All posts by Dr. Douglas Rice

Econ update

Economic Summary

We got a plethora of news last week.  The beige book came out along with CPI, the unemployment numbers and a interesting look at the trade deficit.

The summary of the beige book showed that reports from the twelve Federal Reserve Districts indicated subdued growth in economic activity from mid-November through early January, with little change in overall conditions relative to the last survey period. Most Districts characterized growth as “sluggish” or economic activity as “soft” or “subdued.” The weakest report came from Dallas, where economic activity “remained anemic.” As in the last survey, conditions in the New York, Philadelphia, and Cleveland Districts were more favorable overall than in other Districts, with each, especially New York, describing various signs of improvement.

Reports on consumer spending were consistently weak, with disappointing holiday sales that, in nominal terms, mostly were at or below last year’s levels. Automobile sales surged at year-end in response to favorable sales incentives. Manufacturers expanded production a bit on balance, with notable gains for defense-related and biomedical products. Providers of nonfinancial services saw little change in existing weak demand, and business travel remained slow, although there were some reports of improved performance in the tourism sector. Home sales and residential construction activity remained at high levels but slowed a bit in some areas, and the widespread overhang of commercial real estate persisted. Agricultural production was hampered by adverse weather in some areas and performance was mixed. Extraction activity in the energy sector responded very little to sharp increases in energy prices. Bank lending continued to expand in most Districts due to strength in consumer and real estate borrowing. Labor demand was mostly flat, and despite rising costs for employee benefits and some inputs, increases in employee compensation and final prices were held down by competitive supply conditions.

We also saw U.S. consumer prices rose slightly in December but ended the year on a tame note, the Labor Department said in a report on Thursday that underscored the lack of inflationary pressures in the U.S. economy. Consumer Price Index, the most widely-watched gauge of U.S. inflation pressures, gained a seasonally adjusted 0.1 percent in December. It also posted a 0.1 percent increase outside of the volatile food and energy categories.

For the year, overall prices rose 2.4 percent, the biggest gain since 2000. But outside of food and energy, prices were up a much smaller 1.9 percent, the smallest increase since 1999.

In December, energy prices were down for a second consecutive month, dipping 0.4 percent. Clothing and transportation costs also fell, the latter mostly because of lower prices for new vehicles. Most categories of goods and services posted only modest price increases, with the largest gain coming in the medical care area, which showed a 0.3 percent gain.

A separate report, also by the Labor Department, showed initial claims for jobless benefits fell by an unexpectedly large 32,000 to 360,000 in the week ended Jan. 11. The level was much lower than Wall Street economists had been expecting but a Labor analyst warned that adjustments intended to deal with seasonal fluctuations in claims may have had a downward impact on the numbers. Should claims continue to remain below the key 400,000 level, they will be seen as showing an improvement in the lackluster U.S. job market. U.S. unemployment held steady at 6.0 percent in December.

Another report by Labor said inflation-adjusted earnings for nonsupervisory private workers outside the farm sector were flat in December, after November’s revised 0.1 percent gain.

The U.S. trade deficit will probably set record highs over the next two years despite sluggish economic growth, a Reuters poll found, as U.S. consumers continue to outspend shoppers in other countries.

While official U.S. international trade balance data for 2002 won’t be released for another month, economists say it is a foregone conclusion that last year’s trade deficit will break the current record of $365.5 billion hit in 2000. Already, the trade deficit from January through October 2002 stands at $350.2 billion.

In times of recession and slower economic growth, trade deficits typically narrow as consumer spending weakens, and as a weak economy tends to undermine the value of the dollar, imports become more expensive and exports cheaper for foreign buyers.

While U.S. economic growth remains sluggish, economists are quick to point out the economies of many of America’s major trading partners are growing even more slowly, leading to slack demand overseas for U.S. goods, services and financial assets.

However, forecasts for the U.S. trade deficit might have been even larger in the future were it not for the moderating pace of U.S. consumer spending.

Economists said a widening U.S. trade deficit over time puts downward pressure on the value of the dollar. In the 1990s, huge demand for U.S. assets such as stocks and bonds helped fill the gap left by outflows of dollars for goods and services. But with the stock market trading sluggishly, foreign investors have been less eager to fund the huge trade deficit. The dollar has lost 16 percent of its value on a trade-weighted basis since its 2002 peak in February. The trade deficit does remain a problem for the dollar unless you get other sources of capital flow and we know that capital flows have slowed significantly

Sources: Fed Beige Book, AP, Reuters, Economist, WSJ, and other news organizations.


Let me (try) to explain the Mundell-Fleming model regarding perfect capital mobility under fixed and flexible exchange rates and see if any of you agree with their model.

Mundel-fleming extends the standard IS-LM model in their 1960’s model of how policy’s work with capital mobility.

Under perfect capital mobility the slightest interest rate differential provokes infinite capital flows which leads to the conclusion that under fixed exchange rates, a country can’t pursue an independent monetary policy. Interest rates can’t move out of line with those prevailing in the world market. Any attempt at independent monetary policy leads to capital flows and a need to intervene until interest rates are back in line with those in the world markets.

