Thursday, October 29, 2009

Rogoff: China's Dollar Problem

Ken Rogoff talks about China's serious dollar problem:

CAMBRIDGE – When will China finally realize that it cannot accumulate dollars forever? It already has more than $2 trillion. Do the Chinese really want to be sitting on $4 trillion in another five to 10 years? With the United States government staring at the long-term costs of the financial bailout, as well as inexorably rising entitlement costs, shouldn't the Chinese worry about a repeat of Europe's experience from the 1970's?

During the 1950's and 1960's, Europeans amassed a huge stash of US Treasury bills in an effort to maintain fixed exchange-rate pegs, much as China has done today. Unfortunately, the purchasing power of Europe's dollars shriveled during the 1970's, when the costs of waging the Vietnam War and a surge in oil prices ultimately contributed to a calamitous rise in inflation.

Perhaps the Chinese should not worry. After all, the world leaders who just gathered at the G20 summit in Pittsburgh said that they would take every measure to prevent such a thing from happening again. A key pillar of their prevention strategy is to scale back "global imbalances," a euphemism for the huge US trade deficit and the corresponding trade surpluses elsewhere, not least China.

The fact that world leaders recognize that global imbalances are a huge problem is welcome news. Many economists, including myself, believe that America's thirst for foreign capital to finance its consumption binge played a critical role in the build-up of the crisis. Cheap money from abroad juiced an already fragile financial regulatory and supervisory structure that needed discipline more than cash.

Unfortunately, we have heard leaders – especially from the US – claim before that they recognized the problem. In the run-up to the financial crisis, the US external deficit was soaking up almost 70% of the excess funds saved by China, Japan, Germany, Russia, Saudi Arabia, and all the countries with current-account surpluses combined. But, rather than taking significant action, the US continued to grease the wheels of its financial sector. Europeans, who were called on to improve productivity and raise domestic demand, reformed their economies at a glacial pace, while China maintained its export-led growth strategy.

It took the financial crisis to put the brakes on US borrowing train – America's current-account deficit has now shrunk to just 3% of its annual income, compared to nearly 7% a few years ago. But will Americans' newfound moderation last?

With the US government currently tapping financial markets for a whopping 12% of national income (roughly $1.5 trillion), foreign borrowing would be off the scale but for a sudden surge in US consumer and corporate savings. For the time being, America's private sector is running a surplus that is sufficient to fund roughly 75% of the government's voracious appetite. But how long will US private sector thrift last?

As the economy normalizes, consumption and investment will resume. When they do – and assuming that the government does not suddenly tighten its belt (it has no credible plan to do so) – there is every likelihood that America's appetite for foreign cash will surge again.

Of course, the US government claims to want to rein in borrowing. But, assuming the economy must claw its way out of recession for at least another year or two, it is difficult to see how the government can fulfill its Pittsburgh pledge.

Yes, the Federal Reserve could tighten monetary policy. But they will not worry too much about the next financial crisis when the aftermath of the current one still lingers. In our new book This Time is Different: Eight Centuries of Financial Folly , Carmen Reinhart and I find that if financial crises hold one lesson, it is that their aftereffects have a very long tail.

Any real change in the near term must come from China, which increasingly has the most to lose from a dollar debacle. So far, China has looked to external markets so that exporters can achieve the economies of scale needed to improve quality and move up the value chain. But there is no reason in principle that Chinese planners cannot follow the same model in reorienting the economy to a more domestic-demand-led growth strategy.

Yes, China needs to strengthen its social safety net and to deepen domestic capital markets before consumption can take off. But, with consumption accounting for 35% of national income (compared to 70% in the US!), there is vast room to grow.

Chinese leaders clearly realize that their hoard of T-Bills is a problem. Otherwise, they would not be calling so publicly for the International Monetary Fund to advance an alternative to the dollar as a global currency.

They are right to worry. A dollar crisis is not around the corner, but it is certainly a huge risk over the next five to 10 years. China does not want to be left holding a $4 trillion bag when it happens. It is up to China to take the lead on the post-Pittsburgh agenda.

GDP: Grossly Distorted Product

An inside look of Q3 GDP data (source: WSJ):

If the Obama administration was managing a company, it might have hoped the latest gross domestic product numbers would be greeted with cries of "great quarter, guys!"

At least the stock-market obliged, rising on better-than-expected GDP data Thursday morning. But then bulls have grown used to looking to Washington, D.C., for inspiration. Zero rates and stimulus programs boost economic data as well as nudge money towards riskier assets.

Fully 2.2 percentage points of the third quarter's 3.5% growth figure related to vehicle purchases and residential construction, both juiced by government support. Federal spending added 0.6% to growth.

If these GDP data really were company earnings, they would be what analysts euphemistically call "low quality." Investors buying into the market on these figures are ignoring weekly unemployment claims data that came in above 500,000 again on the same day.

The wider danger is that all these short-term fixes leave the economy dangerously addicted to taxpayer-funded steroids. The circularity in the housing market, whereby Washington provides tax-breaks to first-time buyers, guarantees most of the mortgages written, and then buys most of those, beggars belief -- and suggests a worrying case of amnesia following the bursting of the housing bubble.

Another idea that has been floated is to give tax-breaks to firms encouraging them to hire. Yet with quarterly earnings besting forecasts so far, it doesn't look like firms are exactly short of funds to pay workers. What they lack is a clear sense that the economy is on a stable footing. Distorting the cost of money, durable goods demand and labor productivity will not help that; it will merely serve to build up further problems.

Market valuation

Let's look at where the market stands in terms of valuation.

(click to enlarge; source: David Rosenberg)

Facts about "Great Crash 1929"

Financial Historian on '29: 'Great Crash' Vs. 'Break in the Market'

Today marks 80 years since the best known part of the 1929 stock market collapse, a two-day rout on Oct. 28 and Oct. 29 of that year. The equities crash brought a painful close to the period of unbridled financial optimism that was the 1920s.

To mark the occasion, MarketBeat has been asking financial historians for their thoughts — mini-essays if you will — on how the Great Crash informs the way we think about the current market recovery. Today's offering comes from Richard Sylla, Henry Kaufman Professor of the History of Financial Institutions and Markets at New York University:

Because their teachers and their history books said so, most people know that the Great Crash of 1929 caused the Great Depression of the early 1930s. I am not one of these people.

What I know is that the Dow Jones Industrial Average closed at 306 the day before Black Thursday, October 24, 1929, and at 199 on November 13, three weeks later. That drop of 35 percent was the Great Crash. I also know that on April 17, 1930, the day before Good Friday, the Dow closed at 294, or 96 percent of its level before Black Thursday. In other words, almost all of the decline of the crash proper had been undone by a recovery of 48 percent in the Dow between Halloween '29 and Easter '30. Most people don't know that, or if they ever did they forgot it.

