Category Archives: Economics

Living in Never-Never Land

Article review of Living in Never-Never Land, from the Economist, Jan 9, 2003

This article discusses the continuation of consumer spending regardless of the falling stock markets. They offer as a primary reason for this the home refinancing that has been occurring because of low interest rates. Three countries, America, Britain and Australia, have been on quite a binge. In all three countries spending has been partly propped up by rising house prices, which have offset the effect of a decline in equity wealth. Indeed, housing has a bigger impact on spending, because more people own homes than own shares. It has also become easier to turn capital gains into cash by refinancing mortgages or taking out home equity loans.

Falling interest rates have allowed millions of home owners to take out equity and not increase their debt service payments. But how long can this continue? The article points out the concern of an impending increase in interest rates will cause housing prices to fall and leave many home owners with no equity at all. But more to the point, eventually consumer spending based on low home mortgage rates and refinancing is not a long term situation. Hence the title of the article, “living in never-never land.”

One interesting point is that even if house prices don’t fall, the one time cash influx of a refinancing will not be there again, at least for most people. So the shot in the arm that we have been getting in consumer spending may dry up even if the housing market doesn’t burst like a bubble.

My Take: I believe that the housing market will burst like a bubble. The amount of house payment you can afford is basically fixed. If interest rates rise, you will be able to borrow less money for the same payment and therefore people will be able to afford less house on the same salary. So prices will naturally decline. When they start to decline, there could be horrible spiral effect that causes them to keep declining as demand shrinks and it becomes a buyers market. Also, I should mention that those that got in on exceptionally low adjustable rate financing may be very unhappy as adjustments start to take hold.

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.

Mundell-Fleming

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… 😦

Econ Update

After nine years of robust growth, America’s economic bubble burst in 2000. Technology shares plunged in the spring, foretelling a sharp economic slowdown later that year. The Fed, led by Alan Greenspan, slashed interest rates. But the economy failed to pick up and was in recession before the devastating terrorist attacks of September 11th. Its health took another knock in December when Enron”s collapse shook investor confidence.

Yet once again America”s economy defied the pessimists. On the back of strong productivity growth, resilient consumer spending and an upswing in corporate profits, it surged in the first three months of 2002. George Bush”s $42 billion economic-stimulus bill seemingly came too late.

But by the summer of 2002 the recovery seemed to be sputtering. A rash of corporate scandals undermined already weak investor confidence and sent equity markets into turmoil in July. George Bush””s projected $5.6 trillion budget surplus over ten years had almost disappeared. America seemed set for a “double-dip” recession or the onset of deflation, but by December commentators were seeing signs of resilience, though not a strong recovery. To reinvigorate the creaking economy, George Bush reshuffled his economic-policy team and is lobbying for tax cuts worth $670 billion.

Last week

The Dow Jones Industrial Average rose by 3.0%, as investors hoped that President Bush”s proposed tax cuts would spur both equity-buying and the American economy. Markets also cheered a jump in the ISM”S manufacturing index, from 49.2 in November to 54.7 in December. (ISM readings above 50 signal expansion, those below contraction.)

The price of gold hit a six-year high of $356 an ounce, as worries about a looming war in Iraq encouraged investors to seek a safe haven. Oil prices eased on expectations that OPEC will increase production by as much as 1.5m barrels a day to cover the shortfall caused by the strike in Venezuela. The price of West Texas Intermediate slipped to $30.35, from a recent high of $33.65.

Next week

This is a big week in economic news.  Tuesday we get the retail sales numbers and the import and export prices.  Wednesday we get the producers price index (PPI) and Thursday the all important inflation measure of the consumer price index (CPI).  We also get the initial jobless claims and the fed’s beige book on Thursday.  Friday is the trade balance and industrial production.  Lots of great stuff next week.  As you hear of these releases try to gage the market opinion of the information and if it makes a difference.  Some numbers will and some won’t.  The beige book will certainly be interesting reading.