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

[Roland]

"... and descriptive analysis is at times too ambiguous"

Well it shouldn't be. Economics is still a social science.

"...when you seemingly make little effort to listen to some of the things I am telling you"

I'm listening. One problem is that I've read most of the stuff you recommend or repeat anyway.

"But Japan isn't limited by its capacity."

Can we agree that overcapacity reduces demand as there is less incentive for capacity expanding investment ?

"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."

Yes, but I want to know why that is so.

"Well, once the spiral starts it gets built in to price expectations, which exacerbates the problem."

No issue with that.

"Another factor is of course the rising real value of debt"

What do you mean there ? That rise is already in real rates, is it not....

"Remember the real equilibrium rate is negative."

Yup. And I still want to know why it is there. You and eg Krugman always say deflation began for whatever reason, the equilibrium rate is negative for whatever reason...

"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"

It is pretty obvious that once you know that nominal rates can't be below zero and real rates are above the equilibrium rate the only way out is a rise in the level of prices. Again you're running in open doors.

"No. And should deflation start to kick in we know exactly what needs to be done and why."

Like what ? Cut Fed rates to zero ?

"Damn the site is down. The most important piece to read is "Thinking about the liquidity trap", by Krugman (1999).... at pkarchive.org"

Don't know that site but I assume you mean this:

http://web.mit.edu/krugman/www/trioshrt.html

Anyway let me put forward a heretical proposition: If overcapacity is the problem, you always suggest to raise demand. What about reducing capacity ?

[Roland]

Originally posted by 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.

I don't think it's devastating but it's an additional problem. You have various measures for house prices, but they all ahow a roughly 5-7 % rise from the mid 90s accelerating to 7-10 % over the last years. All that with a GDP deflator of usually in the 2-3 % range.

That is not necessarily a problem per se but that rise did not come from an extremely depressed housing market, and the driving force is low interest rates. How do the low rates come about ? The Fed has managed to bring even lower rates down, and the GSEs have eliminated the risk premium from the interest rate by implicit federal guarantee and funny risk management models.

Our DrSpike will cringe at the thinking at this site, but I'd recommend the credit bubble bulletin (don't agree with all in there but a couple of interesting - and often repeated - points about the workings of the financial sector).

http://64.29.208.119/archive_home_com.asp

[DrSpike]

Aha! Success at last. Now I see your reasoning (I would see it immediately if we were talking in models - a social science is still a science) and see exactly why you are wrong.

Overcapacity is annoying. Sure, everything else being equal there is less reason to invest when you already have overcapacity. Fine.

So, say all the law professors in the world snap their fingers simultaneously and overcapacity in Japan is wiped out as a result. Why not say they also make banking reforms........sort out all NPLs etc.......so there are no supply side problems left in this hypothethical economy.

Great you cry, except that of course the real interest rate is still negative, and there is still unemployment, and the deflationary spiral is not broken.

You indicate you do not understand about the role of deflation is raising the real value of existing debt. I apologise for not clarifying this earlier - I thought you understood due to some comments I remembered you making on the US in the 30s. This is a critical strand to understanding the problem. Deflation raises the real value of existing debt in the same way that inflation erodes the value of existing debt. If I borrow £100 from you today and agree to pay back £105 in a years time, the real rate of interest on that loan is 5% - inflation, so inflation redistributes from lenders to borrowers. Deflation works in reverse, making people and firms more indebted in relation to income as prices and wages fall.

When initially wading in to this debate a few years ago I shied away from saying thing like 1) above.......you don't want to get labelled a neanderthal-type Keynesian , and supply side issues sure made the problem worse, and solutions harder.

But the problem (sing along, you all know the words) is still one of lack of incentives to invest and consume with the given real rate of interest and deflationary price expectations. This continues until inflationary expectations are credibly induced.

For what's its worth (even if you understand a little better now I don't see you suddenly agreeing with me now, you have too much at stake here) it's not just me. Every economist under the sun whose voice mattered told the central bank of Japan what to do, and when they stopped denying the problem existed they started following the procedure of trying to induce inflationary expectations. It is ongoing now; it is largely the world macroeconomic outlook that is delaying things.

[DrSpike]

Originally posted by 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.

Things are a little perturbing, both in the US and the UK. "A bubble" is an imprecise term unfortunately (but hey, that doesn't matter cos economics is a social science and hence we can use terms without really knowing what they mean).

