Do people realize that in the next economic downturn the dollar will most likely strengthen?

People talk about a weak economy and weak currency almost like they are the same thing.  Certain commentators like Peter Schiff encourage this view. However, the correlation in the US has actually been the reverse.

When there is growth, a lot of things are pushing down the dollar at the same time the market goes up.

1. Increased demand for commodities weakens the US's terms of trade.

2. Re-leveraging allows people to increase their bets against the dollar.

3. Many other countries (excluding Japan) have interest rates that react more strongly to global growth, so an economic recovery means that the interest rate differential will become less favorable for the US.

4. When the Federal Reserve promises weaker monetary policy than expected the market reacts positively.

Of the variables listed here, numbers one through three will most likely reverse in a downturn not centered around a dollar crisis. People in macro often focus on reason number 2, calling any dollar strengthening during a downturn a "Dollar carry unwind" in reference to the people who have been short the dollar and long a higher yielding currency that have to close out their positions during volatile markets.  This explanation is probably underweighted by people following the markets from day to day, but correlation it describes is still accurate even if the causal reasons behind it are not.

Political Time Preference: A Case Study

Jerry Brown was governor of California in the late 70's and early 80's.  During that time he had an opportunity to try and push government towards defined contribution plans rather then defined benefit plans, but the topic never came up because he was a big supporter of unions*. Defined contribution plans contain the potential for economic volatility, something unions try to avoid at all costs.  

When Jerry Brown was mayor of Oakland some unions received generous pension increases, presumably in lieu of large pay increases. Defined benefit pension promises are currently a major cause behind California's budget problems, some have estimate that California has about $500 billion in unfunded pension liabilities. So 25 years after his governorship when the pension problem is coming home to roost the people of California decide to elect... Jerry Brown**.

And if we wonder why politicians seem to think too short term, it is because voters don't have very good memories. This short sighted point of view is also why the economic environment of election year is much more influential than other years.

*Maybe it is unfair to blame him for not fixing a problem that no one else in the public sector fixed, but 401(k)'s were written into the law around 1980. His first governorship's term coincided with a large shift among private companies towards defined contribution and away from defined benefit plans. 

**The budget was balanced when he was governor, and the stupider pension mistakes have occurred in the last few decades such as SB400 passed in 1999.  If not for Brown's support of union pensions from his position in Oakland and his support of unions more generally things might be looking up.

Reason's Ford Blind spot

In the course of promoting free markets, Reason points out that Ford is a free market success story while the recipients of government bailout money are still struggling to become profitable. The headline of the story is Unsubsidized Ford Profitable for Six Straight Quarters.

Ford was the only domestic auto manufacturer to avoid bankruptcy or take a bailout from the federal government. 

This simple analysis misses the a lot, because the government's programs did a lot to help Ford.  There was a cash for clunkers program and various government stimuli that helped keep the consumer in a better position to spend money, but the largest subsidy was the bail out of Ford's suppliers. Without the GM and Chrysler bailout Ford's supply chain would have been in dire straights, and the final impact on Ford would have been anywhere from bad to catastrophic. 

This blind spot appearing in the blog of a libertarian oriented magazine bothers me.  Libertarians often become libertarians because they habitually look at second order effects of government action. If an unpopular company whose suppliers were subsidized by the government was distorting the market by out competing a company with unsubsidized borrowers I'm sure Reason would be quick to point this out.  Just because Ford did a lot of things right and is popular doesn't mean that it is an example of a free market success.

Taking Buffett's idea about the EMH being good for him one step farther

I was listening to a relatively old book about Warren Buffett in my car.  In the book, the author mentions that Buffett likes to talk about how MBAs who are taught to believe in the efficient markets hypothesis are making his job much easier because he has competitors who aren't thinking clearly about investment opportunities.  I find it funny that the same thing can be said about Buffett's ideas on the impossibility of forecasting.  

The MBAs who believe in the EMH and the followers of Buffett* both believe that forecasting the future macro environment is too hard.  A more subtle version is that even if someone is right slightly more often than not the transaction costs make trading off of the forecasts useless. 

The net effect of this is the same as the impact of the efficient market hypothesis being popular - the more people who believe that forecasting is irrelevant then the less accurate the current market forecasts are, which means there is more reward for those right forecast.  We saw this during the housing bubble, with many investors making a lot of money off of a forecast that was pretty accurate in hindsight. 

In the immediate aftermath of a bubble which shook many businesses to their core there will be more focus on forecasts in the short term, but identifying under appreciated or unsustainable trends is usually an undervalued approach.

*Buffett does forecast in that he has a slight bias towards inflation

BLS Benchmark Revision

Last Friday the BLS released their benchmark revision with this month's nonfarm payroll number. This number is an under appreciated statistic, as the information it provides about the jobs picture is much larger than the monthly change*. The benchmark revision was -366,000, while the monthly job change in September was -95,000. This means that their 2010 estimates of the amount of people working need to be adjusted down by 0.3%.

