29 November 2011
The beginning of the next crash is overdue
This blog has been silent for three months. I was waiting for the first estimate of third quarter GDP in order to calculate the income velocity of money, which as we have shown earlier, is a vital parameter in judging the health of the economy.The graph of corrected money supply (we have considered sweeps too in our calculations) continued to rise until the end of September 2011 as seen in the graph below.
The income velocity of money is as seen in the graph below.
As can be seen, at the end of September 2011 we were exactly in the situation we were in at the beginning of 2006. This, if readers recall, was when housing starts began to fall, though the equity markets did not reflect the fall in money supply until more than a year later.
Someone (I think it was Popper) observed that interesting theories should make predictions that are easily falsified. Saying that it will rain in 2012 is too easy; a really interesting theory would predict that it will rain on 12 August 2012 but not on 1 September 2012.
I shall therefore go out on a limb and predict that in December 2012 the S&P 500 will touch 800.
Those to whom Corrected Money Supply and Income Velocity of Money (as we calculate it) seem like Greek may find it useful to read The Riddle of Money, Finally Solved.
Category: Economics
14 August 2011
Krugman's advice to Japan: 1997
It is interesting to read Krugman's remedy for Japan's recession, advanced in 1997. The Fed has followed it to the hilt so far in the US and has nothing to show for its pains."The simple fact is that there is no limit on how much a central bank can increase the supply of money. [sic] Could the Bank of Japan, for example, double the amount of monetary base - that is, bank reserves plus cash in circulation - over the next year? Sure: just buy that amount of Japanese government debt. True, even such a large increase in the money supply might not drive down interest rates very much, since they are already so low. But an increase in Japan's money supply could ease the economic problem in ways other than lower interest rates. It is possible that putting more cash in circulation will stimulate spending directly -- that the extra money will simply "burn holes in peoples' pockets". Or banks, awash in reserves, might become more willing to lend; or individuals, with all that cash on hand, will bypass the banks and find other ways of investing. And even if none of these things happens, when the Bank of Japan increases the monetary base it does so by buying off government debt -- and therefore makes room for spending increases or tax cuts.
"So never mind those long lists of reasons for Japan's slump. The answer to the country's immediate problems is simple: PRINT LOTS OF MONEY. But won't that be inflationary? Well, remember that the Bank of Japan is supposed to be impotent: if it prints more money, people will simply hoard it rather than save it. But printing money is only inflationary if people spend it, and if that spending exceeds the economy's capacity to produce. You cannot first argue that monetary policy is ineffective as a way to increase demand, then reject a proposal to print more money on the grounds that it will cause inflation."
The full article can be seen at What is wrong with Japan?.
Readers might wonder why a Keynesian was advocating such notably monetarist remedies instead of recommending public spending. The reason was that the Japanese government had tried it and failed.
Category: Economics
08 August 2011
The graph of Corrected Money Supply below shows a massive increase upto June 2011.
It has gone way above its previous peak at the end of 2005. But the situation is still (I am speaking of June, remember) a little less dangerous than it was then, as the graph of Velocity of Money below shows. Since then, of course, it has probably got a lot worse.
I wonder whether the real crash is going to occur in the treasuries market. Perhaps all those who bought treasuries at rock bottom yields are going to get a rude shock if interest rates go up. Buyers of short-term treasuries can of course hold them to maturity but those with longer-term treasuries may suffer a sharp erosion in capital.
If you haven't been keeping up with this blog you might want to read The riddle of money, finally solved which explains Corrected Money Supply.
Category: Economics
08 August 2011
Corrected Money Supply and the S&P 500
Here's an interesting graph showing Corrected Money Supply from January 2001 to June 2011 against the S&P 500 Index at close.
Those who haven't been following this blog might want to read The riddle of money, finally solved which explains what Corrected Money Supply is.
Category: Economics
29 July 2011
Why are financial bubbles so easily popped?
When Paul Volcker set out to slay the inflation monster in the early eighties, the Effective Fed Funds Rate had to go up to more than 19% before he was successful. In contrast, financial asset inflation seems to be a delicate creature; it takes only an interest rate of 5%-7% to kill it. Why?The answer is obviously leverage.
Consider a hedge fund with an equity capital of $5 that borrows $95. It invests the money in the stock market.
At an interest rate of 0%, when the market rises 1% the fund earns a return of 20% on equity. Given five such days in a year when the market rises 1% the fund can easily earn a return of 100% on equity. Nice bonuses all around. Thank you, Mr Bernanke!
When the interest rate is 1% the annual cost of financing is 0.95%. So the market needs to rise nearly 2% to give a return of 20% on equity. If the market remains stationary, the fund undergoes a loss of nearly 20% on equity.
When the interest rate is 2% the annual cost of financing is 1.9%, so the market needs to rise nearly 3% to give a return of 20% on equity. If the market does not rise, the fund suffers a loss of 38% on equity.
When the interest rate is 5% the annual cost of financing is 4.75%, so the market must rise 5.75% to give a return of 20% on equity. If the market does not rise, almost all the fund's equity gets wiped out.
We have not considered staffing and other costs or the fact that a hedge fund can bet on the market's fall as well as its rise. But despite the simplification the idea is clear. Each percentage rise in interest rates increases the risk that a highly leveraged hedge fund can go bankrupt. It is not surprising, therefore, that a Fed Funds Rate of 5% is enough to pop most bubbles.
So what are the implications for policy? The US government has tried to set limits on bonuses, on the transparency of hedge funds and other financial institutions, on capital requirements and so on. I rather agree with Alan Greenspan that no regulator can keep pace with changes in financial engineering. To remove all risk from the system one would need to have a regulator looking over the shoulder of every trader. That would be going the way of the Soviet Union. And I doubt whether even that would prevent catastrophes.
On the other hand, a Fed Funds Rate of about 5% seems guaranteed to prevent any asset bubble from growing, judging from the past decade. But won't that also penalise businesses producing real goods and services? I have argued in Why banks do not lend at near-zero interest rates that both the economics and the evidence give the lie to this fear.
For a firm producing real goods and services, an interest rate of 10% probably won't add more than a percentage point or two to total cost. And this can easily be absorbed or passed on to customers. For financial trading firms, though, such an interest rate would be disastrous.
There is a curious corollary to the above thesis. I argued that raising the interest rate to moderate levels prevents any money from going to feed bubbles. Carrying the argument a step further, low interest rates, by diverting money to asset inflation, keeps the inflation of real goods and services down.
This conclusion militates against all common sense. In its favour, consider the fact that before the Great Depression, the crash in Japan, and the Great Recession, inflation was very low. That is to say, low inflation need not be a sign of slow monetary expansion, but quite the opposite: an indication that money is growing steeply.
Category: Economics