Any monetary expansion (contraction) of the money supply is met capital flows that are so fast and large that the central bank must reverse the expansion (contraction) as soon as it attempts it. Basically, Mundel-Fleming shows that monetary policy as a economic tool is very much moot with fixed exchange rates. So fiscal policy (government taxation and spending) is the key economic driver in this case.

The opposite is true for flexible exchange rates. With flexible exchange rates and perfect capital mobility, monetary policy can be independent and thus the central bank can act to effect capital inflows or outflows. The exchange rates adjust ensuring the sum of the capital account and current accounts (the balance of payments) equals zero. So monetary expansion under flexible exchange rates provides for output expansion (GDP growth and a better economy) and exchange rate depreciation whereas fiscal expansion results in no output change, reduced net exports and exchange appreciation.

Another factor that must be considered is the mix of both fiscal and monetary policy and the need for both of them to be moving in the same direction. But I’ll save that for another day.

Did I lose anyone? I bet I did… 😦

Changing of the face of investors

We have moved, quite quickly, away from defined benefit (pensions) to defined contribution (401K) plans. This provides a company with the advantage of contributing and forgetting it but burdens the employee with management of their own retirement investments. Although many company plans are set up by reputable investment companies that offer a range of sound investment opportunities, once employment is changed, capital can rolled into just about any investment and there are plenty of sharks in the waters. This means that many will fail to invest wisely and end up on public assistance even though they had ample opportunity to do otherwise.

Is it cynical or maybe just realistic to predict more regulation?

Japan vs. US

One reason some don’t believe that we will face the same economic problems as Japan after a bubble bursting is that we have a more efficient financial system. One that will not tolerate corporations, especially banks, that are insolvent remaining in the marketplace. In some cases efficiency equals pain, hopefully short term. This is something many feel Japan has yet to learn.

The derivatives market and LTCM

For those not familiar with the situation, Long Term Capital Management (LTCM) was a hedge fund run by John Meriwether, a legendary trader who, after a spectacular career, had left Salomon Brothers following a scandal over the purchase of US Treasury bonds. This had not tarnished his reputation or dented his confidence. Asked whether he believed in efficient markets, he replied: “I MAKE them efficient”. Moreover, the fund’s principal shareholders included two eminent experts in the “science” of risk, Myron Scholes and Robert Merton, who had been awarded the Nobel prize for economics in 1997 for their work on derivatives, and a dazzling array of professors of finance, young doctors of mathematics and physics and other “rocket scientists” capable of inventing extremely complex, daring and profitable financial schemes. The fund had investors that were the crème de la crème of society. (A hedge fund is a private investment partnership that is NOT subject to strict governmental oversight)

The fund’s operations were conducted in absolute secrecy. Investors who asked questions were told to take their money somewhere else. Nevertheless, despite the minimum initial payment of $10 million frozen for three years, there was a rush to invest and the results appeared to be well up to expectations. After taking 2% for “administrative expenses” and 25% of the profits, the fund was able to offer its shareholders returns of 42.8% in 1995, 40.8% in 1996, and “only” 17.1% in 1997 (the year of the Asian crisis).

But because of the reputation of the managers, big banks continued to lend massive amounts of money to the fund in terms of margin. The banks’ staggering lack of curiosity about the fund’s activities is particularly disturbing in view of the astronomical sums involved. At the beginning of the year, LTCM had capital of $4.8 billion, a portfolio of $200 billion (borrowing capacity in terms of leverage) and derivatives with a notional value of $1,250 billion. But in September, after mistakenly gambling on a convergence in interest rates, it found itself on the verge of bankruptcy.

William J. McDonough, president of the Federal Reserve Bank of New York, (who just announced retirement) called on the cream of the international financial establishment to refloat the fund which was virtually bankrupt. And, in only a few hours, 15 or so American and European institutions (including three French banks) came up with $3.5 billion in return for a 90% share in the fund and a promise that a supervisory board would be established

The CATO institute argues that the intervention also is having more serious long-term consequences: it encourages more calls for the regulation of hedge-fund activity, which may drive such activity further offshore; it implies a major open-ended extension of Federal Reserve responsibilities, without any congressional authorization; it implies a return to the discredited doctrine that the Fed should prevent the failure of large financial firms, which encourages irresponsible risk taking; and it undermines the moral authority of Fed policymakers in their efforts to encourage their counterparts in other countries to persevere with the difficult process of economic liberalization.

Shouldn’t we be able to believe in someone?

In Senate hearings testimony was given by David Tice of David Tice and Associates. He testified that, “an analyst is just a banker who writes reports. No one makes a pretense that it’s independent.” He quotes Sean Ryan, a former banking analyst at Bear Stearns Co. when he explained his reasons for recommending NetBank like this: “I put a buy on it because they paid for it.” Ryan said he told clients that “we just launched coverage on NetBank because they bought it fair and square with two offerings.”

Further, Greg Hymowitz of Entrust Capital, a financial house for wealth investors and a former Goldman Sachs employee. He testified in defending current practice, “Investing is as humbling as golf. Every day is riddled with mistakes. Unfortunately, often the only way to learn in this business is from mistakes and that costs money. Investors have learned a hard lesson: with huge rewards come equally huge risks. The bubble has burst. Investors should not believe everything they read, hear or see.”

Shouldn’t we be able to believe someone? And who would that someone be?