GDP, M&A, EBITDA, P/E, NASDAQ, Econo-thread Part 11

[DrSpike]

Hehe I like you Roland........I think I would enjoy a few beers and some debate with yourself. Sorry I didn't respond earlier; I just got back from teaching a seminar, albeit not one where people had silly ideas about recession and deflation.

Deflation did not set in immediately after the bursting of the bubble; in this you are correct. The BOJ kept interest rates way too high for too long: this started the ball rolling.

I admit defeat on one thing. I can think of no simple way how to explain why Japan's immense fiscal stimulus in the 90s was never going to work without referring to the seminal works in this area. I wasn't b*ll****ting about this being a technical area earlier, it truly is and I'm sure a man of your clear intelligence can realise that sometimes descriptive analysis is insufficient, and laypeople should listen to those whose profession it is to understand such issues.

Ok I lied. I can think of one way, but it might not be clear. Once a deflationary spiral kicks in it feeds upon itself, and you need a massive boost to demand to free the economy. But that isn't enough, as I'll explain in a second. You also need to realise that the element that makes the situation analysis to the laughable liquidity trap ideas is that there is a floor to monetary policy in that nominal interest rates cannot fall below 0. Should the equilibrium real rate (say the rate at which the GDP gap is closed - not quite right, but it'll do for now) given the inflationary/deflationary situation be below this the crucial element is in the beliefs of the consumer sector. The only way to break the cycle is to credibly (this is paramount) commit oneself to a postive inflation target and do whatever it necessary to attain that target. If the BOJ had done this early enough they may have escaped.

Now although the BOJ and the institutional wrangling within Japan was a factor I should point out we know far far more about these things now..........which is part of the reason it should be avoidable in the US.

That's my last shot at this, and it's not great. If you truly want to understand the situation there are some great articles I can refer you to (I even wrote one myself when this problem started to fascinate me in early 2000).

I cringe at the quote you offer in your last post. Fortunately for every dumbass comment made by some economist wannabe I can show you academic articles stating the true state of affairs. However, if truth be told part of the problem is the lack of interest held by experts in communicating their thoughts. Coupled with this is the apparent joy taken (by such individuals as Robert Reich, Lester Thurow, whoever wrote that Dow 32,000 book to name but a few) in peddling rubbish, rubbish that gets read by intelligent people and fills them with dumb ideas.

There are a few great resources out there now for the hobby economist. I suggest you check out Brad DeLong's site, and read everything that Paul Krugman writes in his NYT column, Fortune and Slate (incidentally Krugman has a brutal piece on the Hayek and the Austrian school's views on recession, if I can find it I'll give you a link). Also if you haven't done so already a basic macro text is useful, Mankiw or Blanchard and Fisher's texts are quite accessible. Though we economists are all blind and conventional it remains a fact that with 6 models you can understand the world macroeconomy better than 99% of individuals. These are the basic Keynesian model, IS-LM (this is the jumping off point as well if you want to understand deflationary spirals), AS/AD, Mundell-Fleming, Dornbusch and finally the Solow model.

Phew, long, long posts.

To the Taylor-rule guy, yeah, the Taylor rule is a great first approximation in normal times. Actual policy-making uses many more complex modesl, but the Taylor rule has its heart in the right place. Kinda tricky to apply outside of 'normal' times though.

[Sten Sture]

re: Wayne Angel - at least Bear Stearns has John Ryding (a Brit) on staff to temper the crazy Texan's Wylie Coyote collection of witicisms. As an aside Angel's son is named Wylie - coincidence??


re: Japan vs the USofA - prelude or divergence - Two interesting divergences are employment and non-performing loan realization.

When Japan's economy started contracting and their bubble burst they pursued a policy of adding employment ~70% of the working age populace in 1988 to ~74% in 1992, and held there until this past year. In the US, companies immediately began shedding workers as they had in the early 1990s. This should help the States Utd to reduce overcapacity, improve profitability and repair corporate balance sheets and attract capital much quicker than Japan - provided of course that the small companies, that provide the real strength of American job growth, are able to avoid the disappointing corporate governance issues facing some of the big boys.