On Good Friday '30, the New York Times referred not to the Great Crash, but to "the break in the market last Fall." The Times that day also noted that the day before, April 17, "average prices worked higher and a few outstanding issues shot up smartly to new high prices for the year to date," and that "British interests were investing heavily in these issues."

The Great Depression began sometime after the spring of 1930, most likely when a lot of banks failed late that year. But the so-called Great Crash a year earlier had almost nothing to do with those bank failures, the first of thousands of bank failures that occurred from late 1930 to March 1933.

What's interesting from the perspective of 2009 is that from September 12, 2008, the Friday before Lehman, to the low of March 9, 2009, the Dow lost 44 percent. The Great Crash of 2008-09 was actually a greater crash than the Great Crash of 1929. And half a year after the crash lows of last March, the Dow again is up about 50 percent, as it was half a year after October 1929.

Is the market's recovery since March now giving us a better forecast of what lies ahead than it did in April 1930? Let's hope so. Let's hope, too, that people stop exaggerating the effects of "the break in the market" in October '29.

Wednesday, October 28, 2009

Why industrial revolution happened in Britain?

An excellent piece that offers convincing evidence and reasoning of why industrial revolution happened in Britain, not in China, India or France.

(click on the graph to watch; best material for weekend musing, lasting about one hour)

China to become the global center for auto design

It's amazing to read this piece...thinking about it in a global macro context: Japan suffered two decades of stagnant growth; the US just barely emerged from the worst crisis in a century; while China has emerged as the No. 1 car market in the world. The world is fast changing, indeed. (source: WSJ)

Chinese Inspire Car Makers' Designs

BEIJING -- A decade ago, in search of inspiration for an ultra-luxurious Mercedes-Benz, designer Olivier Boulay studied Japan's chauffeur-car culture.

Now, as he dreams about the future of the automobile, he zips around the streets of Beijing on a $367 electric bike, along with throngs of the city's residents.

"China is the perfect place to think about the future shape of mobility," said Mr. Boulay, the 52-year-old design chief for Daimler AG's Mercedes-Benz unit in China, who moved to Beijing from Tokyo this year. "It's my job here to push my staff to push the envelope and think about the global automotive future from Beijing."

Mr. Boulay reflects a profound shift taking place in the car industry. As the Chinese car market expands, global auto makers increasingly are making design decisions in China. The result is that consumer trends in China are being felt in models sold around the world.

[Shift in Fortunes chart and photo]

Car makers from General Motors Co. to Volkswagen AG to Toyota Motor Corp., are pouring resources into China, which displaced Japan as the world's second-biggest auto market a few years ago and is now poised to surpass the U.S. this year as the world's biggest.

The consequences are on stark display at the Tokyo auto show, which runs through Nov. 4. Regular exhibitors including Mercedes-Benz, GM, and Hyundai Motor Co. from neighboring South Korea all stayed home this year.

After emerging from bankruptcy protection in July, GM located its international headquarters in Shanghai, where it has a flagship joint venture with Shanghai Automotive Industry Corp. And Ford Motor Co. recently decided to move its Asia-Pacific head office to China from Bangkok.

GM already has three global vehicles designed with China-inspired features: the Buick LaCrosse and Regal and the Chevy Cruze. The LaCrosse emerged from a concept car called the Invicta GM developed by GM's design studios in Shanghai and Warren, Mich.

The LaCrosse's interior is splashed with light and warm colors. The wood grain on the steering wheel and dash blend in almost imperceptibly with the seat leather, a nod to the Chinese, who are used to monotone color schemes.

"We take our Chinese customers' and we take our Chinese partners' input extremely seriously," said Lowell Paddock, vice president of product development for GM's international operations.

In China, global auto makers are pondering not just the next model cycle in four or five years but also the shape of cars 10 to 15 years down the road.

"China is a very important pillar for Daimler and its global strategy," said Ulrich Walker, chairman and chief executive of Daimler Northeast Asia, who is overseeing Mercedes-Benz 's expansion in China.

Through September this year, Mercedes-Benz sold 44,300 vehicles in China, up 52% from a year earlier, according to company figures. During the same period, sales in Japan fell 28% to 21,829 vehicles. (Sales in the U.S. reached 147,800.)

Separately, Daimler on Tuesday posted an 80% drop in third-quarter net profit, but rebounded from two quarters of losses as sales at Mercedes improved. The Stuttgart-based car maker said third-quarter profit was €41 million ($60.9 million). Third-quarter revenue fell 21% to €19.3 billion.

Japan is now the eighth-biggest market for Mercedes-Benz, slipping from sixth place three years ago. China has become the brand's fourth-largest market, compared with 10th in 2006.

China is one of the biggest markets for the top-of-the-line S-Class sedan, whose redesigned model was launched in China earlier this year after significant input from Chinese consumers. Mercedes even flew some of its customers and those of competitors to Germany to see early prototypes.

While China accounts for only about 4% of overall Mercedes sales, customers around the world are seeing features the Chinese like: bigger, limousine-like back seats with more-advanced entertainment and climate-control systems, among other amenities. In China, many upscale buyers have chauffeurs and drive on their own only on weekends. Such customers also are generally in their 30s and 40s -- much younger than elsewhere. They prefer light-colored interiors, such as tan, not the somber blacks and grays often preferred in other regions.

Mr. Boulay's arrival in Beijing illustrates China's rise. A Frenchman by birth, he had spent 17 years in Japan, where in the late 1990s, as head of the Mercedes design studio in Tokyo, he styled the car maker's ultra-luxurious Maybach sedan.

In Beijing, he wants to soak in the country's new fascination with electric-powered bikes and cars to develop concepts for future Mercedes global products, including a luxury electric vehicle. His advance-design center is one of five that Mercedes operates around the world.

Mr. Boulay is especially fascinated with how ordinary Chinese people embrace e-bikes for daily transportation, and the way the country's governments at all levels are prompting a rapid adaptation of all-electric battery cars and plug-in hybrids.

"You can see how a new generation of consumers in this country is way out in front," said Mr. Boulay.

He believes the shift to electricity opens up new possibilities for designers to be more creative because of the simplicity of fully electric cars, which need neither bulky engines nor transmissions. Some companies such as Japan's Nissan Motor Co. are experimenting with round, cartoon-like electric pod cars with no hoods or trunks.

China's culture of conspicuous consumption and its big luxury market make the country an ideal place to "generate new ideas and new concepts," Mr. Boulay said.