Personally I'd take a relatively optimistic view; debt/asset ratios aren't that overblown. Remember the property "bubble" in Japan was far more pronounced that any potential "bubble" in the UK or US today. There are plausible nasty scenarios, and to be sure the overstretched consumer plays a big role in those scenarios. In the absence of any nasty surprises though, the US doesn't need to worry IMO.

[pchang]

I like math

Hey, if you need to break out the calculus, please feel free to do so.

[Colon™]

Dan, I wouldn’t be so sure that the US has become less dependant on oil because “it learned it lesson”. It seems to me that it became less dependant because of a general technological evolution, decreasing intensity globally. I assume this because the US’ economy is a lot more energy intensive than the EU and especially Japan. (see this eurostat tabel)

If you have time-tables of oil-intensity, comparing the US with the EU and Japan, I'd be happy to see them.

DrSpike, you missed my point re Taylor rule, which is that the BOJ seemed to have reacted similarly to changing economic conditions as the Fed does. The reason they cut rates more slowly is because the Japanese economy wasn’t going down the drain as fast. It’s easy to argue in hindsight that the BOJ was too slow to cut rates, but the fact was that the Japanese economy was holding up very well for a couple of years after the stock bubble burst. (not the least because consumption and real estate were strong)

Re real estate, it doesn’t surprise me that debt/asset ratios look good, they often look good in bubbles, as the asset part of ratio is inflated. The issue here is what happens after asset prices deflate because, after all, we live in a world of world of nominal rigidities and because the income/mortgage debt ratio is already at record heights.

[DanS]

Don't have Europe's figures, but attached are the US figures. The "half" figure above was based on oil and natural gas. It's not quite half, as you can see.

[Ned]

Dr. Spike, I am sorry I hadn't looked at this thread earlier. I thought it was about M&A primarily.

I only went back two pages, but, let me say, that I agree with your analysis that deflation is a re-inforcing phenomenon that is caused by high real interest rates that are in turn kept high on a real basis because, as we all know, "nominal interest rates cannot go below zero."

But, is this latter point true - at least with overnight discount rates? Let us assume they could go negative? What would be the adverse consequences, if any?

[el freako]

DanS,

I have data for Europe (indeed the entire OECD) for 1990 and 2000.

Using the slightly different measure of GDP at constant 1996 US prices*/tonnes of oil:

GDP produced per tonne of oil consumed:

United States:
1990: $8,710
2000: $10,350
growth: 1.7% per annum

EU15:
1990: $12,130
2000: $14,650
growth: 1.9% per annum

Japan:
1990: $10,420
2000: $11,760
growth: 1.2% per annum

OECD total:
1990: $10,040
2000: $11,710
growth: 1.5% per annum


*this is derived from the US national accounts for the US and from the relative shares of current GDP converted using PPPs for other countries.

[Colon™]

Dan, it's interesting the intensity dropped precipitiously after the second oil shock in '79. My guess is that the high oil price was a strong incentive to invest in fuel efficiency. And if so, why couldn't the same effect be obtained by raising energy taxes? The govt could separate the revenues from normal expenditures to invest it in

EF, I should have guessed you'd have the data.

Originally posted by Ned
Dr. Spike, I am sorry I hadn't looked at this thread earlier. I thought it was about M&A primarily.

I only went back two pages, but, let me say, that I agree with your analysis that deflation is a re-inforcing phenomenon that is caused by high real interest rates that are in turn kept high on a real basis because, as we all know, "nominal interest rates cannot go below zero."

But, is this latter point true - at least with overnight discount rates? Let us assume they could go negative? What would be the adverse consequences, if any?

Sort of what I am thinking, I don't see why a central bank couldn't lend money paying a fee instead of receiving one. It's not like it can't print the money to finance this.

[DrSpike]

Taylor rule dude: The BOJ screwed up...........that much is clear in hindsight. Not just that the institutional wrangling and buck-passing delayed any potential solutions for long enough for incipient deflation to set in. The Taylor rule isn't really important here, as I said it is in times of unrest that it isn't really that applicable.

Re: real estate you'll have to excuse the debt/asset ratio comment. I was of course referring to debt/income (or sometimes wealth) ratios, otherwise it makes no sense whatsoever, as you rightly said.

