Dubai World

Since I grew up there, I feel I can add something to the commentary about Dubai.

Firstly, Dubai is one Emirate (Kingdom) of the 7 that make up the country, the UAE. Imagine it as a State if Federalism really existed.

Secondly, Dubai does not have that much money, but loads of marketing savvy, and more business acumen than the other Emirates. Obviously not enough business acumen, but certainly more.

Abu Dhabi, the capital, is the wealthiest Emirate and is deeply jealous of Dubai for all the glitz it has built around itself. Dubai sits beside "London, Paris, and New York" on Barneys ads, while Abu Dhabi remains the punchline in a 1980s Garfield cartoon. (Yes, Garfield tried to mail Nermal to Abu Dhabi).

Each Emirate really is a Kingdom, and the Kings are kind of like an extended family. They feud. They party. etc.

Abu Dhabi will bail out Dubai, but it will want more political power over the Emirate, as well as some of its crown jewel businesses (Emirate Airlines, maybe some of the malls, maybe some of the Free Zones).

Happy Thanksgiving

In lieu of a Thanksgiving post, I give you this excellent thread, where you can enjoy JKH schooling me on the importance of real assets while the charming Nick Rowe avoids being schooled at all. Read all the comments, they are worth it.

ClimateGate

Climate fraud finally made it to the New York Times.

Hundreds of private e-mail messages and documents hacked from a computer server at a British university are causing a stir among global warming skeptics, who say they show that climate scientists conspired to overstate the case for a human influence on climate change. In one e-mail exchange, a scientist writes of using a statistical “trick” in a chart illustrating a recent sharp warming trend. In another, a scientist refers to climate skeptics as “idiots.”

The NYTimes also nails the likely reaction, which you can see amongst establishment wannabes like Marginal Revolution, and Jane Galt.

The evidence pointing to a growing human contribution to global warming is so widely accepted that the hacked material is unlikely to erode the overall argument.

Since everyone knows it's real, who cares if it's shown to be a fraud?

The nonsense that Steve McIntyre's been dealing with for years directly matches my experience in some of the most prestigious university departments on the planet. Of course, my work was pretty inconsequential, but the dollars and prestige (Gore, Nobel Prize Committee, Democratic Party, every European Government etc.) means that the mask could not afford to slip there. And now it has.

That said, I think the Times still has it right. So what if it's all bogus?

Saving is not Investment

There's a long and ultimatily unsatisfying thread over at Nick Rowe's. Sadly, I cannot recommend it.

One clear idea emerged -- the confusion around "savings" and "investment".

If you get some money and don't spend it, then it's clearly savings. If you get some money and you use it to buy something you then consume (like a donut), then it's clearly "consumption". But how about when you spend your money on something that you hope will give you even more money in the future, like a share of Goldman Sachs, or a Treasury Bill, or a lottery ticket, or a house? Is that "consumption", "savings", or "investment"?

When you're thinking about and tracking the movement of money, then all of those "investment" activities should not be thought of as "saving". They should be thought of as "investment", and may, retroactively, be reclassified as "consumption" -- almost certainly in the case of the lottery ticket, and commonly nowadays in the case of the the house. So, you need all three definitions: saving (money in the bank or under the mattress), investment (money spent in the hope of getting it back), and consumption (money spent with no hope of getting it back). They key difference between these is that investment and consumption is money spent, it triggers income for some other party in the sector, while savings is not. If you are looking at demand or money, velocity, aggregate demand, or anything that involves transaction, you must understand that "saving" does not generate a transaction while both forms of "spending" (consumption and investment) do.

In the end, the amount of saving will equal the amount of investment (S=I) but the causality behind this is subtle, and requires complete attention be paid to the difference between real and nominal. That is a post for another time.

(Small note. In the above example, the Treasury Bill would count as "savings" because it does not trigger a spending event. Government spending is independent of anything the private sector does, and treasury bills simple change the term structure of outstanding reserves, as a mechanism to set interest rates, and are not a "funding" source for anything. Similarly, putting money in the bank does not "enable" the bank to make a loan, as bank deposits are CREATED through the act of lending)

Models vs. Accounting

I concluded a very enjoyable exchange with Nick Rowe from Worthwhile Canadian Initiative. You can check it out here. The crux of the discussion was the failure of monetary policy: we're at ZIRP and yet the economy keeps getting worse. How can we reduce interest rates below zero? What is the mechanism by which interest rates impact the real economy, and what is going wrong with that mechanism, &c.?

