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What is Optimal Monetary Policy, Anyway?

Ever since the important contributions of new classical economists Finn E. Kydland and Edward C. Prescott during the 1970s and 80s, modern macroeconomics seeks optimal rules for monetary policy. Indeed, Milton Friedman had previously emphasized the importance of a binding rule for monetary policy. He recommended a constant but moderate expansion of the money stock over time as well as the abolition of fractional reserve banking in order to improve the central bank’s control over the money stock. Neither of these two measures has ever been implemented over an extended period of time.

Creating Rules for Monetary Policy

Many modern macroeconomists have come to reject the idea of a constant growth rule in favor of a more complex rule that incorporates feedback effects from other macroeconomic aggregates. According to their rationale, political discretion in the form of unexpected accelerations of the money growth rate may lead to short-term benefits. Yet, the latter would come at long-term costs of either permanently too high price inflation or a consecutive readjustment to lower money growth rates that goes hand in hand with real economic losses in output and employment. This is what economists would refer to as the sacrifice ratio. Optimal monetary policy thus requires abstention from reaping some of the potential short-term benefits for the sake of long-term financial and economic stability.

The most famous monetary policy rules that have been deemed optimal are named after John B. Taylor. According to such Taylor rules the central rate of interest should be set in response to changes of actual price inflation, the natural rate of interest, as well as the output gap. There is one obvious practical problem, namely, that the output gap and the natural rate of interest are non-observable theoretical concepts that have to be estimated or replaced by more or less arbitrary empirical proxies.

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The Relevancy of Probability in Economics

Modern economics in addition to sophisticated mathematics also employs probability distributions. What is probability?  The probability of an event is the proportion of times the event happens out of a large number of trials.

For instance, the probability of obtaining heads when a coin is tossed is 0.5. This does not mean that when a coin is tossed 10 times, five heads are always obtained.

However, if the experiment is repeated a large number of times then it is likely that 50% will be obtained. The greater the number of throws, the nearer the approximation is likely to be.

Alternatively, say it has been established that in a particular area, the probability of wooden houses catching fire is 0.01. This means that on the basis of experience, on average, 1% of wooden houses will catch fire.

This does not mean that this year or the following year the percentage of houses catching fire will be exactly 1%. The percentage might be 1% or not each year. However, over time, the average of these percentages will be 1%.

This information, in turn, can be converted into the cost of fire damage, thereby establishing the case for insuring against the risk of fire. Owners of wooden houses might decide to spread the risk by setting up a fund.

Every owner of a wooden house will contribute a certain proportion to the total amount of money that is required in order to cover the damages of those owners whose houses are going to be damaged by the fire.

Note that insurance against fire risk can only take place because we know its probability distribution and because there are enough owners of wooden houses to spread the cost of fire damage among them so that the premium is not going to be excessive.

 

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The Looming Crisis in the Private Provision of Public Services Close Parallels With the Systemic Failure of Banks

The collapse in January of Carillion PLC, the UK’s second largest construction and outsourcing company has attracted considerable media coverage. Carillion was principally engaged in public sector contracts to build (and in some cases operate) hospitals, prisons, roads, and part of the new high-speed rail link between London and Leeds.

Mainstream media rightly reported many unpalatable aspects of the collapse: aggressive accounting, suspension of pension fund contributions, the company’s rapid growth by acquisition. However, they generally missed the parallel with the story of systemically important financial institutions. The truth is that companies such as Carillion, Capita, G4S and MITIE now manage such a large slice of UK public services that the failure of more than one raises the spectre of the armed forces being deployed to keep schools open. Unfortunately, all these companies might be in financial trouble because, just like large banks, it is impossible to assess their health or lack of it by studying their financial reports and accounts.

Background – 25 Years of Privatisation of UK Public Sector Procurement
Since the early 1990s, all British governments have embraced public-private partnerships as the preferred construction procurement method. The initial appeal of such partnerships was an accounting trick whereby the payments were expressed as conditional upon service provision, and hence the long-term liabilities did not appear on the public sector balance sheet. They came on balance sheet in 2012, but the procurement method persists.

However, the privatisation of public sector infrastructure quickly changed the industry. So great was the volume of business, and so complex was the tendering process that initially consortia of building companies and facilities management companies were formed to pool resources and submit joint tenders.

