Thursday, 31 May 2012

Bloomberg bested: Update on the "Housing Bubble"

Bloomberg had an article recently where the currency controls were blamed for a formation of another possible housing bubble in Iceland. The take was that since the capital/currency controls locked funds inside the economy and investors were finally realising that they were going to be around for a long time, they best get their money into cement rather than let them rot in low-interest deposit accounts or bonds. The influx of money into the housing market then creates and supports unsustainable house prices - and inflation since housing is about 20% of the Consumer Price Index base in Iceland.

House prices went through the roof in mid 2000s only to come down crashing again. Now nominal prices are rising again, pulling inflation up with them.

I am not going to disagree on the possible formation of an unsustainable rise in the housing prices in Iceland supported with funds of high net-wealth investors, I already warned of that in February (Daily Mail and House Prices in Iceland). I am, however, going to emphasise the point that the influx of money into the housing market due to the capital controls is massively supported by creation of new mortgages (Bloomberg mentions this). Taking the expansion of new mortgages into account I'm not so sure the (acclaimed) flow of capital-controls-locked money into the housing market matters that much on its own, it is the leverage in the form of mortgages that brings the fuel.

First, what seems to support the view that capital-controls-locked money is mainly causing the rise in housing prices is the apparent divergence between new mortgages and prices, starting in mid year 2011 or so. Until then, house prices had always run parallel to the issuance of new mortgages. 

New mortgages and change in house prices. Notice the apparent divergence around mid year 2011 supporting the view that the recent rise is only caused by new funds locked in by the capital controls.

But cracking the data shows that the connection between new mortgages and the change in house prices is still around - correlation of 0.83. Both the change in the flow of new mortgages and the acceleration of the flow of new mortgages are still strongly connected to the change and acceleration of house prices. And notice that the mortgages lead the change in house prices, not the other way around!

Although the flow of new mortgages into the market has dislocated itself with the change in house prices (see previous graph) the change in the flow has certainly not!

Relative acceleration of house prices and relative acceleration of new mortgages (if new mortgages accelerate, the change in house prices should as well). Mortgages have been rather constantly accelerating since May 2010 and guess what, so have housing prices. Mortgages are still driving the housing market, with help from new funds or not.

In conclusion, the locked-in money is not suddenly infusing the rise in housing prices on its own. The connection between house prices and mortgages is still around and still going strong and I do not see any reason for changing my opinion since February: high net-wealth investors use mortgages to leverage up their position in the housing market. 

Good thing Bloomberg finally picked that up.

Thursday, 24 May 2012

The Rate of Interest and the Nominal Monetary Target

Jeffrey Frankel's article "The Death of Inflation Targeting" and my comment on a Facebook link of a friend to it are the soil of this post. In the comment I said that it was a shame people did not understand that the classical/neoclassical/Austrian theory of rate of interest being the price of waiting to spend your money was wrong. I was asked to clarify better what (the Hell!) I meant and how it was connected to the Death of Inflation Targeting. 

The classical theory of rate of interest
Most of us and all of us who went for Econ 101 know this theory. Higher interest rates spur people to save higher part of their income and at the same time those same rates cause investment, which is funded with the savings of people (savings must come first, investment follows... also incorrect but that matter is somewhat out of the reach of this post), to decrease as rates becomes higher. In "equilibrium" the savings and investment schedules meet and that is where the rate of interest and amount of savings and investment is decided.

The well-known supply-demand diagram of how interest rates are decided according to the amount of savings and investment in the economy.

This is the static theory of rate of interest: rates get higher and people will save more, no questions asked. This is of course nonsense, otherwise how would one explain situations like this one?

A question in a survey I asked people to participate in. Higher rates don't seem that interesting if you cannot access your money. Obviously, the number of responds might not be significant enough, but you get the point: higher rates don't necessarily mean that people jump automatically on that bandwagon as the static theory of rate of interest implies. 

The classical dynamic version is that people ask for the rate of interest because they are willing to wait for that price (rate of interest) for their chance to spend their money. The longer you wait the higher rates you will get. Interest rates are the price of time according to this theory. This seems like the most accepted view of most economists and it’s an old one. It is essentially built on the idea that interest rates are decided on where the marginal disutility of waiting to consume (save) is equal to the marginal productivity of capital (I’m not going to get into how flawed the terms “marginal disutility of savings” and “marginal productivity of capital” are).