"We want to use China as leverage to push ourselves," he said. "That's why I am here and why we are setting up an advance design studio-just like we did years ago in Japan."

Tuesday, October 27, 2009

Financial deregulation to the extreme

PBS FRONTLINE, "The Warning". The inside story: why this financial crisis could have been avoided.

The deeper question is: even with regulation in place, could we have been able to prevent this crisis? I am not sure.

Ferguson on the US Dollar

Two pieces of the perspective of US Dollar:

Is "Chicago School" to blame?

Interview of Michael Mussa: his view on whether Chicago School of economics is to blame for this crisis.

Saturday, October 24, 2009

UK in dire strait

Posting from Paris...

The market continues to punish British pound, now the euro/pound exchange rate declined to 1.08, not far from parity. UK's economy has declined for the consecutive 6 quarters. (reports WSJ)

A note from Goldman Sachs said it all. The U.K.'s latest gross-domestic-product data showing the economy shrunk by 0.4% in the third quarter and by 5.2% over the past year was "Unbelievable. Literally."

This result wasn't just at odds with the Bank of England's 0.2% growth forecast but was out of line with recent survey data showing economic pickup.

If the official statistics are right, then the U.K. is in more trouble than the market thought. A sixth consecutive quarter of economic contraction would confirm this as the worst U.K. recession since World War II.

But the Office for National Statistics has a poor track record of explaining what is going on in the economy. Goldman Sachs notes the correlation between the ONS's first estimates of quarterly growth and the actual outcome is just 0.10. That suggests this data is very likely to be revised upward.

Even so, the data could provide just the excuse the Bank of England's Monetary Policy Committee needs to expand its quantitative-easing program. That should boost the government-bond, or gilt, market which had recently started to sell off, assuming recent positive economic signals would complicate the BOE's ability to continue buying gilts.

Good news for gilts, however, looks like bad news for sterling. The combination of the poor GDP data and any expansion of quantitative easing will reduce pressure on the U.K. government to address its dire fiscal position. With the Treasury already on course to overshoot its £175 billion ($291 billion) borrowing forecast this year, the biggest risk to the U.K. remains that the markets conclude its triple-A rating also is literally unbelievable.

Tuesday, October 20, 2009

Inflation hedge: the common traps

What you need to know when you buy inflation-hedge investments (source: WSJ):

Inflation Protection: No Guarantees

The threat of inflation is drifting through the collective consciousness of investors these days. But will the inflation-protection investments so many are turning to work as advertised?


Though the widely watched consumer-price index was down 1.5% in the 12 months through August, in blogs, newsletters, online chat rooms and elsewhere, institutional investors, economists and others are wringing their hands. They're warning that the vats of stimulus money and credit that governments are pouring into economies world-wide will, at some point, result in rising prices for goods and services. Warren Buffett, the heralded investment oracle running Berkshire Hathaway Inc., wrote in an August editorial in the New York Times that the unchecked dumping of dollars into the U.S. economy "will certainly cause the purchasing power of the currency to melt." That means inflation.

Worried investors have been looking for insurance in the form of assets such as mutual funds and exchange-traded funds focused on gold, commodities and Treasury inflation-protected securities, or TIPS. In the past year, interest in TIPS funds in particular has been running at record levels, with some weeks recording more than $400 million in sales.

But many of these investments have never been tested during a bout of meaningful inflation. The last time inflation ramped up significantly was three decades ago. Yet TIPS have been around only since the late 1990s, and commodity funds are of even more recent vintage, as are the gold funds that invest in bullion or track the metal's market price.

So investors are taking it on faith that these investments will perform as expected. "There's no guarantee with any of them," says Christian Hviid, director of asset allocation at Genworth Financial Asset Management.

Indeed, there are reasons to believe that some investors are likely to be disappointed. To understand the pros and cons and potential risks of popular inflation-protection strategies, consider how each works:

TIPS and TIPS Funds

TIPS are designed to track changes in the monthly CPI, as reported by the Bureau of Labor Statistics. If the CPI rises, the securities' principal, or face value, increases. That increases interest income for the holder—because the interest is set as a percentage of the principal—helping investors keep pace with rising prices. Plus, when the securities mature, investors get back the CPI-adjusted principal.

For many investors, TIPS appear to be the purest form of inflation protection, since they are the only asset explicitly tied to an inflation benchmark.

But that raises a key question: Does the CPI accurately reflect inflation? "No," says Paul Brodsky, a partner at QB Asset Management. "The CPI is deeply flawed. It is not an accurate indication of how much purchasing power a dollar loses."

The index, for instance, doesn't reflect borrowing costs. When the Federal Reserve raises interest rates, rates on credit-card balances and other adjustable-rate loans rise, and consumers must spend more to pay off their debt or support a lifestyle funded with credit cards. And there are other quirks: When airlines lower prices, that is captured by the CPI, yet when they impose a $25 surcharge for luggage, that is not. Your own mix of expenses could also be very different from the one the benchmark uses.

So, in terms of both the interest payments and the principal returned, TIPS could disappoint investors expecting these securities to help them preserve their purchasing power.

Moreover, the market value of TIPS won't necessarily perform as expected. That could lead to losses for investors who own TIPS directly and sell them before maturity, or for investors in TIPS funds.

Amid nascent inflation, TIPS prices would likely perform better than those of regular Treasurys, as investors rush to own inflation protection. Once the Fed responds by raising interest rates, however, TIPS already in the market would begin to lose some luster, just like regular Treasurys. After all, if a new TIPS offers a yield of, say, 5%, investors would have little interest in older securities yielding 3%. The market price of those older TIPS would fall, which could result in losses for investors who own them and decide to sell.

Of greater concern is what happens to TIPS if the market or the Fed is particularly aggressive in pushing up interest rates.

That's a scenario reminiscent of the late 1970s and early 1980s, when the Fed quickly shoved interest rates as high as 20% at a time when inflation as measured by the CPI was running in the low teens. A similarly aggressive move wouldn't be good for Treasurys in general, but it would be particularly bad for TIPS, say bond-market pros, because it would mute inflation expectations, leaving investors less willing to pay for the inflation protection offered by TIPS.

Gold Funds

Though long heralded as a hedge against inflation, gold hasn't always gone along for the ride when U.S. consumer prices are rising. Consider data from Morningstar Inc.'s Ibbotson Associates research and consulting unit: The correlation of spot gold prices to an Ibbotson-tracked inflation benchmark is just 0.096. (Correlation is perfect at 1; the closer to 0, the less the correlation.)