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From the Moneyness Blog: Electronic Money Will Only Save Central Banks From Subjugation if it is Anonymous

50 SEK banknote issued by the Riksbank in 1960

“Do we need an eKrona?” asks Stefan Ingves, the Governor of the Riksbank, Sweden’s central bank. The Riksbank is probably the central bank that has advanced the furthest in discussions surrounding the introduction of a central bank-issued digital currency (CBDC)—a new form of risk-free digital money for use by the public. CanadaNew ZealandAustraliathe ECB, and China are also dissecting the idea, with more central banks to come in 2018.

Sweden is approaching the issue from a unique angle, says Ingves. It is the only country in the world showing a consistent decline in cash and coin usage. I’ve written about this interesting pattern herehere, and here. Below is a chart:

Ingves floats two theories. Either the Swedish public no longer wants central bank money, or alternatively they do want central bank money but not the type that is “made of pieces of paper,” preferring instead an as-yet non-existent digital alternative. If so, then it may be the Riksbank’s duty to provide that alternative, says Ingves.

Duty is an admirable motivation, but let me propose another reason for why the Riksbank is exploring the idea of an eKrona—self preservation. I think Sweden’s central bank is terrified that it will become powerless in the future. It is desperately casting around for solutions to resuscitate itself, one of these being an eKrona. This fear is rooted in the fact that declining cash usage has led to a collapse in the resources that the Riksbank believes that it needs to function.

These worries about powerlessness are shared by central bankers around the world, many of whom expect advances in private payments technology to lead them to the same cash-light world that Sweden is currently entering.

…click on the above link to read the rest of the article…

A Warning Knell From the Housing Market–Inciting a Riot

  • Global residential real estate prices continue to rise but momentum is slowing
  • Prices in Russia continue to fall but Australian house prices look set to follow
  • After a decade of QE, real estate will be more sensitive to interest rate increases

As anyone who owns a house will tell you, all property markets are, ‘local.’ Location is key. Nonetheless, when looking for indicators of a change in sentiment with regard to asset prices in general, residential real estate lends support to equity bull markets. Whilst it usually follows the performance of the stock market, this time it may be a harbinger of austerity to come.

The most expensive real estate is to be found in areas of limited supply; as Mark Twain once quipped, when asked what asset one should invest in, he replied, ‘Buy land, they’re not making it anymore.’ Mega cities are a good example of this phenomenon. They are a sign of progress. As Ian Stewart of Deloittes put it in this week’s Monday Briefing – How distance survived the communication revolution:-

In 2014, for the first time, more of the world’s population, some 54%, lived in urban than rural areas. The UN forecasts this will rise to 66% by 2050. Businesses remain wedded to city locations. More of the UK’s top companies are headquartered in London than a generation ago. The lead that so-called mega cities, those with populations in excess of 10 million, such as Tokyo and Delhi, have over the rest of the country has increased.

Proximity matters, and for good reasons. Cities offer business a valuable shared pool of resources, particularly labour and infrastructure. Bringing large numbers of people and businesses together increase the chances of matching the right person with the right job. 

…click on the above link to read the rest of the article…

Can We Ascertain the Facts of Reality in Economics by Means of Mathematics?

It is generally held that by means of statistical and mathematical methods one can organize historical data into a useful body of information, which in turn can serve as the basis for the assessments of the state of the economy. It is also held that the knowledge secured from the assessment of the data is likely to be of a tentative nature since it is not possible to know the true nature of the facts of reality.

Some thinkers such as Milton Friedman held that since it is not possible to establish “how things really work,” then it does not really matter what the underlying assumptions of a theory are. On this way of thinking, what matters is that the theory can yield good predictions.

According to Friedman,

The ultimate goal of a positive science is the development of a theory or hypothesis that yields valid and meaningful (i.e., not truistic) predictions about phenomena not yet observed…. The relevant question to ask about the assumptions of a theory is not whether they are descriptively realistic, for they never are, but whether they are sufficiently good approximation for the purpose in hand. And this question can be answered only by seeing whether the theory works, which means whether it yields sufficiently accurate predictions.[1]

For instance, an economist forms a view that consumer outlays on goods and services are determined by disposable income. Based on this view he forms a model, which is then validated by means of statistical methods. The model is then employed in the assessments of the future direction of consumer spending.

If the model fails to produce accurate forecasts, it is either replaced, or modified by adding some other explanatory variables.