This mechanism does not exist, but that did not stop Nick from coming up with this--this!--to explain the framing (or "social construction") of monetarism:

Phillips Curve: p = 0.25(y-y*) + 0.5p(t-1) + 0.5E(p)

IS curve: y-y* = n-r

p = 0.25(n-r) + 0.5p(t-1) + 0.5E(p)

B=1/(1+i)

R=P(1+E(p))/(1+r)

(1+i)=(1+r)(1+E(p))

1. P=1 (or p=0 and E(p)=0).

2. B=1/(1-n) (or i=n)

3. R=1/(1-n) (or r=n)

&c

I ask a very simple question: if the private sector wants to increase its net financial assets, can that be achieved by interest rates or can that only be done via fiscal policy (aka deficit spending)? The point of that question was for Nick to realize what monetary policy can and cannot do, and then we could begin a discussion of what cause of this current crises: ie. is the private sector overly leveraged? This is all d'uh stuff to me, and to most people I think, but d'uh never got you a PhD in Economics. Anyway, this is what Nick came back with:

Yep. In a closed economy:

S-I = G-T

That's just an accounting identity. It's a way of using words in a consistent way; it doesn't tell us how the world works.

Isn't that just fantastic?! Someone who spewed "p = 0.25(y-y*) + 0.5p(t-1) + 0.5E(p); IS curve: y-y* = n-r; p = 0.25(n-r) + 0.5p(t-1) + 0.5E(p); B=1/(1+i); R=P(1+E(p))/(1+r); (1+i)=(1+r)(1+E(p))" dismissing accounting because "it's a way of using words in a consistent way; it doesn't tell us how the world works"?! I want everyone to be totally clear on this point -- someone who is trying to understand finance is dismissing accounting. Finance is accounting. If you cannot track the accounting consequences of a financial act, then there was no financial act. I particularly love all the coefficients in Nick's model, 0.25, 0.5, 0.5 etc. Is he sure they are not 0.26, 0.49, and 0.51? Inquiring minds want to see the regressions.

I am more sympathetic towards economic models, and more suspicious towards accounting than most -- I learned both at U Chicago. But the disdain that economists hold accounting in, and the inability to see beyond their models blinds them to understanding the world around them. Dismissing accounting with "It's a way of using words in a consistent way; it doesn't tell us how the world works" by someone who models shows profound... primitiveness. Not sure if there's a better word.

Also, Nick got the pop quiz wrong:

If desired savings increases (i.e. desired consumption falls), then the rate of interest falls until desired savings falls back to where it started (or desired investment increases, or some mixture of the two).

Wrong! Lower interest makes it even more difficult to reach the desired savings level, so lower rates make things better, not worse. Moreover it is impossible to increase net assets within a sector, the solution can only lie out of the sector.

I love this

There is so much right with this post:

“All speakers are equal but some of the speakers are more equal then others”

The more I exposed to the different loudspeakers, the more I’m learning that the horn-loaded loudspeakers are the most interesting creatures. Nope, not because they might or might not do sound reproduction more accurate or because they might produce or might not produce some audio tricks better. The major beautify of the horn-loaded loudspeakers is that they the most accurate and with very-very high degree of precision portray the objectives and the reference point of the system owners.

You can not lie to horn-loaded loudspeakers because they return your own lie to you all across their big mouth. You can not BS the horn-loaded loudspeakers because they have own identity and integrity that is not bribable or persuadable. You can not belittle the horn-loaded loudspeakers because they are too demanding and do not care about you. You can not sometimes understand the horn-loaded loudspeakers as they are too complex, capricious and very arrogant. You can not develop a sense of intimacy with horn-loaded loudspeakers because they are wrong gender. You can not annex the horn-loaded loudspeakers because they do not feel slavery. All that you can do is juts live near the horn-loaded loudspeakers demonstrating your respect to them.

Being a reflection of us the horn-loaded loudspeakers honestly present us with one more aspect of us. It is not secrets that there are practically none existing among audio people well-performing horn-loaded installations. Why? Is it some kind of failure of the horn-loaded topology? Not really. The problem is the “us”. The horn-loaded loudspeakers juts spit to us who we are returning right into our faces the magnified BS and stupidity we are practicing in audio. So, when I’ve been telling you folks that 99.9999% of all horn-loaded installations out there are garbage and that 99.9999% of all people who do audio are Morons then I personally do not see any luck of reasoning between these two numbers…

The Public Purpose of Banking

While Lloyd Blankfein claims bankers are worth Billions, even as they destroy Trillions, it's worth taking a look at what the public purpose of banking is. Chicago economists, sit back down, the public purpose of banking is not to enrich their shareholders any more than the public purpose of pharmaceutical companies is. Capitalism works by enriching owners as they compete to provide some value to customers. So, what is the value that banks deliver to their customers?