Certainly, gold has done well in some inflationary periods, like the late 1970s, when the metal spiked above $800 an ounce. Still, investors would do better to view gold as an international currency that hedges against weakening paper currencies, particularly the dollar. For instance, the U.S. dollar index, tracking the greenback's performance against a basket of currencies, has slipped more than 13% since March, when the index hit its peak so far for this year. Gold prices, meanwhile, are up more about 14% so far this year.

The current rally in gold prices is driven in part by growing worries about a weakening dollar tied to the expanding U.S. budget deficit and the outsize obligations the U.S. has in its Social Security and Medicare systems. But that sentiment could reverse, particularly if investors perceive that political leaders and economic policy makers have a grasp on the problem. In that situation, the dollar could strengthen and push down the price of gold, even if inflation is heating up.

Moreover, many economists expect the Fed to react slowly to rising prices, to ensure the economy doesn't tip over again, and then play catch-up by aggressively pushing interest rates higher. Depending on what central bankers are doing globally, rising rates in the U.S. typically make the dollar more attractive to overseas investors and currency traders. In that scenario, buying pushes up the dollar and "gold will get knocked down," says Chuck Butler, president of online financial-services firm EverBank World Markets.

And because bullion generates no income, gold also would become less attractive as interest rates rise.

But there's another issue: What does your gold fund own?

Exchange-traded funds such as SPDR Gold Shares and related trust products such as Canada's Central GoldTrust own physical bullion, held in secure bank vaults and regularly audited.

Others don't own physical gold and instead seek gold exposure through derivatives. PowerShares DB Gold, for instance, tracks an index of gold-futures contracts. The risk there is that the fund faces possible counterparty woes. In a major market dislocation, not unlike the credit crisis, if investors on the opposite side of a trade fail to make good on their obligations, "there is risk that the expected price change in some commodity-proxy funds won't be delivered," says QB Partners' Mr. Brodsky.

Invesco Ltd.'s Invesco PowerShares unit referred questions about the fund to Deutsche Bank AG, which declined to comment.

Investors also frequently choose funds that own shares of gold-mining companies for inflation protection. Shares of the gold miners do generally rise alongside gold prices; in the past year, the Dow Jones U.S. Gold Mining Total Stock Market Index is up 26%. But, besides the fact that gold prices don't always track inflation, there's another reason for investors to beware of these funds. Though gold miners own vast sums of gold in the ground, their share prices are affected by events ranging from governmental actions to earnings forecasts to various corporate troubles, meaning the companies could underperform even as gold prices rise.

Commodities Funds

Commodities include food staples such as wheat, corn, sugar and soybeans; industrial metals such as nickel and copper; and energy resources such as coal, oil and gas. These products account for about 40% of the CPI, so they track the movement of the index well.

Investors can speculate on commodities using futures contracts, but that can be a challenge for individual investors. Commodity-focused mutual funds and exchange-traded products have sprung up in recent years, and for the most part they've done a good job of reflecting the ups and downs in the commodity markets.

However, investors need to be careful about exactly what they're buying. "The word 'commodity' in a fund's name should not be the end of your research," says Scott Burns, director of ETF analysis at research firm Morningstar.

One potential problem: Unlike a gold fund that can easily own and store bars of metal in a vault, commodity funds can't easily own commodities—agricultural commodities are perishable, and industrial commodities would consume far too much space. Instead, the funds use derivative investments such as futures contracts, which the funds roll over from month to month—continually selling contracts as they near expiration and buying new ones.

While commodity funds generally make money when commodity prices are rising, in certain situations that isn't the case because of a phenomenon known as contango. That's when futures prices are higher than the spot price for a commodity. In that situation, a fund ends up selling expiring contracts at a lower price and then reinvesting the money in higher-priced contracts—only to watch prices of the new contracts slide in value as the next expiration approaches.

"Effectively, the fund is always selling low and buying high," says Bradley Kay, an ETF analyst at Morningstar. So even though the underlying commodity is rising in price, "the fund could be losing money every time the contract rolls over."

Many commodity-based securities are exchange-traded notes, or ETNs, which pose a different risk. Unlike ETFs, which generally own a pool of hard assets or securities, ETNs own nothing. They are promissory notes issued by a bank, meaning they're unsecured debt; the return you earn is calculated based on the movement of an underlying commodity index.

"You're loaning money to a bank, and the bank pays you the return of the underlying index," Morningstar's Mr. Burns says. So long as the bank is healthy, no worries. But if it fails, you're in the pool of creditors hoping to recoup your money. Lehman Brothers, Mr. Burns notes, "had a few ETNs when it went under," two of which tracked commodities. Those ETNs were delisted and their holders became Lehman creditors.

Monday, October 19, 2009

Snapshot of China's energy consumption

This is from BOFIT:

China was the world's second biggest energy user last year after the United States. The third and fourth largest energy consumers were the EU and Russia. Figures from British Petroleum show China accounted for an 18 % share of global energy consumption in 2008. China's most important energy source remained coal (70 %), with China accounting for 46 % of the total world consumption. China satisfied 19 % of its energy needs with oil, and accounted for 10 % of world consumption (making China the world's second biggest consumer of oil after the United States). China's heavy reliance on coal recently made it the world's largest carbon dioxide and sulphur-dioxide emitter. The easiest way for China to reduce air pollution would be to replace coal with cleaner energy sources. For example, natural gas produces 45 % less CO2 emissions than coal, practically no SO2, and lower NOx emissions. Natural gas satisfies just 4 % of China's energy consumption at the moment.

Globalization 2.0 in historical comparative perspective

Niall Ferguson compares today's globalization with globalization 1.0 more than one hundred years ago.

link to the speech at HBS

(note: speech date October 2008; start to watch from 13' 30")

Saturday, October 17, 2009

British pound crisis?

WSJ questions whether UK's central bank really knows what it is doing. I think this applies to the US too, only to a lesser degree.  Without curing the capital holes on banks' balance sheet, it's just a game of catch-22: let's hope government's heavy spending can revive market confidence so bank lending can gradually resume; otherwise, if buget deficits reach to an unstainable level before market confidence comes back, we might really have a currency crisis.

What has quantitative easing ever done for us? For the British who ask that question, the list offered by the Bank of England seems to lengthen every day: lower government-bond yields, the revival of the corporate-bond market, lower unemployment and the rally in the stock market -- in fact, pretty much anything good happening in the U.K. right now short of the balmy autumn weather. All that is missing from the list is a revival in bank lending and an increase in the money supply, the very things the BOE originally said its policy of buying government bonds was supposed to deliver.