Hayek (Austrian) held that interest rates reflected the collective (market) preference of individuals to consume now rather than later. If people wanted to consume now, interest rates would have to be high in order to get them to save part of their income until they could use it and the accrued interests for consumption later.

Mises (Austrian) was of the same opinion: “Interest is the difference in the valuation of present goods and future goods; it is the discount in the valuation of future goods as against that of present goods” and “The greater the fund of means of subsistence in a community, the lower the rate of interest.”

Hicks (neo-Keynesian, the one who thought he grasped Keynes’s General Theory in the IS-LM model but apologised for his faults later): “There are other instruments of economic policy which can attain the same objective as a rise in interest rates; and some of these may well be less destructive instruments. But we should not forget that in these days of scarcity time is short; and the rate of interest is the price of time.” (1947, ‘World Recovery After War – A Theoretical Analysis’ my emphasis).

Marshall (neoclassical): “Interest, being the price paid for the use of capital in any market, tends towards an equilibrium level such that the aggregate demand for capital in that market, at that rate of interest, is equal to the aggregate stock forthcoming at that rate”.

So the rate of interest is the price of waiting according to the classical/neoclassical/Austrian theory. A rather convenient corollary of this – note especially the latter quote from Mises – seems to be that the only thing needed to decrease the rate of interest in the economy is to get the public to save more: if the public increases its savings, the supply of investment-funds increases and, given the same investment schedule, the rate of interest lowers and investment increases exactly by the same amount of increased savings.

This view of the origin of rate of interest has never been proven to apply in practice. And it is of course very very flawed once one takes a step back and thinks about it.

“This is a nonsense theory”
Keynes declined the classical theory out of the simple observation that it was inconsistent with the assumptions it rested on:

The independent variables of the classical theory of the rate of interest are the demand curve for capital and the influence of the rate of interest on the amount saved out of a given income; and when (e.g.) the demand curve for capital shifts, the new rate of interest, according to this theory, is given by the point of intersection between the new demand curve for capital and the curve relating the rate of interest to the amounts which will be saved out of the given income. The classical theory of the rate of interest seems to suppose that, if the demand curve for capital shifts or if the curve relating the rate of interest to the amounts saved out of a given income shifts or if both these curves shift, the new rate of interest will be given by the point of intersection of the new positions of the two curves. But this is a nonsense theory. For the assumption that income is constant is inconsistent with the assumption that these two curves can shift independently of one another. If either of them shift, then, in general, income will change; with the result that the whole schematism based on the assumption of a given income breaks down. (from the General Theory, Chapter 14, my underlining)

So Keynes had to come up with another theory since he realised the classical theory was useless for the simple fact that one cannot both eat the cake and keep it.

Keynes’s Liquidity Preference Theory of Rate of Interest
Keynes’s LPT was based on the sober observation that savings could be kept in many different forms. It wasn’t the amount of savings that decided the rate of interest, as in the classical/neoclassical/Austrian theory, but the form which the savings were kept in. 1,000 euros kept in cash are just as much of savings as 1,000 euros kept in corporate bonds. If people were willing to shift from one form to the other, interest rates would change. How people saved mattered, not the amount they saved.

A simple way to show the subtle difference is hopefully the following. A man has 1,000 euros in after-tax income. He spends 900 of them in living expenses (consumption) and the rest is savings.

Now the question he must ask himself is the following: “will I possibly need the 100 euros I’ve saved this month in case something happens in the near future that calls for unexpected expenditures that I cannot meet with my regular after-tax income? If so, I need to keep the savings in a form which I can easily access to meet the unexpected expenditures. If not, I can keep the savings in a form that could possibly take me days or years to access.”

If the man thinks he needs the cash in near future, he will keep it in liquid form, such as cash, which yields no rate of interst, or a demand-deposit bank account which he can withdraw the money from any time he wants. But at the same time, the demand-deposit account has very low rate of interest.