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Homos Economics: A Largely Irrational Animal

Or ‘How Expected Utility Theory was Successfully Challenged by a Nobel Prize-winning Hypothesis’

2002’s Nobel prize-winning economist Daniel Kahneman wrote about Prospect Theory, which is hard to summarise succinctly because he wrote an entire thesis to explain it.

He and his academic partner Amos Tversky examined how economic decision-making is not always rational, whereas orthodox economic theory held decisions were made on the basis of utility – the maximum return on a given amount of resources. Expected utility theory originated in Bernoulli’s 1738 essay, which argued that when faced with a choice involving risk, the logical action is to “maximize the expected utility of wealth.” In other words, the more capital you have, the more likely you are to put it at risk for expected returns. It follows that poor people will be more risk averse and less inclined to invest in financial products with a concerning risk profile.

Hence, poor people do not sell insurance products, because they cannot afford to pay an insurance premium if the owner makes a claim.

Kaheman et al had a problem with the assumption of expected utility, on the basis of a number of experiments they had conducted where even highly intelligent people like students at Princeton and University of Michigan failed basic logic and maths tests because they took a cognitive short cut. Let System 1 be our ‘intuitive’ reasoning, one which has evolved to be rapid response and influenced by emotions and immediate concerns as much as by experience. And let System 2 be our ‘analytical’ reasoning, which is slower but more thorough and draws more on our learned experience.

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A Brief (and Messy) History of Modern Gold Standards

Although gold prices hit a new high in mid-January, Americans, by and large, are still reluctant about gold. They don’t quite “get it.” This incomprehension is different than that of Americans not “getting,” for example, bitcoin (as few seem to). They may understand gold as a safe haven that has always stood the test of time, war, crises, inflation, etc. Some also understand that no gold proponent advocates harkening back to a mythical 19th century gold hey-day (one that did not exist — certainly not consistently), or recommends re-issuing gold minted currency, or reverting to any kind of bimetallism (the 19th century norm).

That said, the “barbarous relic” view tends to persist. Overall, it is thought that gold simply has no place in a modernized (read: central bank-controlled) economy. Making matters more complex is the question of what is gold and what is not. The recent proliferation of gold derivatives, “paper gold,” ETFs, certificates, bogus gold; the Chinese, the Russians, depleted reserves, actual supply make its study opaque and abstract. In light of this confusion, a basic overview of the role of gold in an economy, both in classic and modern terms, is in order:

The Complexity of the Age of Gold Standards

In the beginning of the modern economic era of the later 19th century, a pure “gold standard” was never consistent. However, its rise to preeminence as ‘the’ pillar of sound economic theory was that of gold’s role as a hedge against inflation and against Unsound Money — paper money easily manipulated to reckless credit whims. In this regard, the European central banks of the day were excellent watchdogs.

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Central Banks Put a Safety Net Under Financial Markets

Most early business cycle indicators suggest that the global economy is pretty much roaring ahead. Production and employment are rising. Firms keep investing and show decent profits. International trade is expanding. Credit is easy to obtain. Stock prices keep moving up to ever higher levels. All seems to be well. Or does it? Unfortunately, the economic upswing shows the devil’s footprints: central banks have set it in motion with their extremely low, end in some countries even negative, interest rate policy and rampant monetary expansion.

Artificially depressed borrowing costs are fueling a “boom.” Consumer loans are as cheap as never before, seducing people to increasingly spend beyond their means. Low interest rates push down companies’ cost of capital, encouraging additional, and in particular risky investments – they would not have entered into under “normal” interest rate conditions. Financially strained borrowers – in particular states and banks – can refinance their maturing debt load at extremely low interest rates and even take on new debt easily.

By no means less important is the fact that central banks have effectively spread a “safety net” under financial markets: Investors feel assured that monetary authorities will, in case things turning sour, step in and fend off any crisis. The central banks’ safety net has lowered investors’ risk concern. Investors are willing to lend even to borrowers with relatively poor financial strength. Furthermore, it has suppressed risk premia in credit yields, having lowered firms’ cost of debt, which encourages them to run up their leverage to increase return on equity.

The boom stands and falls with persisting low interest rates. Higher interest rates make it increasingly difficult for borrowers to service their debt. If borrowers’ credit quality deteriorates, banks reign in their loan supply, putting even more pressure on struggling debtors.

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MONEY AND THE STOCK MARKET: IS THERE ANY RELATION?

Is it true that changes in money supply are an important driving force behind changes in the stock price indexes?