The BOE's endlessly shifting justification for its easing policy is fueling fears in the markets that the BOE doesn't really know what it is doing or how to stop. The uncertainty is partly to blame for the recent weakness in the pound. As a result, next month's meeting of the Monetary Policy Committee, when it must decide whether to expand or halt its £175 billion ($284.7 billion) program, is taking on particular significance. The BOE's credibility and independence is increasingly at stake.

With the economy recovering and inflation proving surprisingly sticky, any decision to expand quantitative easing will need careful explanation. So far, the BOE has stressed that the amount of slack in the economy will keep a lid on inflation. But many economists now predict inflation will be above the BOE's 2% target next year, suggesting that policy may soon need to be tightened.

The BOE has confused the market by repeatedly focusing on lower yields on gilts -- government bonds -- as a key measure of quantitative easing's success. To the extent that this easing raises inflation expectations, ultimately pushing up gilt yields and requiring the BOE to print yet more money, this is a dubious argument. It also reinforces the suspicion that the BOE's implicit aim is to use quantitative easing to support the government's borrowing.

This would hardly be surprising. The budget deficit is likely to hit 13% of GDP next year, the second highest after Ireland in the industrialized world. Gilt issuance in 2008-10 is projected to be greater than in the previous 10 years combined. The market may be able to absorb issuance on this scale without quantitative easing. Private-sector saving is rising rapidly, creating funds for investment, and new liquidity rules will force banks to buy more gilts. But with 30% of demand for gilts typically from overseas, the BOE must fear what happens if foreign demand dries up.

Absent any serious attempt to address the fiscal position, stopping quantitative easing risks at best a rise in market rates and at worst could lead to a sterling crisis. Perhaps it can duck the issue next month by announcing a pause. But if inflation continues to rise, this will be a temporary respite. Sooner or later, the BOE must come off the fence.

China: The world's most capitalistic country

Every time I hear the western media talk about China using the word "Communist China", I just feel laughable. Several most prominent Nobel-winning economists, including Milton Friedman, Robert Fogel and Gary Becker all described today's China as "the most capitalistic country in the world". I tell my students the same thing, they all look puzzled. Why?

Well, if you don't know what's happening, watch this video. (courtesy of James Fallows)

Also, you can also read my previous rebuttal on popular media's misconception about China.

Is America ripe for revolution?

I hope not. America is at a junction point. Can it keep its exceptionalism?  Or become another Europe?

Listen to the discussion from On Point.

Tuesday, October 13, 2009

Becker on future food prices

Gary Becker is optimistic on future world food prices. His argument is a classic one in economics and it provides good guidance how we should think about similar questions.

Will World Food Prices Resume their Sharp Increase?

The worldwide recession has slowed the growth in the demand for cereals and other foods as many countries have experienced stagnation or contraction in their GDPs. Now that the recession appears to be over, world GDP will start growing again. Many are forecasting that this growth in world output, especially the growth in developing nations, will put sharp upward pressure on food prices and that of oil, natural gas, and other commodities. Even the Malthusian specter has been raised again that the growth in world population will exceed the capacity of the world to produce the food demanded to improve living standards in the developing world.

The sharp increases in food and other commodity prices during the period from 2002 to 2008 when world GDP was growing rapidly tends to support these fears. The World Bank's index of world food prices increased by 140 percent from 2002 to the beginning of 2008, and by 75 percent after September 2006. The price of oil went up more than fourfold from the beginning of 2002 to its peak at over $145 a barrel during mid 2008. At that time there were many predictions of oil going to $200 a barrel rather quickly, and also of food prices continuing to rise rapidly. The world recession clearly made these predictions obsolete, at least until world GDP begins to grow again.

Rapid growth in world GDP will put strong upward pressure on some commodity prices. However, the supply responses of exhaustible resources, like oil and natural gas, should be distinguished from the supply response of food production. The supply of fossil fuels is obviously ultimately limited by the amounts in the ground. Outputs of oil, coal, and other fossil fuels can be increased by new discoveries, such as the recent discovery of oil off of Brazil, by extracting more of these fuels out of existing fields, and by squeezing oil and other fuels out of shale and other rock formations. Yet, all these ways combined have rather limited effects on total output. This is why, along with OPEC's restrictions on oil output, long run supply responses of oil, gas, and coal to changes in their prices are usually estimated to be quite modest. The long run elasticities of supply in response to rises in the prices of fuels are about +0.4 to +0.5.

The short run response of world food production to increases in food prices may not be large either, although farmers can shift rather quickly among the production of corn, soybeans, wheat, and other crops. In the long run, however, world production of food is quite sensitive to the world price of food. Given time to adjust, farmers can substantially increase the production from given amounts of land devoted to farming by greater use of fertilizers and capital equipment. Higher prices encourage investments in discovering mew methods of improving farm productivity, such as corn and other hybrids, the green revolution, and genetically modified foods. Productivity advances in agricultural output were very rapid at many times during the past century, often outstripping advances in manufacturing and other sectors.

The amount of land devoted to farming in most countries declined drastically during the past century as urban sprawl, highways, and other land uses took over much of the land formerly used to farm. In the United States, farmers comprising less than 2% of the labor force and using well under half the available land, produce enough farm goods not only to contribute most of the food that feeds the huge American population, but these farmers also export corn, soybeans, wheat, and other farm goods all over the world. With high enough food prices, financial incentives will encourage farmers to take some land back from suburban, ethanol production, and other non-food uses.

World prices of food generally declined during the 20th century when world population and world GDP per capita grew enormously. The reason for these diverse trends is that productivity in the production of food expanded at a more rapid rate than did the demand for food. The advances in production were due to the use of new and more effective fertilizers, better farm machines, and many applications of scientific knowledge to improving the productivity of agriculture. Developed countries spent considerable resources on subsidies to farmers to help keep their prices up, not down. Even though it may not be possible to predict the exact nature of future agricultural innovations, one can reasonably expect similar growth in world farm output during the next several decades, especially if food prices rise by a significant amount.

Rapid growth in future world GDP is likely to greatly raise the prices of oil and other fossil fuels, unless concerns about global warming induce major steps to reduce the demand for these fuels. Rapid growth in world output is also likely to sharply raise the demand for cereals, meat, and other foods in developing countries. However, I have tried to show why food is different from fossil fuels and minerals, like copper, in that the supply of food is not limited by natural bounds on overall quantity. Rather, the efforts and ingenuity of farmers and researchers are able to greatly increase world food supply to meet even very large increases in the world demand for food.

Too early for rate increase

Recent decline of US dollar reflects investors' expectation that it may take long time for the Fed to raise interest rate, probably slower than ECB, certainly slower than commodities exporting countries.

Interest rate differential is the most important factor in predicting currency movement.

