Bull and bear markets in Government

One interesting way of thinking about time periods in American history is by looking at the extent to which government control (measured in the below chart as spending as a percent of GDP) of the economy is going up or down.

Source: USGovernmentSpending.com


In bull markets, government is getting more important in people’s lives. In bear markets, concerns about government are pushed to the side and markets thrive. Considering the entitlement spending shift has yet to hit, it is unlikely that we will be going back to bear market anytime soon.

China & the ABCT

A lot of people have trouble understanding the growth of the Chinese economy. They have grown so fast for so long that a lot people feel that they are due for a bust. Their currency is pegged to the US so their monetary policy has interest rates that seem unnaturally low relative to their natural rate. Even in 2004 and 2005 many observers labeled China as a bubble.  While part of the reason they got China’s growth wrong was because they underestimated the force of convergence, it is also because China is an interesting case of the Austrian Business Cycle Theory.

Even the most casual observer of markets understands that many people believe the housing bubble and financial crisis was to some extent driven by unnaturally low interest rates during the post tech bubble years. Using the framework from Roger Garrison’s Time and Money: The Macroeconomics of Capital Structure, we can see that a lower than natural interest rate sends false signals to consumers and investors through the loanable-funds market, which causes the economy to move outside the production possibility frontier, leading to malinvestments and excess consumption. This process is explained in detail in a very good PowerPoint presentation at Roger Garrison’s website, but here is the big picture: (click to enlarge)

The process starts in the bottom right where the central bank sets the interest rates at a point lower than the natural rate of interest, where savings and investment would clear in a normal market. These false signals tell consumers to save less, which means consume more, and investors to invest more.  Moving up on the chart we see that if the economy was near the production possibility frontier, the lower interest rate sends the economy outside of the frontier due to the increased investment and increased spending. Through the Hayekian triangle on the left, it can be seen why these increases are so disruptive. The increased saving and investment is not uniform, but is distributed towards the early and later stages of the process, leading to inflation when it is determined that certain parts of the economy are underinvested (This middle stage in the past has often been in things such as oil production), then a bust when it is determined that the investment is not in fact going to pay out.

However, China and other Asian countries have gotten around some of these problems with a policy of forced savings. This forced savings comes from policies that keep their currencies artificially weak, discourage imports by making it difficult for foreign companies to enter the market while subsidizing their exporting companies with cheap loans.

This has the effect of shifting the savings curve in the loanable funds market to the right, and it helps turn an unsustainable economy into more sustainable growth.

This isn’t to say that policies of forced savings make countries immune from business cycles. When the government allocates capital, there is more likely to be malinvestments that the market will eventually identify. A lot of recent spending in China has been focused on their real estate sector, in a way that does not seem sustainable. If the real estate market crashes, China’s economy will undergo a recalculation phase during which it’s GDP will be lower as they switch towards producing end products that their citizens actually want to consume.

The main point is that when we look at Asian economies that implement policies that force their citizens to save, they may actually be making their economies more immune to a typical boom/bust cycle. However, when these economies create a massively inefficient domestic sector as part of the way they are implicitly encouraging savings, as they do in Japan, it lowers the standard of living in the country to such an extent that it probably is not worth it once convergence has mostly occurred (because the are preventing convergence in the inefficient parts of the domestic economy).

Why don't people talk about a 3D Laffer curve?

When it comes to the Laffer curve, there is a lot of noise in the debate.  The idea that at some point between 0% and 100%, that the government can immediately raise more money by cutting taxes is true, but it is also trivial.  When we ask ourselves where we are on the Laffer curve, we shouldn't think of the curve as merely two dimensional, the third dimension of time should be included.

What many supply-siders who talk about the Laffer curve assume is that a cut in taxes isn't just about incentivizing people to work more during one tax year, but it is also going to result in increased trend economic growth. This is probably true when the tax cut is coincident with increased private sector control of the economy, but may not be true for tax cuts that just increase the deficit. Increased economic growth leads to higher future revenue.  From this we can conclude that in many more country's tax rates are on the right side of the Laffer curve, but only with a time horizon of 10, 20 or even 50 years.  From this perspective, it can be said that the US implemented policies that other European countries who are on the right side of the Laffer curve did not, and is able to raise just as much money with lower taxes.

From the stock market to the economy or the other way around

A lot of models of the economy use the stock market as a leading indicator. That is why it can be very silly to turn around and use these models in order to figure out where the market is going*. Perhaps more subtle forms of this type of mistake are why economists are generally not known for being good traders. However, there are interesting micro-relationships within the market that correspond to economic activity in interesting ways. One of these is the relationship between consumer discretionary stocks and consumer staples stocks vs. nominal US personal consumption expenditures.

Right now, the market seems to be pricing in a slightly lower nominal growth rate than it did pre-crisis.

*These models can be useful insofar as it helps tell a trader that the market has an incorrect macro view, but that is another story.

