Tuesday, April 21, 2009


Up until now, Paul Krugman’s writings on the current economic crisis have always made sense to me. Not that I always agreed with him, but I understood the logic of what he was saying.

He has suddenly lost me. In a New York Times op-ed column on Sunday, he argues that, in a worst-case scenario, the US could become like Ireland: unable to stimulate its economy out of recession/depression because fiscal policy is constrained by the need to satisfy the government’s creditors. I understand why this is happening in Ireland. I don’t understand how it could happen in the US.

There are a couple of huge differences between the US and Ireland, macroeconomically speaking – differences which, to my mind, render the two nations not even remotely comparable, even under an extreme hypothetical scenario. First, the US is much larger than Ireland, a much larger part of the world economy and much more self-sufficient. Second, the US has its own currency, in which its debts are denominated. Paul Krugman, as much as anyone (if not more), must be aware of the implications of these differences; yet he writes as if they could be ignored.

If our debt-to-GDP ratio rises too high, Prof. Krugman suggests, “we might start facing our own problems with the bond market.” But what problems is he talking about? We surely won’t face the same problem that Ireland faces: namely, that, in order to get enough euros to run our government, we would have to offer high interest rates and engage in austere fiscal policies. We won’t have that problem because we don’t need any euros to run our government and never will. If international lenders lose confidence in the US, the result will be a decline in the value of the dollar, not (unless the Fed and the Treasury allow it to happen) an increase in the interest rate that the Treasury must pay.

We might worry about the declining value of the dollar if there were a problem with inflation in the US. But there’s not, and, as I argue in an earlier post, there isn’t likely to be any time soon. As it is, a decline in the value of the dollar would do for the US exactly what Ireland is unable to do for itself with fiscal policy: it would stimulate the economy and get us out of the recession.

Professor Krugman may disagree with the arguments I made in the earlier post, and he may think that inflationary recession could be a problem for the US. But in that hypothetical event, we’d be dealing with a very different problem than what Ireland is experiencing right now.

The closest analogy I can see would be between leaving the euro (in the case of Ireland) and inflating the dollar (in the case of the US). But the analogy isn’t a close one at all, since the former decision is discrete and nobody thinks it’s going to happen, whereas the latter is a continuum and there are varying opinions on the degree to which it might happen. And if this analogy is what Prof. Krugman has in mind, it seems to me that it is incumbent on him to make it explicit, since it’s hardly something that would be obvious to most readers.

I can imagine a worst-case scenario, one where all the arguments I made in my earlier post turn out to be wrong and the Fed ends up having to choose between serious inflation and serious depression, but that scenario doesn't remind me of what is happening in Ireland.

It’s also worth noting that a lot more has to go wrong in the US, as compared to Ireland, before the US gets to that worst case scenario. In the case of Ireland, it was the collapse of the banking system and the government’s lack of resources in reacting to that collapse (an outcome that Prof. Krugman fears for the US, should current policies prove ineffective). In the US that would just be the beginning. Before we reach the worst case scenario, (1) the rest of the world would have to decide that their sovereign investments are more important than their economic recoveries, so that they would refuse to support a collapsing dollar and instead accept a deterioration of trade with the US; (2) foreign producers would have to pass on most of their increased costs to the US (in contrast to what they did, for example, in the late 1980’s); (3) Americans, despite their newfound thrift, would have to accept most of those increased prices rather than substituting cheaper domestic goods; and (4) US producers would have to raise prices rapidly in spite of weak economic conditions, and keep raising prices despite weakening economic conditions. It’s not impossible, but personally it’s not something I spend much time worrying about.

DISCLOSURE: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management.

Thursday, April 16, 2009

Oil Futures: Money for the Taking?

Maybe someone who knows more about oil than I do can explain this to me. As best I can tell, there is money for the taking, at virtually no risk, available in the oil futures market right now. As an economist, I have a hard time imagining how that can be: when there is money for the taking, we usually assume that someone will already have taken it.

Physical oil is selling for about $50 a barrel today. Just for a specific example, the contract for May delivery of light, sweet crude closed at $49.88 on the NYMEX Thursday. Distant futures contracts, however, are trading at much higher prices, a situation known as contango. Ordinarily contango can be explained by the costs of financing and storage, but today’s contango seems too extreme to admit of that explanation. For example, the December 2010 contract closed at $66.68 Thursday – more than 33% higher than the May 2009 contract.

It seems like a no-brainer: buy some oil, put it in a tank, sell the distant futures, and then just wait. Some time between now and December 2010, either the price of the oil has to go up, in which case you make money by selling the oil, or else the price of the futures has to come down, in which case you make money by buying back the futures contract. The costs of financing and storage can’t be anywhere near large enough to eat up the profit that you’re locking in with these transactions, and the basis risk – the risk that the oil you buy won’t sell for exactly the price of the deliverable oil for the futures contract – has got to be tiny compared to the available profit.