Ned: I am glad you agree; just one Lawyer to go. As to your point regarding interest rates remember there are many interest rates in an economy; saying the rate of interest is just a simplification. All rates that matter derive from the rate that the fed sets, which gives it some power over the nominal money supply and hence aggregate demand.

I am not sure what you mean by the last bit. Do you mean what is the situation when nominal rates could be negative (obviously impossible) ? In this case there is no problem. The liquidity trap depends upon the floor to nominal rates making monetary policy ineffective........without the floor there would be no problem, demand would just increase in response to monetary policy as it always does.

[Colon™]

Originally posted by DrSpike
Taylor rule dude: The BOJ screwed up...........that much is clear in hindsight. Not just that the institutional wrangling and buck-passing delayed any potential solutions for long enough for incipient deflation to set in. The Taylor rule isn't really important here, as I said it is in times of unrest that it isn't really that applicable.

How did the BOJ screwed up? They seem to have followed the same strategy as the Fed does now. (namely following the Taylor rule, so I think it does matter)

Re: real estate you'll have to excuse the debt/asset ratio comment. I was of course referring to debt/income (or sometimes wealth) ratios, otherwise it makes no sense whatsoever, as you rightly said.

And? That ratio is at record heights (in the US and the UK), doesn't that make you feel a tiny bit uncomfortable?

I am not sure what you mean by the last bit. Do you mean what is the situation when nominal rates could be negative (obviously impossible) ? In this case there is no problem. The liquidity trap depends upon the floor to nominal rates making monetary policy ineffective........without the floor there would be no problem, demand would just increase in response to monetary policy as it always does.

I think it's quite well possible to have negative nominal rates, the sum that's lend just has to be larger than the sum that's repaid.

[DrSpike]

And the central bank doesn't lend directly. It merely manipulates the rate at borrowers borrow from lenders, and hence manipulates the money supply. Who lends when you have to pay to lend at 0%, and the alternative is holding cash. Not me. But then I am a economist.

[DrSpike]

To reiterate on the Taylor rule point. Policy is not set by just by the Taylor rule, period. The Taylor rule happens to _replicate_ the actual policy for some periods of time (understandably not at the peak and trough of the cycle). As I said it is useful, because it provides some intuition. But the BOJ and the govt did not handle policy well; whether the BOJ followed the Taylor rule isn't relevant.

And apply the Taylor rule to a world of deflation, a world like I have outlined above. Notice anything?

[Roland]

DrSpike:

"Aha! Success at last. Now I see your reasoning"

No you don't. Btw there is no point in turning into a macro textbooks on legs. I fully understand your pov, I just don't share it. No need to explain Adam and Eve to me.

"You indicate you do not understand about the role of deflation is raising the real value of existing debt.... If I borrow £100 from you today and agree to pay back £105 in a years time, the real rate of interest on that loan is 5% - inflation... Deflation works in reverse, making people and firms more indebted in relation to income as prices and wages fall."

I did indicate that I was not sure whether you meant anything but exactly that effect as I said: "What do you mean there ? That rise is already in real rates, is it not...."

How is that different ? The only possible effect depends on how the loan deals are structured wrt interest payments and principal payments, and that is minimal at best.

"This continues until inflationary expectations are credibly induced."

Well, what happens to prices when excess capacity is liquidated ?

"For what's its worth (even if you understand a little better now I don't see you suddenly agreeing with me now, you have too much at stake here) it's not just me."

Look taking this condescending attitude won't get you any brownie points. How about answering my questions: Why did the real rate go that low ? Why did deflation start ? Did the Fed make the same mistakes as the BoJ (and I was referring to the time when the bubble was building, not when it popped) ? What should the Fed do if it looks like deflation gets a grip on the US - do you agree with unorthodox measures like buying all kinds of financial assets, including stocks ? Why did economies recover from deflationary recessions, eg the post WWI recession in the US ?

PS: Where was you article on Japan published ? If it'sn ot online I'll check whether we have it in the library.

PS2: Krugman is sometimes overdoing his liquidity trap thinking. Eg he siad in 1998/99 that the ECB's policy was too tight with the rate at 2.5 % risking a deflation trap, but a year later the eurozone economy was growing at a 3.5-4 % pace. What is your take on this ? Agree with Krugman ?