US lending institutions have also acted quickly to 'mark-to-market' significant bad loans made during the past decade. While I still believe there is quite a bit more to do in that area, the initial movement contrasts sharply with the abject refusal of Japanese banks to break their affililiation ties and cut off deliquent credit. Leaving underperforming capacity in the pipeline is a recipie for deflation - certainly not what Japan, Inc. needs.

As a market watcher I would put the probability of the US doing a Japan at less than 10%, and am somewhat encouraged by the nascent recovery in the US manufacturing sector and the early process of a return to rational capital market investing.


re: The US budget deficit and its affordability.

I readily admit to el freako that if the US was to consistently borrow funds where the sum of real interest and net borrowing was greater than the growth in real GDP, we would eventually have a problem. However, the affordability of such drastic debt increases would take tens of years to create a situation where the annual interest expense was significant relative to the size of GDP. Current dollar GDP in the States is a little over US$10 trillion and the annual interest expense of government debt is around US$180 billion - a paltry 1.8% of GDP. Easily affordable even at much higher levels.

The chart below shows the level of US debt compared to the GDP, and while the graph is not logrythmic, you can still see that the growth rate of GDP has been in excess of the growth rate in the Govt's debt, and that the recent increases in the deficit are reasonable.

edit: a bit hard to read the chart - sorry - it was Greenspan's idea...

[el freako]

Sten,

Again you are confusing my argument about foreign financing of the US's current account deficit with domestic financing of the US governments budget deficit.
I am talking about the former, not the latter.

In the former case the US's Income payments and transfers already amount to over 25% of total foreign income (from exports, investments etc) and it's current account deficit (borrowing) amounts to a third of it's foreign income.

Applying those figures to the latter example about governmental finance, how worried would you be if the federal government was spending 1/3rd more than it's revenues and the interest on the current debt amounted to a quarter of those revenues.



Good job showing up two important differences between the US and Japan though.

[Sten Sture]

[monte python voice]

Right then, off I go.

[/monte python voice]

it is much more fun to argue about different things!


It will be curious to find out if the capital inflow got waxed to a larger degree than the domestic flows, a la Japan's real estate investments in the states like Pebble Beach and Rockafeller Ctr where the eventual capital outflow was 25% of the inflow... thank you for your business! See you next bubble!

I do not, by the way, think that the foreign capital inflows over the last years will need to be replicated to support US Govt debt levels, the problem may be in the consumer and corporate worlds. Would you agree?

[el freako]

Yes I would agree, there will be a large rise in the net saving of the private sector in the US - this will only partially be offset by the increase in net borrowing by the government.

However this would lead to a largish fall in consumption or investment (hopefully consumption).

If there was no rise in saving then the long-term situation would be dire (and Japan-like).


(Dr Spike will hopefully show me any errors I made in the following...)
I recently did a study of the relationship between net investment as % of net output and the real rise in the capital stock.
There was a very strong correlation (93%) between the share of net investment and the rise in the capital stock (not really surprising).
Using the data I got I obtained a best fit line for the relationship between net investment and the growth in the capital stock.

Now using the same data for the real value of the capital stock I worked out that the rate of capital productivity for the period 1950-2000 (0.4% a year).

Applying that rate of capital productivity to the estimate of capital stock growth I can make a guess at the US's underlying growth rate using estimates of it's net investment - a different method than usually employed (I think, Dr Spike?).

If the US had to finance it's investment itself from it's net (after depreciation) savings - currently 2.5% of net domestic product - then the underlying growth rate would be an alarming 1.2%, even using the average of the net savings rate of 5.5% for the period 1980-2000 the underlying growth rate would be only 2.3%.
It's only with a net savings rate of around 8% that underlying growth would be around the 3.2% average for the last 30 years.
So in order for the US to grow at anything like an acceptable rate it will either have to import lot's of capital - leading to an ever higher indebtedness via the rest of the world - or it will have to increase it's net savings to a level much higher than that seen in the last 20 years (and sustain it there) with the resulting short-term recessionary effects.
I can't see how either of those situations are desirable (although neither is disasterous).

[DrSpike]

I should start by saying I am really impressed at the spare time you guys must put into economics.

Sten Sture are you in investment banking?

