to predict the future. Even if I'm right, it is very difficult to predict the timing of economic corrections.

In the case of the current business cycle, there remains clear evidence that the market is on a path to correction. The essential story is the same as I have mentioned before. The US has enjoyed several years of economic growth as a result of increasing asset prices- especially in the real estate sector. Households have used some of this increased perceived wealth to increase their consumption, by withdrawing equity from their homes. With consumption making up 70% of GDP in the US, this feeds through into increased economic growth.

But there are some risks to this process: now real estate prices, which have been pushed up artificially by easy access to credit (see here), have started falling. The whole process that pushed up economic growth in the past goes into reverse, and before we know it, the US is in recession.

But how long does it take for this process to work its way through the economy? Well, that all depends on how quickly individuals respond to decreased real estate wealth by reducing their consumption. And that is very difficult to predict, although there is some evidence of this effect now- see, for example, this story on CNN.

If it were easy to predict the timing of economic events, then we'd know exactly when to take leveraged positions in US Government bonds (since the Federal Reserve Board will cut interest rates if the US enters a recession, increasing the value of existing bonds), and Macroeconomics would be a recipe for making money. But alas, Macroeconomists are poor at predicting timing. Or, as an Economist for a major international bank recently remarked to me, "there's a big difference between being right and being able to make money." From the point of view of making money, timing is everything.