First, what is a bank? My definition is simple and goes to the heart of their public purpose: a bank is an entity that has a reserve account at the Fed. That is it. If you have a reserve account at the Fed, it means you can lend unconstrained by your reserve balance. Briefly, this is how it works:

1. You make a loan. This debits your reserve account, and you credit a receivable account.
2. The loan gets deposited, which credits that reserve account, and credits a liability. Note how the loan created the deposit, not the other way around.
3. If the loan and the deposit are made at the same institution, that institution has no net change to its reserve levels. If the loan and deposit were made at different institutions, then the institution short reserves borrows what it needs from the institution long reserves overnight. That's it.

If you or I make a loan, we cannot use the reserve credit that the corresponding deposit creates to top up our own reserve levels. Thus this clear, operational difference between banks and non-banks.

Ultimately, the Govt creates all reserves, so why not just have the Govt make loans directly? Because we do not want the Government to make credit decisions, they are too likely to dole out money to politically connected constituencies, while starving worthwhile, but unconnected borrowers. You can see this today, as banks and unions get Billions, while shop keepers, dry cleaners, manufacturers, and restauranteurs shutter their businesses and go on the dole. An institution that makes loans it knows will not be paid back is not making loans at all, it is making gifts, and the operational bankruptcy of the FHA is a great example of this in action. Many adjectives come to mind: corrupt, wasteful, abominable, unfair, fraudulent, etc. This is the opposite of Responsible Governance. Barry, we really expected more.

So, to keep responsible lending, we put private capital infront of public capital and ask that private capital take the first loss on loans it makes which turn out to be bad. Ultimately, taxpayer money is there as backup, but it should not be directing investment. We call this institutional arrangement a "bank".

This simple sensible construct is utterly lost on policy makers and the commentariat alike. For banking to do the job it is meant to do (ie. make loans that will be paid back), a bank should be required to keep all loans it makes on its books until maturity. It should be forbidden to participate in any secondary markets, in any way. It should not run a prop trading desk. It should not sell insurance. It should not have a fee-for-service business. It should simply conduct its own credit analysis, make loans, and service them. And in return for providing this public purpose, a bank shall have a reserve account at the Fed.

Larry Summers is in charge -- may God help us all

When I first typed in the title, I wrote "Gold" instead of "God". Freudian slip (if I were an Austrian).

Just a quick quote from Vanity Fair on Larry Summers, the man behind Geithner:

Summers has plenty of other things figured out as well, including the origins of the current financial crisis, for which he has crafted a cogent explanation worthy of his reputation as a policy wonk and his days as a college debating champion at M.I.T. “I think crises like this get made by multiple cascading misjudgments,” he explains, and then catalogues them: too much government spending, not enough private-sector saving, too much dependence on foreign debt, too much demand for “riskless” financial instruments that weren’t, in fact, riskless …

Unfortunately, Government spending was too small and this did not fund private savings sufficiently, foreign debt merely improves our terms of trade (and is therefore a net plus), and Govt actions have made the gap between credit analysis and lending worse, not better.

This is why the policy response will be a spin of the roulette wheel. The doctors believe in phlogiston.

An attempted truce between neo-chartalism and monetarism

I don't know what the difference is between "neo" chartalism and straight up chartalism. Either way, Nick Rowe tries to split the difference between conventional monetary policy, which focuses on the Fed setting interest rates and thus managing money in the private sector via lending, and chartalism, which focuses on fiscal policy and believes the interest rates don't make much difference.

Let's start with the short run government budget constraint.

G-T +iB = dB + dM

Where G is government spending, T is taxes, i the interest rate on B, the existing stock of government bonds, dB the change in B, and dM the change in the stock of central bank money.

Fiscal deficits must be financed by issuing bonds, or money, or some combination of the two.

One conventional definition of "fiscal policy" is a change in G or T holding M constant (bond-financed deficits). A change in M counts as "monetary policy". Suppose instead we define "fiscal policy" as a change in G or T holding B constant (money-financed deficits). A change in B is what now counts as "monetary policy".

What the new dictionary calls "fiscal policy" the old dictionary considers as fiscal policy supplemented by monetary policy. And what the old dictionary calls "fiscal policy" the new dictionary considers to be fiscal policy with a countervailing monetary policy.

It's a step forward, but implicit in this model is that M (or more precisely M0) has some bearing on private sector money. The private sector holds two types of financial assets: those issues by the Government, and those issues within itself. It is a net saver of Government issues assets, as the Govt is a net dissaver, but it carries a net zero balance of private sector issued assets (through double entry bookkeeping).