China's shift in exchange rate policy

China is changing its RMB exchange rate policy. Here are the key quotes:

In view of the recent economic situation and financial market developments at home and abroad, and the balance of payments (BOP) situation in China, the People´s Bank of China has decided to proceed further with reform of the RMB exchange rate regime and to enhance the RMB exchange rate flexibility.


In further proceeding with reform of the RMB exchange rate regime, continued emphasis would be placed to reflecting market supply and demand with reference to a basket of currencies. The exchange rate floating bands will remain the same as previously announced in the inter-bank foreign exchange market.

I can think of a few reasons why they are choosing to do this now.

1. By promising action right before the G20, it allows them to avoid this contentious issue and instead make the developed countries focus on their debt problems.

2. They have been trying to moderately tighten their policy in other ways, so this move is a natural extension of their policy that as an added benefit placates members of the international community.

3. They figured that because everyone is now worried about the Euro, they could change to a basket and have a smaller effect on the markets than if they implemented this policy while everyone was already selling the dollar.

4. Due to recent currency movements, they are worried about export competition from manufacturing in the Euro-zone more than they are about US competition. This move could be a medium term move to strengthen the Euro.

Of the above reasons, #1 and #2 are pretty obvious and are generally well known. #3 seems like it could be true, while for #4 to be correct the reference basket of currencies would have to be changed pretty drastically.

It is worth noting that while the language does not imply revaluation, but as long as the forward rates are pricing in some type of revaluation (and the only time they don't seems to be when there is a liquidity shock and people are forced to exit their positions) the last time the PBOC used similar language the RMB appreciated pretty steadily for a few years. However, this steady appreciation encouraged speculation in RMB based assets, driving up the real estate bubble that China is presumably worried about now. If they let (encourage) the RMB be priced to steadily appreciate at a similar rate again that would imply that either they haven't learned their lesson or that the party has decided that they cannot let the real estate bubble collapse anytime soon and are desperate to keep it going.

Ironic protest

A group protesting how much money was spent on oil instead of poverty was protesting at the G20.

The group paraded through Toronto's financial core with an outsized papier-mache head of Canadian Prime Minister Stephen Harper, handing out fake C$1 billion bills that spoofed the price tag just for security at the summits.

Were they bragging about how much money they and other groups like them were forcing these people to spend on the meeting?

Of course, it does raise the issue of whether or not these events should be held in cities. Security would be a lot cheaper if they just completely rented out some out of the way resort. The reasons for not doing this could either be status related or because some of the leaders feel that allowing nearby protests makes things vaguely more democratic somehow.  The latter reason doesn't make too much sense, so it is probably the former.

On Media Bias

Julian Sanchez, one of Megan McArdle's guest bloggers, has a very interesting post highlighting Jay Rosen's post on media bias.

The debate on media bias is generally rather partisan. Critics on the left believe that the media is pro-business because they are businesses, and that they do no want to risk angering those who buy advertising from them.  

The right sees that most journalists are college educated cosmopolitans (who mostly ignored economic incentives when it came time to choose a career) who mostly vote for democratic candidates, and labels the journalists and therefore media as leftists.

Jay Rosen highlights a lot of the more complicated biases that he thinks matters more than the above arguments. Journalists gain status by publishing stories that anger one or both sides of the political spectrum (He quotes some journalists who are proud of getting attacked by both the left and the right in the same week). They gain more status from a take down than from a glowing profile, so they are apt to report on more pessimistic events.  Skepticism is valued, and journalists who are true believers aren't taken seriously. Journalists need to produce stories that are seen as bias free, so instead of trying to figure out the truth they take quotes from both sides and try to appear like they are in the center. Journalists identify some ideas as outside the mainstream and ignore them completely (placing the ideas in a "sphere of deviance"), or if they do mention them they make sure to present the ideas as extreme or impossible.

Many more of these biases are listed, and they are quite an interesting framework for seeing how news stories are biased to present certain types of views.

However, the existence of these biases don't rule out additional biases.  For the average person, it is very difficult to identify with arguments of the opposing side. Journalists trying to be neutral in a "he said/she said" story know which leftists arguments work, but may be less likely to pick the best rightist arguments. If true believers aren't taken seriously, then both hardcore environmentalists/communists and the religious right will be excluded from the conversation. This is still biased though, because this excludes a larger percentage of the right than the left.  Also, the placement of the "sphere of deviance" might be more centered around their views, which could lead to views of the slightly far right being taken less seriously than views of the slightly far left.

One additional critique of Jay Rosen's post is that he assumes that reporters are big believers in the law of unintended consequences while it seems like this generally isn't the case. The way stories are structured many potential unintended consequences of government action are often ignored or merely given a single sentence towards the general idea of unintended consequences towards the end of the article. The framework of "There is a problem, here is how they are trying to fix it" dominates the story. Of course, my generally libertarian perspective is in the sphere of deviance, so perhaps Rosen's post does account for this issue.