If you annualize the difference in the futures contracts, it comes to 20.1% or $10,036 for 1000 barrels of oil. Admittedly knowing little about the market, I just can’t imagine that it costs more than a few thousand dollars to store 1000 barrels of oil for a year. So we’re looking at an implied financing rate in the high teens. If you can finance, say, at 10% (which shouldn’t be too hard for a well-established institution that can offer 1000 barrels of oil as collateral and show that the futures contract will assure the ability to pay back the loan), you can pocket the difference.

Anyhow, we don’t really need to talk about the financing and storage costs for a hypothetical arbitrageur that needs to borrow the money and store the oil. There are plenty of oil producers that have the option of storing the oil in the ground at zero cost. Unless they’re desperate for cash (which seems unlikely given the amount that many of them piled up when oil prices were high), it’s a puzzle why they continue producing at over 90% of capacity. Why not just sell the futures, put off the extraction until late next year, and either sell the oil at a higher price or buy back the futures at a lower price?

And even if they are desperate for cash, it’s still a puzzle. Given the huge amount of highly liquid US Treasury bills in circulation, it’s clear that not everyone is desperate for cash. Some are just highly risk-averse and don’t want to invest their cash right now. But this arbitrage offers them a risk-free investment with a return much higher than that of T-bills: pay an oil producer today for some oil to be delivered in December 2010, sell the futures contract, and then wait. You can offer the producer more than today’s price of oil, so it will certainly be in the producer’s interest to accept your offer: they get the cash now, and they don’t have to send the oil until later. Meanwhile you’re assured of making money come December of next year: you either re-sell the oil at a higher price as soon as it gets delivered, or you buy back the futures contract at a lower price.

Everything I know about economics says that there ought to be so many people trying to do these transactions that they would already have driven up the price of oil or driven down the price of the futures contract to the point where no obvious risk-free transaction is possible. So why hasn’t it happened?

DISCLOSURE: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management.

There Will Be No Inflationary Episode...Unfortunately

Rapid money creation usually results in rapid inflation. That point is hardly disputable. It is indisputable that the Fed has been creating money rapidly over the past six months, and there is every indication that it intends to continue doing so in the immediate future. Will this rapid money creation result in rapid inflation?

In the immediate time frame – say over the next 12 months – the answer is clearly “no,” for two reasons. First, the Fed’s money creation is designed in part to offset money (and credit) destruction by the banking system. Second, the demand for money is unusually high, and the increase in the demand for money offsets the increase in supply, leaving the value of money approximately constant.

But both these factors are at least partly temporary. Eventually, the condition of the banking system will improve, and it will start creating more money and credit, multiplying the money already created by the Fed. And eventually, households and institutions will get more comfortable and stop wanting to hold so much of their assets in the form of money, thus reducing money demand and causing the value of money to go down (i.e., inflation). At least that’s the way the story is typically told. And the usual version of the story suggests that, in order to prevent this inflation, the Fed will have to scamper very quickly to destroy much of the money it has recently created. It is often argued that losses on assets, or market inefficiency, or political pressure, will prevent the Fed from doing so, thus making an inflationary episode likely.

I’m extremely skeptical of that argument. In particular, I’m skeptical of the premise that the Fed will ever have to scamper quickly to prevent an inflationary episode. To see why I’m so skeptical, consider what “inflation” means: inflation is an ongoing pattern of rising prices. For the moment, let’s leave aside the “ongoing pattern” issue and just say that inflation means rising prices. In a modern economy, what is the immediate cause of rising prices?

In a commodity market, of course, the immediate cause of rising prices would simply be an excess of buyers over sellers at the current price. But most goods and (especially) services (which are more important than goods today) in a modern economy do not trade in commodity markets. Rather, their prices are set by sellers. The only immediate cause of rising prices is that sellers decide to raise them.

So why would sellers decide to raise prices? It boils down to two possibilities: an increase in actual or anticipated demand, so that they can (or think they can) get away with raising prices without losing customers, or an increase in actual or anticipated costs, so that they are forced to raise prices to keep their profit margins positive. The impact of money creation on prices must operate through one of these two channels.

We saw this process operating during the 1960’s and 1970’s. Over the course of the 1960’s, the Fed began to create money more rapidly than it had in the past. Gradually, over several years during the late 1960’s, the increase in actual demand induced sellers to start raising prices more quickly than in the past. Then gradually, over the course of the 1970’s, sellers began to anticipate higher and higher levels of (nominal) demand and higher and higher levels of (nominal) costs, so they started raising prices even before the demand materialized. Under the circumstances, the only way to keep the economy growing was to create enough money to realize the anticipated level of demand, so the inflation rate remained high until Paul Volcker’s Fed finally decided to stop the economy from growing for a while.