If the man thinks he doesn’t need the cash, he’s OK with keeping it in illiquid form that takes him days to get into the type of wealth he can spend on consumption, i.e. cash. One such form is time-deposit bank account which he cannot withdraw the money from until sometime later. This is beneficial for him as the time-deposit account has very high rate of interest in comparison to the demand-deposit account.

Notice the very subtle difference: no matter how he decides to keep his savings (20 euros in the demand-deposit bank account and 80 in the time-deposit account or 50 in each...) he will always save the same amount! The rate of interest does not influence the amount he saves but only how he saves it – how much goes into the immediately accessible but low interest rate demand-deposit bank account in comparison to the ill-accessible but high interest rate time-deposit account.

So the rate of interest is not the price of waiting to consume (to save) but the price of our willingness to depart with the ability to use our money in case something unexpected happens. Interest rates are, as Skidelsky called it, the price we are willing to accept for losing our “instant command over sums of money.”

A wonderful corollary to this fact is that the Central Bank can, and should, influence not only the short term rate of interest downwards but the long-term rates as well. It does this by securing full liquidity in the market for public-debt instruments of all maturities. Doing so, the public can be as liquid as it wants and the rate of interest will decrease.

The Future Nominal Monetary Target?
It is here where the “Death of the Inflation Target” plays its part. The inflation target was built on the classical, and wrong, theory of the origin of the rate of interest. More importantly, the majority of central bank theorists have not accepted what market makers have been knowledgeable about for a very long time: money is endogenously created at the same time as credit is but not exogenously (the textbook helicopter model): money does not come first and then credit but credit-demand first and then credit-creation and money-creation at the same time. And it is the Endogeneity of money that creates the asset boom-and-bust cycle.

Blatantly, as the Austrians realised (although they used the wrong theory of interest to reach that conclusion) and Keynes as well, if the rate of interest is lower than the marginal efficiency of capital, a bank credit-driven investment boom and bubble will commence. But at the same time, the rate of interest must be kept low in order to fuel investment demand and thereby labour demand. High interest rates kill off productive investment that would have otherwise lowered the unemployment and increased production in the economy. Low enough interest rates – as low or lower than the marginal efficiency of capital – would almost definitely secure full employment in the economy, permanently.

The problem that arises from a situation where interest rates are lower than the marginal efficiency of capital is the threat of a credit boom with all the accompanying money creation and demand that will hit supply-constraints resulting in the inevitable: high inflation.

But the remedy against this is to keep the endogenous nature of money on a short leash. Money in a modern economy is created by the banking system sidelong the creation of credit and debt. If the credit creation capabilities of the banking system are kept under control, not with high rates of interest – for dear money does not automatically mean that money will not be easy – but with direct control of how much credit it can give, the credit boom problem is solved. If those limitations are put into place, there is no chance that credit-driven investment bubble can form with the resulting inflation unless the funds come from abroad.

But foreign inflow of funds into an economy means that the nominal exchange rate of the currency will strengthen. Stronger exchange rate means lower exports and shift from domestically manufactured goods to imports, resulting in a decrease in employment. Full employment in an economy where the Endogeneity of money is kept on a short leash does not go along with too strong exchange rate. At the same time, too low exchange rate means imports-inflation.

Somewhere, there is a wonderful but ever-changing balance in the exchange rate which is weak enough to secure full employment but not so weak that it causes overinvestment, credit-fuelled expansion of money supply and imports-inflation.

The future monetary target should be to keep interest rates low at all times with full liquidity provision of the central bank, fulfilling the public’s demand for liquidity – i.e. full access to their wealth – at all times. At the same time, in order to stop bank-credit fuelled investment booms-and-busts from forming, the credit creation capabilities of the banking system should be limited in such a way that the limitations are directly influencing the banking system to reach full employment and low inflation at the same time through balancing the exchange rate.

Nota bene: this exchange rate would be a free-market solution restrained only by the rules the central bank puts into place regarding credit creation. At the same time, the central bank influences the rate of interest downwards in order to reach the rather socially and economically well acceptable target of full employment through private investment projects.

Wednesday, 23 May 2012

I need your help!

OK, I'm going to plead to my readers for assistance for my PhD. If people could answer the following questionnaire regarding interest rates and savings it would help me tremendously! It's only nine questions and it would only take about 5 minutes to answer them but your answers would assist my research a lot!