Intuitively it makes sense to argue that an increase in the growth rate of money supply should strengthen the growth rate in stock prices.

Conversely, a fall in the growth rate of money supply should slow down the growth momentum of stock prices.

Some economists who follow the footsteps of the post-Keynesian (PK) school of economics have questioned the importance of money in driving stock prices[1]. It is held that rises in stock prices provide an incentive to liquidate long-term saving deposits, thereby boosting the money supply.

The received money then employed in buying stocks and other financial assets. According to the PK the trend is reversed when stock prices are falling. Hence, changes in stock prices cause changes in money supply and not the other way around.

Does a shift of money from savings to demand deposits affect money supply?

Is it possible to have an increase or a decline in money supply because of a shift of money from long-term saving deposits to demand deposits and vice versa?[2]

Can there be such thing as saving deposits? The existence of such deposits implies that money somehow can be saved. We hold that individuals do not save money. They only exercise demand for money in order to be able to employ it as a medium of exchange whenever they deemed it necessary.

For instance, out of his production of twelve loaves of bread a baker may consume two loaves of bread and save ten loaves. He then exchanges these ten loaves for ten dollars with a shoemaker.

…click on the above link to read the rest of the article…

The Risk of a Correction in the Equity Bull Market

  • Rising commodity prices, including oil, are feeding through to PPI
  • Unemployment data suggests wages may begin to rise faster
  • Federal Reserve tightening will continue, other Central Banks may follow
  • The bull market will be nine years old in March, the second longest in history

Since March 2009, the US stock market has been trending broadly higher. If we can continue to make new highs, or at least, not correct to the downside by more than 20%, until August of this year it will be the longest equity bull-market in US history.

The optimists continue to extrapolate from the unexpected strength of 2017 and predict another year of asset increases, but by many metrics the market is expensive and the risks of a significant correction are become more pronounced.

Equity volatility has been consistently low for the longest period in 60 years. Technical traders are, of course, long the market, but, due to the low level of the VIX, their stop-loss orders are unusually close the current market price. A small correction may trigger a violent flight to the safety of cash.

Meanwhile in Japan, after more than two decades of under-performance, the stock market has begun to play catch-up with its developed nation counterparts. Japanese stock valuation is not cheap, however, as the table below, which is sorted by the CAPE ratio, reveals:-

Star_Capital_-_Equity_Valuations_31-12-2017

Source: Star Capital

Global economic growth surprised on the upside last year. For the first time since the great financial crisis, it appears that the Central Bankers experiment in balance sheet expansion has spilt over into the real-economy.

An alternative explanation is provided in this article – Is Stimulus Responsible for the Recent Improved Trends in the U.S. and Japan? – by Dent Research – here are some selected highlights:-

…click on the above link to read the rest of the article…

The Truth About Trade

The one subject, which became a headline issue last year, and even divides experts is trade. It will become increasingly important in 2018 as the US develops her trade policy, particularly with respect to China, and as the UK negotiates her Brexit terms with the EU.

Ignorance dominates this subject. Surely, people say, industry should be protected from unfair trade practices, such as goods manufactured in foreign sweat-shops, or unfair dumping of commodities, such as steel. If President Trump can protect American business from unfair competition, it would be good for the American economy. Then there’s the business of currency rates. Doesn’t a lower currency help restore the trade balance, by making exports cheap, and imports expensive? And surely, Britain leaving the EU risks trade tariffs being set up against British business. This means sterling must fall against the euro to rebalance trade.

These are all misconceptions, disproved by verifiable history. Why was it that before the euro, German export surpluses persisted, despite a rising mark, and why is it that after joining a weaker euro, her surpluses have not increased significantly further? And why did Japan, like Germany, also have a strong currency from the 1960s onwards and a persistent trade surplus? Why did Britain in the post-war years have a continual trade deficit despite a falling currency? And why was it that American trade protectionism intensified the depression in the 1930s?

The answers to these questions are relevant today to the development of both US trade policy and post-Brexit trade policy. It is no coincidence that trade imbalances have only become a significant feature since fiat currencies replaced the sound money disciplines of gold.

The purpose of this article is to tell the truth about trade, by addressing the relationship between trade imbalances and exchange rates, and to expose the harm caused by the imposition of tariffs.

…click on the above link to read the rest of the article…

Is the Fall in Prices Bad News?

Contrary to the popular way of thinking, we suggest that there is nothing wrong with declining prices. What signifies industrial market economy under a commodity money such as gold is that prices of goods follow a declining trend.