But that whole process took a long time. The inflation rate rose from 1% (in 1964) to 10% (in 1980), but it took 16 years to do so. And it took a series of policy errors, not just a one-time failure. William Martin’s Fed (along with the Johnson administration) made errors in the late 1960’s; Arthur Burns’ Fed (along with the Nixon administration) made errors in the early 1970’s; William Miller’s Fed (along with Carter administration) made errors in the late 1970’s; and OPEC took several unprecedented moves to restrict oil production over the course of the 1970’s. And the whole process began with a huge economic boom. The unemployment rate fell from 5.7% in 1963 to 3.5% in 1969. The inflationary pressure didn’t happen overnight: boom conditions, with the unemployment rate below 4%, lasted for about four years, from 1966 through 1969.

For whatever reason – misguided economic theories, pressure from the Johnson administration, inexperience with policymaking during boom conditions, timorousness about restricting credit too much, political bias, concern about the war effort in Vietnam, or come up with your own reason – the Fed repeatedly chose to allow the boom to continue, until sellers learned to anticipate rapid growth of nominal demand. And once the Fed finally did put its foot on the brake, President Nixon took the first opportunity to replace the Fed chairman with one who promptly put his foot back on the accelerator.

The unemployment rate remained at or below 4% from December 1965 through January 1970. Most economists expect the unemployment rate to be above 9% in 2010 and to fall only slowly thereafter. We will not get a late-1960’s-style boom any time soon, certainly not in 2010, 2011, or 2012. Over the next few years, the pressure will be on workers to accept flat wages at best. If actual demand, or actual domestic costs, are going to induce rapid price increases, it is going to happen in the distant future, and one will hardly be able to blame today’s rapid money creation.

The are two ways in which high inflation could conceivably happen in the not-too-distant future, but both seem highly unlikely to me. The first is that costs of foreign products and inputs could rise so quickly that they have a large effect on the overall price level and anticipated future costs. That’s the typical “emerging market” scenario that some fear for the US.

But the US is not at all like a typical emerging market country. The US is a large country, and though it may seem otherwise at times, statistics show that the vast bulk of the value consumed in the US is produced in the US. The ratio of imports to GDP is only about 16%. If the foreign exchange value of the dollar were to fall by half, theoretically doubling the prices of foreign products (under the unrealistically pessimistic assumptions that foreign sellers fully pass on the increased cost and that Americans continue to buy the same foreign products), the resulting increase in the domestic price level would only be about 16%, and that would likely be spread over several years. That’s inflation (by some definitions) but hardly the runaway inflation that some are worried about.

In any case the foreign exchange value of the dollar is not going to fall by anywhere near half, because the consequences would be disastrous for the rest of the world’s economies. China won’t let that happen; Japan won’t let that happen; Europe won’t let that happen. Until today’s weak conditions are completely reversed and turn into a major boom, every other country or currency area will find it in their national interest to buy huge quantities of dollars, if necessary, to prevent a dollar crash. In all likelihood, the dollar will fall slowly over the next decade, imparting only a tiny amount of inflation, certainly not making the difference between a high-inflation economy and a low-inflation economy.

The other theoretical inflationary possibility is that, even if actual domestic demand rises only slowly, anticipated nominal demand will rise quickly due to the observation that the money supply has risen quickly. If so, theoretically, inflation could become a self-fulfilling prophecy.

But there’s a problem with that scenario. If sellers raise prices in the face of high anticipated demand, actual demand will come in far below their expectations, forcing them to cut prices again. In the slow recovery that is likely over the next several years, no matter what the Fed does, sellers will not be able to make large price increases stick. Eventually, presumably, the recovery will run its course and we’ll arrive at the point where demand expectations could be validated by a sufficiently loose monetary policy. But by the time we get to that point, sellers will have been kicked in the face repeatedly and are unlikely to have the courage to implement large price increases.

The Fed will have years to unwind the positions wherewith it has created money so quickly in recent months. Egged on by economists of all stripes, the Fed has stated in no uncertain terms its intention to do so. I have every confidence that it will.

But “confidence” may not be quite the right word. It’s kind of like being confident that someone’s blackjack hand is not going to go bust. You can be confident that a particular bad outcome is not going to happen, but that doesn’t mean being confident that the actual outcome will be a good one. Unless it’s feeling particularly daring, the Fed is going to stand on 12, and history shows that to be a losing strategy.