A person's perspective on media bias depends on their own position on the spectrum. Someone on the far left would see the media as failing at its job as a corporate watchdog, and might attribute this to corporate influence. Those in the center left to center might see no particular problem, while those farther to the right see a bit more bias as their views are relegated to the "sphere of deviance".

With the advent of the internet, some parts of media might become marginally less biased - they are more likely to be called out more often when they show any significant bias. The bigger effect is that there are more openly biased websites, giving viewpoints from a particular ideological perspective. People can choose to take their news with a known bias, especially if it corresponds to their own bias (in which case it doesn't seem as much like bias as a correct viewpoint to the reader), over a vague bias. This is happening on the left and the right. The Huffington Post is a popular openly progressive news portal and there are many slightly less popular (when measured in hits) conservative news websites and blog networks. As more people switch their news consumption to openly biased sources, the idea of a general media bias may become less important going forward.

China vs. India: Demographics

I thought that it would be worth looking into the demographics of China.  It would be nice to actually quantify its effect a bit more closely.  Luckily, I found a paper that did just the type of analysis that I was looking. David Bloom and Jeffrey G. Williamson wrote “Demographic Transitions and Economic Miracles in Emerging Asia”, published in April 1998. They used demographic and economic data from 1965 through 1990 to generate estimates on the impact of a demographic dividend.  They measured the impact of the growth of the population, the growth of the working age population (15 through 65) and other common variables on per capita GDP growth.  I took the average of the coefficients in table 4 to do a country specific analysis of China and India.  On average, the growth of a working age population helps per capita GDP growth by about 1.7% for every additional percent growth in working population, while every percent growth in the total population hurts per capita growth by 1.4%.

Without a demographic Dividend, China’s GDP growth would be marginally lower:

The demographic dividend’s effect (blue line) is disappearing, and will go negative after 2015. The orange line measures the total impact of population on GDP, combining the dividend’s effect on per capita income with the overall population change.

For India, their demographic dividend is mainly in the future.

India’s overall GDP growth will slow down with their general population growth, but their per capita GDP growth will be benefiting from a demographic dividend for quite some time.

This analysis relies on coefficients from 1965 through 1990, so the impact of the elderly is not going to be properly quantified.  There were no countries facing an abnormally large elderly population that expected benefits from the government. When the Bloom & Williamson paper separated out the youth dependency and elderly dependency ratios, they found that an elderly population actually added marginally to growth (Which makes some sense since unlike with youth the elderly population is marginally productive).  However, after economies have had to deal with the potential fiscal crisis due to their aging population the effect might be found to be quite a bit more negative.

I suspect that some measure of this nature might be helpful in separating out convergence growth from demographic driven growth. Unfortunately, the nature of the demographic dividend is that the dividend occurs during convergence, so a simplistic analysis can only explain so much.  

Data: April 2010 IMF WEO database was used for PPP GDP data. The 2008 UN World Population Prospects database (medium variant projections) was used to get the age structure of China and India.

The legitimacy arbitrage

One thing that China's markets lack is human capital. One part of that deficit is a lack of trust in the markets.  When companies use fake protein in their foods and others put lead into children's toys, there are understandable reasons as to why they may be suspicious of domestic Chinese companies. Some companies figured out that they could gain a certain amount of legitimacy by hiring... inexperienced white workers.

No experience necessary—which was good, because I had none. I’d be paid $1,000 for a week, put up in a fancy hotel, and wined and dined in Dongying, an industrial city in Shandong province I’d also never heard of. The only requirements were a fair complexion and a suit.

This arbitrage benefits the companies and the inexperienced white workers while it hurts those people using white people as signals for true legitimacy to an operation. Going forward, it will be more difficult for companies and people to prove their legitimacy. This might explain why in South Korea my little brother had to send multiple agencies his actual college diploma in order to get a visa/job.


Addendum: According to my brother the restrictions in Korea are due to a scandal where a US student who was a convicted child molester who got his E2 visa forged all of his documents. Because of that, tehy require original documents and even students with mere misdemeanors can't get a visa.

The political class and finance

A while back Falkenblog had a great post about how people who enter finance from politics have a skewed view of wealth creation.  His post highlighted the financial experience of Rahm Emanuel. Jeff Matthews posted what could be a follow up story, this time focusing on Steven Rattner.  The theme is the same: Those who enter finance from politics make money (sometimes in a very morally ambiguous way) from their connections with people running things, so they assume that is how the whole system works*. The interesting point is not that the political class has a skewed viewpoint, but how it is skewed in such a systematic way.

*Finance is basically the intermediation of capital, so networking between those with capital and those with access to good investments (and everyone in between) is integral for the health of the system. The problem is that the networking becomes morally ambiguous when there is a quid pro quo relationship between a private entity and someone acting on behalf of the government.