Industry: Benchmark revision (Percent revision)

Total nonfarm: -366,000 (-0.3)

Total private: -371,000 (-.4)

Mining and logging: -20,000 (-3.0)

Construction: -62,000 (-1.2)

Manufacturing: -114,000 (-1.0)

Trade, transportation, and utilities: -144,000 (-.6)

Information: -11,000 (-.4)

Financial activities: 42,000 (.6)

Professional and business services: 14,000 (.1)

Education and health services: 6,000 (*)

Leisure and hospitality: -91,000 (-.7)

Other services: 9,000 (.2)

Government: 5,000 (*)

(*) Less than 0.05 percent.

The industry breakdown shows that there has been a lot more adjustment in the manufacturing and trade, transportation and utilities, and the leisure and hospitality industries than have previously been accounted for. The carnage in the finance industry was overestimated, and there were more jobs there than previously thought.

The BLS suggests that there revision in the benchmark survey comes primarily from nonsampling error.
Sources of nonsampling error include coverage, response, and processing errors in both data series. Additionally, the survey is potentially subject to sample design and estimator biases.
Calculated Risk collected the data of BLS benchmark revisions over time and a quick glance at the data shows that negative revisions are common during or directly after recessions.  The benchmark revision wasn't as important as last year, when it was revealed that BLS data was too optimistic by almost one million jobs, but it is still an indicator that the economic picture is not quite as rosy as many people would like it to be.

*Some people might argue that the monthly BLS numbers are more important because the direction of where the economy is going is much more important than its level.

China impressions

There have been no posts because I just finished up a Korea/China trip.  My experience in Korea consisted of more of an introduction to the life of western expats teaching English (they drink a lot) than it was an education in the life and economic system of Koreans, so I'm going to focus on China.

Since this was my first time in China, it doesn't really help me understand China very much outside of giving me a rough understanding of what their GDP per capita, adjusted for purchasing power parity, looks like in real life*. Still, there were some interesting things that I learned on this trip.

1. Traffic - it looks almost like a first world country, but then there are some notable differences.  People on bikes seem to feel like they have a right to go wherever they want to without regards to any kind of traffic laws - kind of like the critical mass people in the US but as individuals.  They are often going the wrong way in a two way street, so looking both ways is always important. There aren't very many pedestrian walkways without bikes, and sometimes cars, honking at people to get out of the way. Taxi's are also ruder than in the US - I've seen numerous taxis with their available lights on reject passengers for apparently no reason.  People don't look at their blind spots when the merge, but thankfully they also avoid driving in the blind spot of other cars. There seem to be way more cars than parking spots.

2. Paying for things. First, there are no tips - this makes it hard to get better service unless the person is intrinsically motivated to provide it, while at the same time when this is combined with no sales tax it makes paying relatively easy when the final cost is the listed price. The exception was when I had to haggle.  Sticking close to someone who looks Chinese and can speak the language definitely helped, since it implies that there is someone who knows the scene who is looking out for their friend. One of the shop keepers even mentioned that they find it hard to get good prices when there is an Asian person helping a white person shop.  Otherwise, everything made in China was really cheap, which made certain imported goods like wine seem ridiculously expensive.  I would be surprised if China ever develops a market for rented videos while people can still buy any DVDs they want to see on the sidewalk for the equivalent of 50 cents.

3. Food and drink: McDonald's delivers 24/7. It seems like no one drinks anything like tap water**, nor do they like to drink anything cold. Only places expecting foreigners will have cold drinks. A restaurant with a poor beer selection in the US would have an amazing selection if it were compared to the restaurants in Korea and China.  Perhaps because of the lack of cold beverages, there is a much larger selection of cold dishes than I've seen in the states.  Chinese restaurants will have one menu per table, and often they will have items on the menu that are expensive and that they don't stock because they don't expect anyone to order.  These expensive items are also there because there is huge income inequality in China and these restaurants want to capture as much of the market as they can.

4. Brands*** seem to have a lot more value in China.  It seems to be one of the main ways they can differentiate quality. The premium brands are really expensive, which is part of the point. They see sales as a betrayal - they buy the brands precisely because the brands are expensive and therefore exclusive. This extends beyond products into the job market.  Most people would prefer to work at a company that their parents have heard of, regardless of whether or not it is a better opportunity than a small growing company.  

5. Real estate. Rents are ridiculously low relative to the prices, as many people have pointed out.  I was more intrigued by the policy that makes it illegal for people in certain areas to sell or rent out their homes. They are living in poverty when the real estate they own but can't sell is worth millions of dollars.  In the middle of Beijing it didn't seem like vacancy rates were absurdly high, but this is the type of thing where an anecdotal visit does not give very much useful information.