Coupla comments. The regression stuff: I'm not sure exactly what you've done or why you've done it (I am too lazy too read all that has gone before we started talking about deflationary spirals ), but remember correlation does not necessarily imply causality. For your regression to be valid the explanatory variables must be truly exogenous and there must be no glaring omitted variables. You should also avoid regressing something on something else of which it is a component. If your regression is time series, (ie regressing investment in period t on some explanatory variables at time t for t=1970-2002 say) then you also need to check for stationarity.

I am not quite clear on what it is you are trying to deduce.

What is for sure is that the dollar will still fall a bit yet, and the current account deficit will contract..........No, I don't know when..........hell, economists have been saying the dollar is overvalued for a long time. Exchange rate forecasting is a mug's game. Scenario 1 is a nice steady decline, giving a nice boost to aggregate demand just as it is needed to offset the probable fall in consumption as savings rates adjust to the new equilibrium. Scenario 2 is a less controlled fall, which could potentially put the fed in a tricky situation. Currencies tend to overshoot (the Dornbusch model mentioned above was the first model to show why), so this isn't out of the question.

However, my personal view is that the correction of this imbalance will not by itself cause any grief in the US. It's spectacularly boring of me not to talk of wondrous recoveries or Japanese style deflationary slumps, but the reality is probably one of treading water for some time, around a year, maybe more. The dollar will fall, not too wildly, and yes, I do think consumption will fall and savings rise over this hypothetical year. Certains areas of the stock market still look a touch overvalued to me - expect further shenanigans there. Outside of the TMT sector more and more investment opportunities will emerge soon though, and I think the US will be growing around about its 'trend' rate in say 18 months time.

My you're in a good mood I hear you cry. Well I'll have to leave on a sombre note. The overstretched consumer may well snap (man that is a cool metaphor, I'm going to use that again). But my biggest fear on your behalf is instability in the oil market in the face of any potential conflict. The dynamics of oil market pricing are complex, characterised by mulitple equilibria, and it may turn out that world demand is not sufficient to 'kick' the market into the high price equilibrium. Hehe Russia is your saviour, lol, how ironic. However the US is soooooooo vulnerable to a negative supply side shock from this quarter it worries me. If the timing is wrong this could be the dollop of sh1t that hits the fan and makes things really bad.

[Sten Sture]

fyi - I am a domestic (US only) bond market portfolio manager - worked with a couple of serious macro guys in the past, but its been a few years, I can be pretty rusty. I get to read the wall street econo stuff for work, luckily the coffee is provided by my firm. I usually stick to the US stuff, but occasionally pick up a guy like Gavyn Davies with Goldman on the Int'l side...

I think Adam Smith is the only poster around here that is 'gainfully' employed as an actual economist; I know with a handle like that who would have thought??


The (small) good news for the US on a potential oil shock, is that the bulk of our imports come from the western hemi, iirc, from old API data. The price would still go wack-o, and the drag would be serious, but supply should be available to get heating oil to Boston in January.

We need to very seriously pursue some alternatives. How about an investment boom in alternative fuels and mass transit? Or at least wool blankets.

[el freako]

Originally posted by DrSpike
I should start by saying I am really impressed at the spare time you guys must put into economics.

Well to quote an ex-landlord I once had who was an actuary

"Jon I do this because it's my job - you do it because you think it's fun???!!!"

Originally posted by DrSpike
It's spectacularly boring of me not to talk of wondrous recoveries or Japanese style deflationary slumps, but the reality is probably one of treading water for some time, around a year, maybe more.

Here I agree with you - I think that the couse of the 'bubble' will more closely follow that of my native Britian's or Sweden experience of a decade ago rather than Japan's.

Originally posted by Sten Sture

The (small) good news for the US on a potential oil shock, is that the bulk of our imports come from the western hemi, iirc, from old API data. The price would still go wack-o, and the drag would be serious, but supply should be available to get heating oil to Boston in January.

Assuming of course that we in europe don't outbid the contract and get the oil shipped to rotterdam instead.

[DrSpike]

Originally posted by Sten Sture
We need to very seriously pursue some alternatives. How about an investment boom in alternative fuels and mass transit?

You have indeed needed to pursue alternatives for some time now; you are easily the economy most dependent on oil, and very prone to oil price shocks. In Europe we were screwed in the 70s, and that weaned us off oil...... a bit.