Tuesday, 22 May 2012

Behold the Norwegian Housing Bubble

Nuff' said!

And here is a comparison to Denmark and Sweden from  Statistics Norway.

In relation to this, the Norwegian Minister of Finance pointed out that households in Norway had never been so indebted. Now the only question is when the self-delusion will be realised by the public, which is probably going to be quite late as it is the common man himself who is doing the self-delusion.

Monday, 14 May 2012

Another Look at the Eurozone Crisis

Used the OECD stats to make those:

Investment as a share of GDP, quarterly data, seasonally adjusted

Government consumption as a share of GDP, quarterly data, seasonally adjusted

One can see the investment boom in Spain and Ireland very clearly on those pictures. That boom was fuelled with credit (created at home and coming from Germany amongst other countries) even though it doesn't show on the graph above.

And with the same graph in mind, one can understand why employment has collapsed: lower investment - contraction in wage income - lower wage income - private debt distress - liquidation - fall in asset prices - lesser investment still... and so on.

The only way to keep employment and the economy going is to call for public investment projects (included in the investment graph) and if they don't come, next in line is government consumption, such as pension funds, employment benefits, etc., to maintain cash flows to the public since people don't get investment-employment any more.

But that wasn't allowed: Ireland's and Greece's state coffers were squeezed "since it is the solution to the eurozone crisis" said the slaves of some defunct economist. Ireland and Greece were in fact squeezed so hard that now they are squeezed more than the main squeezer is squeezing his coffers: Germany. Spain is just around the corner (see government consumption graph above).

So when the State cannot meet the collapse in demand from the implosion of investment, public and private, the unemployment skyrockets.

Unemployment levels in the eurozone - Total Unemployment

Unemployment levels in the eurozone - Unemployment amongst people under 25 years

And when the unemployment goes up, as it did in the 1930s, we get to see social unrest and Molotovs flying:

A motorcycle policeman burns as his colleague (right) tries to help him after protesters threw a gasoline bomb in Athens on Wednesday, Feb. 23, 2011. Scores of youths hurled rocks and Molotov cocktails at riot police after clashes broke out during a mass rally that was part of a general strike. Photo and text from The Washington Post

And after the social unrest, the Molotovs and burned down buildings, we see nutcases and lunatics like those guys:

Leader of Golden Dawn, an allegedly neo-Nazi Greek political party, and party supporters. Stinks like early 1930s

"Progress, far from consisting in change, depends on retentiveness. When change is absolute there remains no being to improve and no direction is set for possible improvement: and when experience is not retained, as among savages, infancy is perpetual. Those who cannot remember the past are condemned to repeat it."

Thursday, 10 May 2012

Is Keynes's Clearing Union the Solution for Europe?

The Wolfson Economics Prize, about how to fix/break up the euro, was in the news some weeks ago. After having skimmed through, certainly not read thoroughly, some of the works that were handed in (I did read the entry of the 10 year old Dutch kid, thumbs up for trying) and with this paper in mind - A post-Keynesian interpretation of the eurozone crisis - it has started started to dawn upon me that Keynes may well have the solution: his Clearing Union (CU).

The essential core of the CU was that (current account) surpluses were to be recycled, in a way, between countries. The surpluses would build up as "pool of funds" (don't think for a second that I believe in the nonsense of Loanable Funds Theory just because I use this term) at the Clearing Union. Those surpluses would then be available to countries in deficits in the form of overdraft facility, at very low rate of interest. In today's Europe, the equivalents of the surplus countries are of course Germany and other current account surplus countries. The Peripheries are the deficits countries.

If the CU would be adopted between the countries of the euro zone the surplus of the Core would be up for grabs for the Peripheries, at a very low rate of interest. The Peripheries could therefore finance employment schemes and public investment projects with money from the Core, hoping that the resulting increase in income would get the economy back on track and possibly even getting some capital-and-income convergence with the Core.