In China, there were a lot of ridiculously poor people working at very low productivity jobs such as taking the subway into the city each day to set up little shops on the sidewalk.  There is definitely room for them to move up the value chain, the question is whether or not their human capital and overall economic system will be flexible enough to allow these people to move to higher productivity jobs.

*The main surprise in Korea was getting a glimpse of what poverty can look like in a homogeneous population. Also, as I walked down the main market area into the poorer sections the things for sale got progressively weirder.
**Not drinking the water is important for foreigners, so it might also be a good idea to be careful when ordering hotpot.
***There are counterfeits, but they are obviously much lower quality.

Links to the past

I recently ran across some old posts (1 to 2 years old) that highlight some important ideas.

1. My friend commented on how she keeps getting cut off by Prius drivers and it reminded me of this post*. When people act in an acknowledged socially responsible way, they are more likely to treat other people worse. It is like most people are keeping track of their karma and they feel comfortable as long as it is flat.

2. Another post highlights studies that show that we value what we have to work for.  This explains why some writers turn to esoteric writing** - their main ideas are not good enough to stand on their own, but if people have to struggle to identify their ideas before they have a chance to evaluate them then perhaps the reader will value the ideas more highly.

3. Robin Hanson thinks that IQ isn't that useful a metric - how often people decide to think rationally also matters.  However, I wonder how much of the "rationality quotient" measure is explained by the combination of IQ and Conscientiousness.  A low rationality quotient is how some types of smart people are often very stupid***.

4. Falkenblog looks at the importance of teaching kids how to think about the big picture.  While the macro perspective is more important than he gives it credit for (students who think about the big picture should realize that they need to learn something useful), I am mainly resharing this link for how he worked the comic into his post.

5. Bryan Caplan reminds us that people who think that the 2008 crash changed everything in macroeconomics were missing something to begin with.

*Or rather, it reminded me that I had read it and I had to look through my google reader's history to find a relevant article.

**Beyond the obvious "People would hate me if they knew what I truly thought" reasons.

***Low emotional intelligence is another reason high IQ people are stupid, even if they are otherwise very rational.

The BOJ/MoF Put

People used to talk about a "Greenspan Put."  The idea was that if the markets fell too much, Greenspan, then the chairman of the Federal Reserve, would step in and prevent investors from losing too much money.  The effect was almost as if they had bought an option - a put - to protect themselves from a large drop in the markets.

These days, it is looking like there is a BOJ/MoF put for people interested in selling the yen. Selling the currency with the lowest interest rates, which in recent history has been the yen, is a popular trade because if markets don't move then the seller will make money*. 

Recently, the yen has actually been strengthening, but Japan's finance minister just announced that they were buying dollars and selling yen when the yen was trading around 83.  The Bank of Japan released a statement supporting these actions.

The Bank of Japan strongly expects that the action taken by the Ministry of Finance in the foreign exchange market will contribute to a stable foreign exchange rate formation.

Traders interested in selling the yen and buying the dollar are able to take large positions when they believe they have a central bank backstopping their trade.  Of course, this backstop only matters when the traders selling yen have been losing money, so the best way to trade it may be from a tactical perspective of fading yen rallies rather than a long term "sell and hold" approach.  

*Short term interest rates in the US are low enough that this isn't as profitable to do versus the dollar unless a longer term currency forward is used. If a longer term forward contract is traded, the trade is impacted by both movements in interest rates and in currencies. This isn't as popular as trading purely currency or purely interest rates because most traders like to take specific risks and avoid exposure to variables that they are less familiar with.

Monetary Policy and the Bubble

Senior vice president and research director at the Atlanta Fed, David Altig, has a post up at Macroblog discussing the connection between monetary policy and housing bubbles.  He is responding to John Taylor's comments at Jacksonhole where Taylor blames loose monetary for the housing bubble, citing a recent VAR study that found the deviation from the Taylor rule to be a large explanatory variable. Altig responds with points that deviations from the Taylor rule in the US are correlated with looser lending standards, and that this effect was not seen in Europe and in the UK, where the latter had a large increase in debt and housing prices similar to what happened in the United States.

My view of this debate is as follows:

1. You can prove many preconceived notions by carefully selecting your data set, or citing people who do. This applies to both sides.
2. The United Kingdom should be analyzed more like a large offshore financial center, so its own monetary policy's deviation from a Taylor rule would obviously be less important than exogenous variables.
3. Loose monetary policy might be behind looser lending standards. The banks that aren't relaxing their lending standards their lending standards when monetary policy is loose are likely to lose business. This argument is similar to the typical Austrian Economist's response to the rational expectations arguments against the Austrian Business Cycle Theory. Businesses that don't want to participate in the boom because it is unsustainable have to participate in some form because it is the only game in town.
4. Monetary policy was too loose and helped speed along a crisis, but the properties of the finance industry make bubbles and their subsequent crashes inevitable.