The price of petrol/oil etc should be made higher than the market clearing price through taxation, to internalise the negative externality. The higher price further provides an incentive to develop other technologies, make more fuel efficient cars and so on. Due to the power and vested interests of the relevant players in the US and the tendency of voters not to like people who suggest their petrol is way too cheap you haven't undergone the changes European economies have, and we are IMO still too dependent.

There is little so damaging as a negative supply side shock. You see policy-makers have a nasty choice:

1) Accommodate the shock (cut rates, and increase AD to return the economy to full employment). We tried this in '73, and took 10 years to recover from the inflationary fallout.

2) Do nothing. We tried this in '79 and withstood a long painful recession. You choose.

[Sten Sture]

Why we haven't used the past decade of low oil prices to build in some use tax increases, it would seem that everyone should support a few pennies a year. Instead, all the political folks were against it. The GOP because it would piss-off the Saudis, hurt the economy and business, and the Dems because it would be a regressive tax on the poor. Insane. We have learned little from the oil embargo. Sure a war in Iraq would have negligible impact on global supply, but the eventual fall of the House of Saud will be an event of an entirely different magnitude.

[Sten Sture]

Originally posted by DrSpike
...you are easily the economy most dependent on oil...

though Japan might be the most prone to a shock since we at least produce some of our petro-heroin.

[DanS]

Wow, this thread exploded!

Last things first, I am highly skeptical about any oil taxes. The pace of technological change with regard to energy production cannot be dictated so easily, even though I readily admit that the pace of change might be hastened by incentives through taxing the true cost.

But, as a challenge, what has Europe gotten for the many billions of petrol taxes it has paid? Is it only "a bit"? I would argue that it received insufficient rewards, with proceeds going to everything but addressing the costs inherent in the energy source.

There's a lot that can be talked about on this subject, but I do note that an oil shock could be withstood by the United States without calamity. Oil, both domestically produced and imported, is about 18 million barrels a day, which represents about 2% of GDP, depending on the price.

Put another way, since 1973, the US has successfully halved its oil consumption/GDP intensity. This indicates that we did learn our lessons, even in the absence of petrol taxes.

What is forgotten often about the 70s and 80s is that it was a series of shocks over 13 years. Nowadays, there are more credible non-OPEC and non-Arab players in the market, as Spike alluded to. Further, most large oil reserves holders (Iraq excepted), realize that oil shocks do not maximize the long-term value of large reserves. That's why they weren't continued! Also, they do not maximize the value of equity holdings in Western equities markets.

Anyway, this continues to be interesting reading.

[Roland]

DrSpike:

"I should start by saying I am really impressed at the spare time you guys must put into economics."

Ecomomic analysis of law, economic constitutional law, central bank law.... all part of the job. Macro is a good part of law studies here, and I've done some semesters of macro. Anyway it is quite pointless to rely on formal qualifications for a discussion on an internet board.

"...read everything that Paul Krugman writes in his NYT column"

Do that. But Krugman is about 2-3 years behind me in realising that the US is in a bubble economy.

"incidentally Krugman has a brutal piece on the Hayek and the Austrian school's views on recession, if I can find it I'll give you a link"

Read that ages ago. What I remember is that he thrashes a brutally misunderstood concept. Which leads me to this - we are much less apart in our views than you may think:

"Should the equilibrium real rate.... be below this the crucial element is in the beliefs of the consumer sector."

Don't share the hip consumer obsession, but let's say this rate is a real 4 %. Inflation is -2 %. Nominal rate at 2 %. Can we agree that there is no problem at this point ? And shouldn't we wonder WHY the real rate for Japan looks to be something close to zero ?

Positive inflation target - how will the BoK get monetary policy to get traction ?

"I should point out we know far far more about these things now..."

Which is why it took economists ages to realise that the US is a bubble economy, and most are still in denial ?

"That's my last shot at this, and it's not great. If you truly want to understand the situation there are some great articles I can refer you to"

Refer me to your article. I assume you've read this boj after the bust assesment here:

http://www.imes.boj.or.jp/english/publication/edps/2000/00-E-12.pdf

Wouldn't you agree that virtually all the errors committed in Japan during the bubble evolved were repeated in the US ?

"Fortunately for every dumbass comment made by some economist wannabe"

Well that wannabe has some econ degree and was at the FOMC. I could point out legions of such dumbasses (don't make me bring up Kudlow ) so I again urge you to rely on arguments rather than on titles.