M (or M0) in Nick's model is the Government issued assets that the private sector holds. Government deficit spending funds net private savings. But private sector issued financial assets (loans, stocks, etc.) while leveraged on top of Government issued financial assets, are not Government issued financial assets re-lent out. Banks do not loan out reserves, banks make loans, and then create the related deposits once they are deposited in the banking system.

This takes M0 completely out of the model and leaves us with the straightforward position: Government deficit spending funds in the increase in the non-Government sectors net financial assets (or, if you prefer, net savings).

He is correct in his model that interest paid on privately held debt increases non-Govt savings as well. But please note, this says that low interest rates are deflationary as the reduce the amount of income/savings the private sector gets, while high interest rates are inflationary. The exact opposite of monetary theory.

Update: Do read all the comments in the thread.

10% unemployment and rising

The Obama/Goldman Sachs administration has brought its bonuses back, but unemployment continues to ratchet upwards. The headline number today of 10.2% is dreadful.

The Economist is far to sanguine on the turnaround being imminent. Employment will not improve for a long while, maybe decades, because it is the only mechanism keeping a floor under aggregate demand. It is both ironic and fitting that a magazine calling itself "the Economist" exhibits the profession's disdain for accounting and financial operations. To wit:

Politicians will focus on how to respond to voters’ demands for action. On Friday Barack Obama was expected to sign into law a hotchpotch of stealth stimulus measures. They include some badly designed but popular measures such as letting money-losing companies claim tax refunds against profits earned up to five years earlier and an extension to the tax credit for buying a home. A third measure, extending unemployment benefits for some who have lost their jobs, will alleviate hardship and boost demand but will probably raise, not lower, the unemployment rate. Richer benefits encourage workers to look for a job rather than quit the search, and to turn down unsatisfactory job offers.

Rubbish.

"The US built all these houses, and is now richer in stuff than ever before as a consequence, and then everyone loses their job." Doesn't that seem weird to you? But at its heart, that is the argument freshwater economists make for the recession. The US's problems are purely nominal, the non-Govt sector wants additional financial instruments to add to its net savings, and the one entity capable of providing those instruments is either not doing it, or doing it in a way that poorly targets the non-Govt sector demand.

The best part of the Obama bill was the extension of unemployment benefits. Unemployment benefits (along with taxing labor) is an "automatic stabalizer" that drives deficits higher as unemployment climbs. Higher deficits mean more non-Govt sector net savings, and hence, higher aggregate demand. It is an ugly way to do it, but at least it moves the right levers in the right direction at the right time. There are far better alternatives, but they were rejected by economists right and left. So we do it through unemployment.

If unemployment benefits expired, then being out of work would no longer drive deficit spending as much. The result would be far higher unemployment as aggregate demand took another leg down. That path, truly, leads to another Great Depression.

The bizarre obsession with Zimbabwe

As those who do not understand how the financial system works fret about hyperinflation "just around the corner", and keep trotting out the example of Zimbabwe. This obsession with Zimbabwe is bizarre.

About 50 years ago, when Zimbabwe was Rhodesia, you could describe it as a middle income country, maybe comparable to Poland today. Since independence, it has gone to hell in a handbasket, with the Government mostly being non-existant, except to destroy 50% of the productive output. I do not have details, but I bet tax collection is partial at best, theft and graft is rampant, and the economy runs on a mixed currency model like most of the third world, including barter, US dollars, and Zibabwe dollars (which officially went out of existence a few months ago). The country is also dirt poor, with hardly any real capital stock or inventory. I have no idea what deficits it was running (if any at all), what the status of fx obligations were, or how much of the economy ever existed in the formal sector. Neither does anyone else.

And yet, people think it is somehow a good analogy for the US.

If one insists on arguing by poetry, there is a much better example to use: Japan. It is a modern industrial country, just like the US, with robust tax collection, and Government liabilities entirely in the floating fiat currency of the Japanese Government. It too suffered a huge credit bubble and bust, and it has now gone about 30 years with massive quantities of reserves piling up in the banking system, debt to GDP at 200%, chronic unemployment and underemployment (by Japanese standards), and zero interest rates. But theirs has been a story of deflation, not inflation.

All of the standard elements that are supposedly leading to hyperinflation "just around the corner" -- zero interest rates, massive reserves, huge debt to GDP -- have been operational in Japan for almost a generation, and yet the story has been one of grinding deflation. The reality of Japan defies all these hyperinflation predictions, which I assume is why it's been ignored.

The only example I can think of that's worse that Zimbabwe is a brick, because a brick doesn't have an economy at all, it's a building material.