According to Joseph Salerno,

In fact, historically, the natural tendency in the industrial market economy under a commodity money such as gold has been for general prices to persistently decline as ongoing capital accumulation and advances in industrial techniques led to a continual expansion in the supplies of goods. Thus throughout the nineteenth century and up until the First World War, a mild deflationary trend prevailed in the industrialized nations as rapid growth in the supplies of goods outpaced the gradual growth in the money supply that occurred under the classical gold standard. For example, in the US from 1880 to 1896, the wholesale price level fell by about 30 percent, or by 1.75% per year, while real income rose by about 85 percent, or around 5 percent per year.[1]

In a free market the rising purchasing power of money i.e. declining prices, is the mechanism that makes the great variety of goods produced accessible to many people. Obviously, in a free market economy it does not make much sense to be concerned about falling prices.

On this Murray Rothbard wrote,

Improved standards of living come to the public from the fruits of capital investment. Increased productivity tends to lower prices (and costs) and thereby distribute the fruits of free enterprise to all the public, raising the standard of living of all consumers. Forcible propping up of the price level prevents this spread of higher living standards.[2]

For most economic commentators a general fall in prices is always “bad news” for it generates expectations for further declines in prices and slows down people’s propensity to spend, which in turn undermines investment in plant and machinery.

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Are Inflationary Expectations the Heart of Inflation?

For most economic commentators the underlying driving force of inflation is inflationary expectations[1]. For instance, if there is a sharp increase in the price of oil, individuals may form higher inflationary expectations that could set in motion spiraling price inflation, or so it is held.

If somehow expectations could be made less responsive to various price shocks, then over time this would mitigate the effect of a price shock on price inflation, it is argued.

If we were to accept that inflation expectations are the driving force of the inflationary process, is there a way to make these expectations less sensitive to various price shocks?

Most commentators are of the view that by means of suitable central bank policies it is possible to bring peoples inflationary expectations to a state of equilibrium.

At this state it is held expectations are perfectly anchored or not sensitive to changes in various economic data.

According to various economic experts once inflationary expectations become anchored, various price shocks such as sharp increases in oil or food prices are likely to be of a transitory nature.  This means that over time price shocks are unlikely to have much effect on the rate of inflation.

Note that what matters in this way of thinking is the underlying price inflation. It is for this reason that Federal Reserve policy makers and many economists are of the view that to be able to track the underlying inflation one must pay attention to core inflation – percentage changes in the consumer price index less food and energy.

To make inflation expectations well-anchored individuals must be clear about the monetary policy of central bank policy makers. According to this way of thinking as long as individuals are unclear about the precise goal with respect to inflation that policy makers are aiming at it would be difficult to bring inflationary expectations to a state of equilibrium.

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Our Outlook For 2018 Interest Rates to Stay Low. The Consensus View is That Europe’s Banks Are Recovering But We Are Not So Sure.

The Interest Rate Outlook

Despite their shortcomings, European banks do not seem on the verge of collapse and few commentators, analysts or policymakers think that there will be any systemic wobbles in 2018. We do not necessarily disagree; with ECB interest rates still zero to negative and a raft of generous credit facilities open to banks on softish terms there is little doubt that monetary policy has helped and will continue to help Europe’s banks. We would venture to say that supporting the banking system has been the main objective of ECB monetary policy for a decade now. Keeping rates at around zero not only ensures that mark-to-market profits are maximised, but also enables banks whose depositors might have lost confidence and withdrawn funds to fill the gap by borrowing from central banks at no cost.

The opposite view is that banks are struggling to make money in this low interest rate environment and that profits will rise when rates increase. There are three difficulties with this counter. Firstly, the market for high quality lending business remains very competitive, not least because low rates have helped many banks stay in business that might otherwise have folded. Secondly a raft of fintech businesses have emerged seeking to pick off this ‘low hanging fruit’. Fintech businesses of course have low overheads. Many are targeting the SME market. Larger corporations with internal treasury functions have always been able to borrow at skinny margins. In the retail market the European Union’s new Payment Services Directive will make it easier for third parties, with the customer’s permission, to access secure information and initiate customer payments. This is expected to put pressure on large banks’ pricing power, pushing them closer to market average pricing.

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Olduvai II: Exodus
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Olduvai
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Olduvai II: Exodus
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Olduvai III: Cataclysm
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