In the meanwhile, the Surplus countries would be induced to spend more at the given exchange rate of the euro since the rate of interest of the surplus, ending up being a overdraft facility at the CU, is very low. The increased spending of surpluses would, if spent outside the euro zone, send the exchange rate down, assisting the deficit countries to export their way out of recession. If the spending is euro-zone-internal the increased income of the peripheries, as the surplus is recycled into imports from there into the core, would kick them out of recession.

Note that this system basically fights against huge disbalances in the current account between countries. Today's problem arise from the fact that even though the current account of the euro zone as a whole may be in balance to the rest of the world, there are huge imbalances between countries within the euro zone. This CU system would wipe those imbalances out or at least mitigate their negative effects as the deficits can be financed at low rate of interest.

The beauty of this CU system is that there doesn't seem to be any need to breakup the euro. Obviously, the creditor countries (the Core) are being asked to spend their own money to clear up the internal imbalances. If they don't want to do that, the debtor countries (the Peripheries) get the savings at a very low rate and can do what they want with it. No need for fiscal union.

I don't expect this idea to reach the ears of ruling politicians however, they are already "slaves to some defunct economist" who thinks the way out of the current problems is to apply more and more austerity. One can only hope they realise that it's like trying to put out fire with a dash of petrol.

Tuesday, 8 May 2012

Guest Post: Is Iceland OK now?

Copy-pasted note from Gunnar Tomasson, ex IMF Senior Staff Member, he published on Gang8 website, answering Michael Hudson's question whether "Iceland was OK".


RE: [gang8] Krugman's mistaken belief that devaluation saves anything, even over-indebtedness

No, Iceland is not OK now.

I’m just back in the US after three weeks in Iceland where I had an opportunity to talk to old friends from all parts of the political spectrum.

There is a strong feeling that the long-established political order has outlived its usefulness - if that is a term which can be used to describe its record.

Is Iceland really OK?

I was on the State TV program Silfur Egils on Sunday April 22.

In a 15-20 minute interview, I addressed among other things the insurmountable – on present policies – problems faced by Iceland in the monetary/balance of payments field.

Briefly, Iceland’s current foreign exchange reserves are of the order of ISK 1000 billion (US$ 1 = ISK 125).

Did I say reserves?

Yes, but they are borrowed reserves – not reserves that Iceland has accumulated from past surpluses on its balance of payments.

Iceland’s GDP is currently of the order of ca. ISK 1800 billion (my guesstimate – may be off by ISK 50 billion or so in either direction).

In October 2008 Iceland responded to the collapse of its banking system – and much else – by introducing pretty harsh foreign exchange controls.

For example, foreign owners of pre-crash Glacier Bonds were estimated to be holding ISK 400 billion which were essentially “locked in”.

Just recently, it dawned on the authorities – and, apparently, the IMF – that they had forgotten to factor in another factor.

The Icelandic currency claims of the creditors of the old banks, whose assets are being liquidated for eventual distribution to creditors.

So, to the ISK 400 billion, add another ISK 700 billion – and Iceland’s borrowed foreign exchange reserves become even less impressive than before.

That’s one part of the monetary/foreign exchange problem.

The other part resides in the globs of ISK monetary and other liquid assets left over from the “good years” prior to October 2008.

If the foreign exchange controls were lifted tomorrow, Iceland’s borrowed foreign exchange reserves would vanish in the blink of an eye.

In other words, from a macro-economic point of view, the REAL worth of foreign and domestic ISK balances waiting to exit through the foreign exchange market is a fraction of their pseudo-worth at the current ISK exchange rate.

What to do?

In Silfur Egils I made a twofold suggestion – a summary version is as follows:

1. Let the Glacier bond etc. money exit at a STEEP premium over the current exchange rate of the ISK.

2. Call in outstanding ISK balances and exchange them for New ISK at differential rates – say, one to one for household balances and something much less favorable for larger balances.

The problem at hand is clear as daylight – the chances of anything being done about it along the above lines are zilch, given the current political power structure.

What to do?

Change the current political power structure!

A general election must be held no later than a year from now and there is turmoil in the Old Guard and hopeful urgency in its would-be replacement which cuts across conventional political party lines.

I had an opportunity to meet one-on-one with leaders of two of the latter parties for lengthy and fruitful discussions.

I am hopeful that they will be able to join forces, attract a large number of voters – and

Throw out the rascals come next year!