It’s what the US did in 1937, when 3% inflation was too much. It’s what Japan did in 2006, when 1% inflation was too much. The US subsequently went into the second dip of the Great Depression. Japan became part of the international downturn that we’re all experiencing today.

The next chapter of Japan’s story has yet to be written. The story of the US in the 1930’s eventually has a happy ending (at least for those who survived World War II without crippling injuries), but it’s an ending that involves a lot of inflation. With the excuse of the war, the Fed let the inflation rate rise to an average of about 6% during the early years of the war, before inflation was tamed by price controls. After wartime price controls were lifted, the inflation rate rose to around 10% for a couple of years, making the average inflation rate between 1933 and 1948 a little higher than 4%. Ultimately, the US had chosen to err on the side of too much, rather than too little, inflation – and it was that error that conclusively ended the Great Depression.

DISCLOSURE: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management.

Thursday, April 2, 2009

Time for a Strong Euro Policy

In ordinary times – times when interest rates are positive, inflation is a greater concern that deflation, and recovery from recessions is a foregone conclusion – the effect of a fiscal stimulus is usually to strengthen the currency of the country involved. It might reduce confidence in the currency, which would make the currency less valuable at any given interest rate, but it will normally cause the interest rate to rise enough to offset that effect.

In a sense this has to be true. A country running a fiscal deficit needs to attract enough capital to finance that deficit. By whatever means – generally by raising interest rates – it must make its currency attractive enough to attract that additional capital, and the value of the currency will rise as the demand for it increases.

Granted, there are other options. In theory, a country can finance an increased deficit internally, but this requires households or businesses to increase their saving enough to offset the deficit, which usually doesn’t happen. Or a country can try to create the necessary capital out of thin air by using monetary policy. In ordinary times that’s usually considered a bad idea because it tends to lead to inflation.

Needless to say, these aren’t ordinary times. Households and businesses are suddenly all too eager to save, and inflation risks are for the moment outweighed by deflation risks. The “natural” effect of a fiscal stimulus – to raise the value of the currency – doesn’t happen, because the stimulus is fully accommodated internally by monetary policy. In the absence of an explicit exchange rate policy, the value of the currency depends on the market’s judgments about what the uncertain future might hold.

There’s a certain poetic justice, though, in the behavior of exchange rates during ordinary times. If a country is spending recklessly and overstimulating the world economy, it gets punished with reduced export demand, the result of a strong currency. If a country is saving heavily and thereby facilitating investment throughout the world, it gets rewarded with increased export demand, the result of a weak currency.

In a time like the present, when real investment is out of favor and the demand for it is insufficient to absorb what the world wants to save, poetic justice would call for a reversal of the usual effects. Fiscal spending is good; fiscal spending is, in a sense, altruistic: the benefit accrues to the world economy – spending produces an international stimulus that helps absorb the world’s excess savings and avoid an economic implosion – but the cost is borne by the spending country, which (theoretically anyhow) will have to pay back the debt in the future. Poetic justice would ask that deficit spending be rewarded.

Fortunately, if some country – or let’s say some currency area – pigheadedly refuses to do its part to stimulate the world economy, the rest of the world may be in a position to supply the just punishment. Or, to put it in less moralistic terms, if one player refuses to give a stimulus voluntarily in the form of fiscal policy, the rest of the world may be able to take that stimulus in the form of exchange rate policy. Moreover, after insisting that an additional stimulus is not necessary, the resistant player will hardly be in a position to object to a policy that excludes them from the benefit of such additional stimuli arising elsewhere. If they are forced to provide a stimulus for themselves to offset the stimulus they are not receiving from the rest of the world, so much the better.

Abstractions aside, it’s time for the rest of the world – particularly the US – to start buying euros aggressively. By itself, the effect of the US fiscal stimulus will be to increase the demand for European products: governments in the US will buy machinery from Germany; the newly employed can celebrate with French wine; Americans who escape job loss won’t have to cancel their Italian vacation. It can hardly be considered unfair if we try to offset that effect by weakening our currency and encouraging some Americans to visit the Grand Canyon instead of the Colosseum.

Unfortunately this isn’t likely to happen. That old mantra, “A strong dollar is in our national interest,” still echoes through the air in the District of Columbia. Never mind that the strong dollar was largely responsible for the housing boom that led to the current bust. It was: the strong dollar encouraged Americans to buy from abroad and discouraged those abroad from buying from the US; as a result, the only way the Fed could induce a recovery was by cutting interest rates to levels that sparked a boom in housing. The rest, unfortunately, is history.

A strong dollar is not in our national interest. It is not in the world’s interest. It is not in the interest of justice. It is just wrong.

DISCLOSURE: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management.