"Though we economists are all blind and conventional"

I like eg Samuelson's multiplier and accelerator effects analysis but that is old stuff. As someone said economists in the aggregate usually have a marvellous track record as a contrarian indicator.

[DrSpike]

"Ecomomic analysis of law, economic constitutional law, central bank law.... all part of the job. Macro is a good part of law studies here, and I've done some semesters of macro. Anyway it is quite pointless to rely on formal qualifications for a discussion on an internet board."

Well maybe. But surely someone who has spent years studying economics and has worked professionally on the problem being discussed has more insight. I don't want to hide behind titles, and I have tried to persuade through analysis. However, it is hard with the restrictions I am under; this is a technical issue, and descriptive analysis is at times too ambiguous. I am
all for non-economists making an effort to understand the pressing issues of our time, but frankly it grates a little when you seemingly make little effort to listen to some of the things I am telling you, the parts that are not at all subjective.

1) Deflation is the problem. When an economy's production is limited by its capacity to produce — the normal state of affairs — it is important to make sure that scarce resources like capital are used efficiently, put to work where they yield the highest return. But Japan isn't limited by its capacity. It is plagued by chronic insufficiency of demand — that is, consumers and businesses are unwilling to buy as much as the economy is already capable of producing.

This is a fact. Japan knows it, the BOJ knows it and every economist whose opinion is worth anything knows it.

2) Why is there deflation?

Everyone agrees that what is happening in Japan right now is that the saving Japanese residents would want to undertake at full employment exceeds the investment (including net foreign investment) that businesses find profitable. This means, more or less by definition, that the price of current goods in terms of future goods is above its equilibrium level. This is true despite the fact that the nominal interest rate is virtually zero. In a world in which there was no nominal floor to interest rates there is no problem. It is precisely because there is this floor that the adjustment must take place (slowly and debilitatingly)through a fall in prices.

3) Why is deflation a problem?

Well, once the spiral starts it gets built in to price expectations, which exacerbates the problem. This comes out crystal clear in the models I link to below, but is tricky to understand without knowledge of such models. All I can say is a few arguments about consumer delaying spending (and also firms delaying investment - I did not mean earlier to marginalise the corporate sector, I merely highlighted the consumer sector since that is what is keeping the US afloat at the moment).

Another factor is of course the rising real value of debt, a factor discussed at length by Fisher (an economist you seem to like) in regard to the US in the 30s. The underlying problem is the same in Japan now.

4) What to do? The whole point is that monetary policy as conventionally transmitted to the real economy DOES NOT WORK WHEN NOMINAL RATES ARE 0 WITHOUT THE ECONOMY BEING AT A FULL EMPLOYMENT EQUILIBRIUM. Remember the real equilibrium rate is negative.

Fiscal policy can help in the short term, but is not going to right the underlying problem. Of course we live in a world of nominal rigidities and if the authorities had acted soon enough conventional monetary and fiscal policy would have worked. But once deflation had really kicked in radical thinking is required. The ONLY way to solve the underlying problem is to induce inflationary expectations, which means that the price level need no longer fall to return the economy to full employment equilibrium. Again I apologise, this is by no means obvious, and will not be realised without understanding of the relevant models. Until Krugman wrote some pieces in the late 90s this was not understood even by professionals.

"Wouldn't you agree that virtually all the errors committed in Japan during the bubble evolved were repeated in the US ? "

No. And should deflation start to kick in we know exactly what needs to be done and why. There are sets of circumstances that would prove tricky to deal with........hence the positive probability I mentioned earlier.

Some links as promised:

Damn the site is down. The most important piece to read is "Thinking about the liquidity trap", by Krugman (1999). Also good (and slightly less technical) are Japan's Trap and Japan: Still trapped. All of these pieces are in the Japan section at pkarchive.org, which you should check out when the site is working.

Enjoy!

[Wraith]

Quick question (or two)

--"You do not think the US is in a housing bubble ?"

I'd be interested to see more detail on this, if anyone cares to provide it.
Most of all, I'd be interested to know how bad y'all think this bubble is, and when you might expect it to end.

Wraith
"It is better to be vaguely right than precisely wrong."
-- Carr, Wildon