The first graph below shows you the 4-week average of jobless claims ---we are clearly out of recession. Yet we are nowhere near the normal. The unemployment rate will certainly pass 10%, and it will take a while for the rate to peak.

(click to enlarge; graph courtesy of calculatedrisk)

The second graph shows you that it usually takes the Fed more than a year after the peak of unemployment rate to raise interest rate, which means the Fed won't raise interest rate until 2011, at least. It looks like investor's concerns are well justified.

(click to enlarge; graph courtesy of calculatedrisk)

But we know Bernanke is no Greenspan. Giving the huge liquidity the Fed has put into the system, the Fed may need to raise interest rate much quicker and more aggressively than what is suggested by recent history.

I am still not sure how the Fed can get the timing right. There is a huge risk down the road that the Fed raises interest rate too soon so killing the nascent recovery; however, if the Fed raises rate too slow and by too little, it may cause sharp jump of inflation (expectations).

Monday, October 12, 2009

Oliver Williamson finally got Nobel!

This morning, I was so happy to hear Oliver Williamson won this year's Nobel prize in economics, together with Elinor Ostrom. I have been wanting and actively betting him to win over the last five years, at least.  Now he finally got it.  But I was a little surprised that Armen Alchian and Oliver Hart were not included, giving their equal contribution to the Firm Theory.  Maybe they will be recognized later.

Saturday, October 10, 2009

Feldstein: Better Way to Health Reform

Marty outlines his plan for health care reform. He proposes to scrap the subsidy on employment-based insurance, and he also proposes an innovative government health credit card to deal with sudden hit of a large medical bill. His first part of plan rivals Friedman's school voucher plan.

The American health-care system suffers from three serious problems: Health-care costs are rising much faster than our incomes. More than 15 percent of the population has neither private nor public insurance. And the high cost of health care can lead to personal bankruptcy, even for families that do have health insurance.

These faults persist despite annual federal government spending of more than $700 billion for Medicare and Medicaid as well as a federal tax subsidy of more than $220 billion for the purchase of employer-provided private health insurance.

There's got to be a better way. And it should not involve the higher government spending and increased regulation that characterize the proposals being discussed in Congress.

A good health insurance system should 1) guarantee that everyone can obtain appropriate care even when the price of that care is very high and 2) prevent the financial hardship or personal bankruptcy that can now result from large medical bills.

Private health insurance today fails to achieve these goals. It is also the primary cause of the rapid rise of health-care costs. Because employer payments for health insurance are tax-deductible for employers but not taxed to the employee, current tax rules encourage most employees to want their compensation to include the very comprehensive "first dollar" insurance that pushes up health-care spending.

A good system should not try to pay all health-care bills. That would lead to excessive demand, wasteful use of expensive technology and, inevitably, rationing in which health-care decisions are taken away from patients and their physicians. Countries that provide health care to all are forced to deny some treatments and diagnostic tests that most Americans have come to expect.

Here's a better alternative. Let's scrap the $220 billion annual health insurance tax subsidy, which is often used to buy the wrong kind of insurance, and use those budget dollars to provide insurance that protects American families from health costs that exceed 15 percent of their income.

Specifically, the government would give each individual or family a voucher that would permit taxpayers to buy a policy from a private insurer that would pay all allowable health costs in excess of 15 percent of the family's income. A typical American family with income of $50,000 would be eligible for a voucher worth about $3,500, the actuarial cost of a policy that would pay all of that family's health bills in excess of $7,500 a year.

The family could give this $3,500 voucher to any insurance company or health maintenance organization, including the provider of the individual's current employer-based insurance plan. Some families would choose the simple option of paying out of pocket for the care up to that 15 percent threshold. Others would want to reduce the maximum potential out-of-pocket cost to less than 15 percent of income and would pay a premium to the insurance company to expand their coverage. Some families might want to use the voucher to pay for membership in a health maintenance organization. Each option would provide a discipline on demand that would help to limit the rise in health-care costs.

My calculations, based on the government's Medical Expenditure Panel Survey, indicate that the budget cost of providing these insurance vouchers could be more than fully financed by ending the exclusion of employer health insurance payments from income and payroll taxes. The net budget savings could be used to subsidize critical types of preventive care. And unlike the proposals before Congress, this approach could leave Medicare and Medicaid as they are today.

Lower-income families would receive the most valuable vouchers because a higher fraction of their health spending would be above 15 percent of their income. The substitution of the voucher for employer-paid insurance would be reflected in higher wages for all.

Two related problems remain. First, how would families find the cash to pay for large medical and hospital bills that fall under the 15 percent limit? While it would be reasonable for a family that earns $50,000 a year to save to be prepared to pay a health bill of, say, $5,000, what if a family without savings is suddenly hit with such a large hospital bill? Second, how would doctors and hospitals be confident that patients with the new high deductibles will pay their bills?

The simplest solution would be for the government to issue a health-care credit card to every family along with the insurance voucher. The credit card would allow the family to charge any medical expenses below the deductible limit, or 15 percent of adjusted gross income. (With its information on card holders, the government is in a good position to be repaid or garnish wages if necessary.) No one would be required to use such a credit card. Individuals could pay cash at the time of care, could use a personal credit card or could arrange credit directly from the provider. But the government-issued credit card would be a back-up to reassure patients and providers that they would always be able to pay.

The combination of the 15 percent of income cap on out-of-pocket health spending and the credit card would solve the three basic problems of America's health-care system. Today's 45 million uninsured would all have coverage. The risk of bankruptcy triggered by large medical bills would be eliminated. And the structure of insurance would no longer be the source of rising health-care costs. All of this would happen without involving the government in the delivery or rationing of health care. It would not increase the national debt or require a rise in tax rates. Now isn't that a better way?

Martin Feldstein, a professor of economics at Harvard University and president emeritus of the nonprofit National Bureau of Economic Research, was chairman of the Council of Economic Advisers from 1982 to 1984.

Friday, October 09, 2009

US dollar outlook

Unless the Fed raises interest rate quicker and faster than European Central Bank, the US dollar will probably continue to decline.

CRE meltdown in NYC

Another shoe to drop?

Wednesday, October 07, 2009

Stiglitz: Lots of bumps ahead

Tuesday, October 06, 2009

Glaeser: Lessons from recent housing bubble

What We've Learned: Ugly Truths About Housing

By Edward L. Glaeser

With the anniversary of the failure of Lehman Brothers approaching, we asked each of our Daily Economists to explain what we've learned from the financial crisis. Here Edward L. Glaeser, an economics professor at Harvard, responds.

One year ago, Lehman Brothers fell and our financial markets teetered at the brink of a precipice. This event looms large in global finance, but it appears less momentous from the perspective of the housing markets.

Housing prices peaked not 12 but 40 months ago in May 2006. After experiencing a staggering 96 nominal percent price increase during the six years before then (72 percent in real dollars), prices started a slow decline. By September 2008, prices had already dropped 22 percent from the peak. Of course, they fell another 12 percent in the six months after Lehman collapsed.

What have we learned from the great housing bubble and crash of the aughts? Most obviously, we have learned that housing prices can be extraordinary volatile. This was less obvious from previous housing cycles.

During the last housing cycle, from 1987 to 1993, the Case-Shiller 10-city index increased by 31 percent between January 1987 (when Case-Shiller data starts) and the peak in March 1990. During the 38-month period before the more recent peak, the 10-city index increased by 55 percent.

But during the recent period, five metropolitan areas (out of 20) experienced price growth above 75 percent; no city experienced such a massive boom during the earlier cycle.

After the earlier peak, the market fell for 42 months before bottoming, with the 10-city decline at about 8 percent in nominal terms, which was closer to 20 percent in real terms. While there are no guarantees against further declines, national housing prices seemed to stop falling in May 2009, exactly three years after the more recent peak. In the current decline, housing prices dropped by 33 percent in nominal terms, or perhaps 38 percent in real terms. A 24 percentage point larger nominal rise in the recent boom was associated with a 25 percentage point greater nominal fall.

So let no one ever again say foolish things like housing prices never fall.

In the current drop, eight of the 20 Case-Shiller areas had housing price drops of 40 percent of more. People who bought with a standard mortgage in the years close to the boom have lost all of the equity in their houses. Buyers and bankers should never again think that an area's recent price increases are the sign of a strong market where prices have nowhere to go but up. In the long run, price increases are followed by price drops, and special caution, by regulators as well, needs to be taken in booming markets.

In places like Las Vegas and Phoenix, there are no fundamental constraints on building new homes — like a shortage of land or onerous restrictions on construction — and prices in unconstrained areas must eventually find their way back to the construction costs. I once thought that this obvious lack of limits on building meant that such open areas would sit bubbles out, as Dalllas sat out the recent boom and bust, but I was wrong. The logic of supply and demand can be ignored for longer than I thought, but it ultimately reasserts itself.

The second lesson of the housing debacle is that there is extraordinary pain in both housing price busts and booms.

When housing prices soared, ordinary Americans found it increasingly hard to afford a house. I would certainly cheer if Detroit produced a wonder car for $10,000 that could get 50 miles to the gallon and go from 0 to 60 in five seconds. I would also cheer if the housing industry could produce a beautiful and energy efficient 3,000-square-foot home for $100,000. The same logic pushed me to boo when housing became outrageously expensive. During the boom, I hoped that housing prices would stop rising and even decline.

Yet I didn't understand the terrible impact that declining housing prices would have on our financial sector. While rising housing prices weren't particularly good for America, declining housing prices were particularly bad for the country. The lesson seems to be that large swings in housing prices, in either direction, can be extremely painful.

The third lesson is that American housing policy has been monumentally foolish.

We have used public resources to encourage ordinary Americans to bet all they could on highly risky housing markets. Fannie Mae and Freddie Mac, the home mortgage interest deduction, even the willingness to bail out financial firms that had lost too much on mortgages, can all be seen as policies that encourage ordinary people to risk it all on real estate.

I had once thought that these policies were misguided, but not terrible. We now know that encouraging buyers and lenders to bet on housing can impose vast costs on the country.

Luckily, no one will ever again think that Fannie and Freddie are independent entities that impose no costs on American taxpayers. I am also tremendously gratified that the government did not engage in a quixotic attempt to buoy the housing market artificially by subsidizing even more leveraged home purchases.

Yet I think that we have not yet fully faced the fact that our tax code encourages people to finance their homes with as much debt as possible, and that our financial regulations abet irresponsible lending.

Now that we have backed away from the abyss, we can consider making much-needed reforms, like reducing the upper cap on the home mortgage interest deduction, that could depress housing prices in the short run, but make future housing bubbles and crashes less likely.

Monday, October 05, 2009

America to enter the lost decade of employment

The US has lost more than 7 million private-sector jobs since the recession started. To make up for the job losses during this period and get the labor market back to the pre-recession level, it will take more than seven years, assuming each year the economy will be adding 2 million jobs.

If you sum up the job creation in the recent decade from 2000 to 2009, it's estimated that we will end up with 1.7 million fewer jobs --call it "the lost decade of employment".

Roubini: I'm Dr. Realist

Interview of Dr. Doom on the shape of recovery.

Sunday, October 04, 2009

Lardy on Chinese economy

China's current account surplus is dramatically shrinking.

Summers on the state of the economy

Does stimulas spending work?

Robert Barro, economist at Harvard, deciphers the history and answers the question whether government stimulus spending really work as claimed.

However, Barro did not mention the potential benefits of using government stimulas spening to reverse the "vicious cycle" during the time of panic.

(source: WSJ)

The global recession and financial crisis have refocused attention on government stimulus packages. These packages typically emphasize spending, predicated on the view that the expenditure "multipliers" are greater than one—so that gross domestic product expands by more than government spending itself. Stimulus packages typically also feature tax reductions, designed partly to boost consumer demand (by raising disposable income) and partly to stimulate work effort, production and investment (by lowering rates).

The existing empirical evidence on the response of real gross domestic product to added government spending and tax changes is thin. In ongoing research, we use long-term U.S. macroeconomic data to contribute to the evidence. The results mostly favor tax rate reductions over increases in government spending as a means to increase GDP.

For defense spending, the principal long-run variations reflect the buildups and aftermaths of major wars—World War I, World War II, the Korean War and, to a much lesser extent, the Vietnam War. World War II tends to dominate, with the ratio of added defense spending to GDP reaching 26% in 1942 and 17% in 1943, and then falling to -26% in 1946.

Wartime spending is helpful for estimating spending multipliers for three key reasons. First, the variations in spending are large and include positive and negative values. Second, since the main changes in military spending are independent of economic developments, it is straightforward to isolate the direction of causation between government spending and GDP. Third, unlike many other countries during the world wars, the U.S. suffered only moderate loss of life and did not experience massive destruction of physical capital. In addition, because the unemployment rate in 1940 exceeded 9% but then fell to 1% in 1944, there is some information on how the multiplier depends on the strength of the economy.

For annual data that start in 1939 or earlier (and, thereby, include World War II), the defense-spending multiplier that applies at the average unemployment rate of 5.6% is in a range of 0.6-0.7. A multiplier less than one means that, overall, other components of GDP fell when defense spending rose. Empirically, our research shows that most of the fall was in private investment, with personal consumer expenditure changing little.

Our research also shows that greater weakness in the economy raises the estimated multiplier: It increases by around 0.1 for each two percentage points by which the unemployment rate exceeds its long-run median of 5.6%. Thus the estimated multiplier reaches 1.0 when the unemployment rate gets to about 12%.

To evaluate typical fiscal-stimulus packages, however, nondefense government spending multipliers are more important. Estimating these multipliers convincingly from U.S. time series is problematical, however, because the movements in nondefense government purchases (dominated since the 1960s by state and local outlays) are closely intertwined with the business cycle. Thus the explanation for much of the positive association between nondefense spending and GDP is that government spending increased in response to growing GDP, rather than the reverse.

The effects of tax rates on GDP growth can be analyzed from a time series we've constructed on average marginal income-tax rates from federal and state income taxes and the Social Security payroll tax. Since 1950, the largest declines in the average marginal rate from the federal individual income tax occurred under Ronald Reagan (to 21.8% in 1988 from 25.9% in 1986 and to 25.6% in 1983 from 29.4% in 1981), George W. Bush (to 21.1% in 2003 from 24.7% in 2000), and Kennedy-Johnson (to 21.2% in 1965 from 24.7% in 1963). Tax rates rose particularly during the Korean War, the 1970s and the 1990s. The average marginal tax rate from Social Security (including payments from employees, employers and the self-employed) expanded to 10.8% in 1991 from 2.2% in 1971 and then remained reasonably stable.

For data that start in 1950, we estimate that a one-percentage-point cut in the average marginal tax rate raises the following year's GDP growth rate by around 0.6% per year. However, this effect is harder to pin down over longer periods that include the world wars and the Great Depression.

It would be useful to apply our U.S. analysis to long-term macroeconomic time series for other countries, but many of them experienced massive contractions of real GDP during the world wars, driven by the destruction of capital stocks and institutions and large losses of life. It is also unclear whether other countries have the necessary underlying information to construct measures of average marginal income-tax rates—the key variable for our analysis of tax effects in the U.S. data.

The bottom line is this: The available empirical evidence does not support the idea that spending multipliers typically exceed one, and thus spending stimulus programs will likely raise GDP by less than the increase in government spending. Defense-spending multipliers exceeding one likely apply only at very high unemployment rates, and nondefense multipliers are probably smaller. However, there is empirical support for the proposition that tax rate reductions will increase real GDP.

Friday, October 02, 2009

Update: Where is housing market headed?

Every month when we have a uptick on housing price index, there will be a discussion on whether housing price will recover soon.

Following my last update in August, here is another update from two housing experts on recent housing trends.

First, David Levy on housing:

Then, the interview of Robert Shiller on longer-term housing trends.

Q&A: Shiller Sees 5 Years of Stagnant Home Prices

Robert Shiller, the Yale University economist who famously predicted the housing bust, was awarded the Deutsche Bank Prize in Financial Economics today. In this interview, he talks about the state of the housing market and the implications of low interest rates.
Robert Shiller is awarded Deutsche Bank Prize in Financial Economics 2009. (Center for Financial Studies)

Is the slump in U.S. home prices bottoming out?

Shiller: The situation has definitely changed. With our numbers — the S&P/Case Shiller home price index — going up sharply. It looks like a major turnaround. We’ve been watching that for three months now, and we have some concern that it could be an aberration and temporary. But, at this point, it seems to be evident in just about every city in the U.S. That suggests it’s real. But it probably isn’t the beginning of a major boom, just because the economy is in such bad shape. There’s also a chance that it will reverse. It’s still only three months old, so it’s very hard to be sure at this point. The most likely scenario is that it won’t continue at this high rate of increase, but that it will neither go down a lot, nor up a lot.

So the index will move sideways for a while?

Shiller: Yes, for a while, meaning five years.

What are the main factors driving U.S. house prices? What could push them up, or cause another slump?

Shiller: The main factor is the world economic crisis and the efforts of governments around the world to stimulate the economy. Parts of those efforts have been directed at the housing market. In the U.S., there is an 8,000 dollar first-time home buyer’s tax credit which expires at the end of November. That’s a reason for concern, as it comes to an end. Also, the Federal Reserve has a plan to buy $1.25 trillion worth of mortgage-backed securities to support the housing market. They are most of the way through the program and anticipate phasing it out at some time in 2010 - that’s another thing that will go away. We’ve yet to see how the housing market will continue. Part of the problem is that people are buying now rather than later. When later comes, there could be a downturn in the market.

Is there an oversupply of houses in the U.S.?

Shiller: That’s been a problem. The inventory of unsold houses has been high, but has come down a bit. On top of that, there will be more foreclosures, more homes are going to be dumped on the market as people default. Now, that may show down as home prices will start going up again. But I suspect that this isn’t going to happen. Also, banks have more REO, or real estate owned, that they’re holding on to for the time being. But eventually those REOs are going to be dumped on the market. So that’s why it doesn’t look particularly encouraging from a supply consideration.

Turning to interest rates, which are at exceptionally low levels: Is there a risk that this eventually will cause irrational exuberance?

Shiller: There is always a risk of that. Those things are hard to predict. However it seems like the present time is least conducive to bubbles of any time. We’re in what some people call “pretend-and-extend” economy, which means that banks that have commercial loans are often extending those loans and pretending that the property is worth something. That’s because they don’t face reality. This kind of economy isn’t really suited to a beginning of a real bubble. Now, everything could change… It’s surprising how strong the residential, single-family home market looks right now. It makes me think that it’s hard to predict animal spirits.

How long can central banks afford to keep expansive policies in place?

Shiller: In principle we can keep this in place for a long time. That’s what Japan did… But confidence is definitely coming back. The depression scare is over at the moment. So it would be plausible that central banks could be raising interest rates — both in the U.S. and Europe — [as early as next year]. But I just have a worry that this isn’t going to happen and that it’s not going to be so easy to extricate [themselves from the low-rate environment].

Will the sharp increase in global debt levels drive up inflation over the medium to long-term?

Shiller: My best guess is that we won’t have inflation, that central banks will pull it back as inflation starts to begin. But I think that there’s a chance of it; people have to be defensive in their investments. It always amazes me that people are so trusting and that they want nominal debt as much as they do… So a good long-term strategy is to invest a good part of one’s portfolio in inflation-indexed bonds, even though it doesn’t particularly look like the time to worry about inflation right now.

In Yen intervention looming?

FT's short view explains why Yen is so strong at the moment and whether an intervention is looming.

What to take away is Dollar's interest rate is so low right now that it is being used as a funding currency for carry trade.

(click to play video; Source: FT)