Fed weirdness

Scott Sumner's Money Illusion has a piece commenting (not approvingly) on a speech by St. Louis Fed President James Bullard.  In the speech Bullard (1) argues that Fed monetary policy since 2008 has been nearly optimal (2) and has been superior to that which would have been delivered by a nominal GDP targeting rule (NGDP).  Both points get Sumner's goat as he has been a (maybe the) primary proponent of Market Monetarism and a NGDP targeting rule.  Furthermore Sumner has repeatedly argued that actual Fed policy has been way too tight when compared to the policy that would have been delivered by an NGDP rule.

The first strange thing that jumped out to me from Bullard's presentation is that he cites Michael Woodford's Optimal Monetary Stabilization Policy chapter as a defense of the Fed's performance since 2008.  (Woodford is arguably the world expert on optimal monetary policy.)  Bullard argues that prices have approximately tracked a 2% growth rate since 2008 and that is what is delivered by Woodford's optimal policy rule.  Specifically Bullard presents a graph from Woodford of how prices should behave if the central bank is following optimal monetary policy in response to a shock to the economy.  However beneath the graphs it says response to a transitory cost push shock.  Is Bullard arguing that what hit the economy in 2008 was a cost push shock?  I think most rational people would say that we had a massive demand shock in the form of a collapse in asset values.  I had not read Woodford's paper though so I suspended judgement.

After reading a good chunk of Woodford's paper..no I was right...Bullard is showing optimal response to a cost push shock.  Furthermore if you actually read Woodford's paper you will see that he specifically addresses the case that we currently find ourselves in - with short term interest rates effectively at zero - aka the zero lower bound (ZLB) - as being different.  Yet Bullard is referring to the generic case where the ZLB does not hold and whats more the graph he cites is a supply shock not a demand shock.

Again is Bullard really arguing that what we experienced in 2008 was a supply shock?  If so we would expect to see P spike and Y fall yet we saw P fall even as the Fed was driving rates to zero.  What was this huge supply shock that hit the economy?  He repeatedly refers to the 2007-2008 financial crisis and Reinhart & Rogoff's This Time Is Different for evidence that after a financial crisis economies tend to grow slowly (btw Pres Obama also cited them).  R&R may be correct but that does not mean we had a supply shock.  Did part of the US economies capital stock get destroyed in 2008?  Did we forget how to employ some technologies?  Yes it is possible that credit conditions tightened...but that is more demand side.

Very strange.

Late Note:  I really should read more on optimal policy before commenting...but at risk at venturing into a area which I know little about...Let's assume that Bullard is correct and we are not suffering from a demand shock but a supply shock generated by the 2008 credit crisis.  And lets further assume that it was in fact a transitory supply shock.  He does present a chart of the St. Louis Fed's financial stress index which spiked massively in 2008 - although it still looks high relative to pre-crisis.  Note that assuming a transitory shock is is somewhat contrary to R&R's argument that financial crises take years to unwind - but let's go with it. And further lets assume that we did not immediately go to the ZLB (this is stretching reality).  Then yes the path for prices that did occur looks like the path that would have resulted from an optimal policy regime.  However what does the impulse response (graph) for output versus trend (the output gap) look like under an optimal response to a transitory supply shock?  I will bet it does not look like this

The "intellectual center" in action

Ryan says it would take too long to explain math behind Romney’s tax proposals

"WASHINGTON — Paul Ryan says it would take too long to explain the numbers behind the tax plan that he and Mitt Romney are proposing. The Republican vice presidential nominee says he and Romney want a 20 percent cut in all income tax rates. He says they would pay for those cuts by closing loopholes and deductions.   President Barack Obama and Democrats have hammered Romney and Ryan for refusing to say until after the election which tax loopholes they would close. Ryan told “Fox News Sunday” that “it would take me too long to go through all the math.”  Ryan said he and Romney would start by closing loopholes for higher-income Americans."

Here is the interview.  So his plan is

• an across the board 20% income tax cut.  More on that here.
• but their plan is revenue neutral so unless we rely on the magic Laffer curve we are going to need to cut loopholes / deductions or raise some other taxes.  Rep. Ryan says that they plan to fund it by cutting loopholes - specifically on higher income Americans.
• but he won't tell you which loopholes they are going to cut.

If this is the "intellectual center" of the GOP I would hate to see the outskirts of town.  (Would that be Rick Santorum?)

Btw (here here here) are papers from the Tax Policy Center (Urban Institute + Brookings) looking into what it would take to do a revenue neutral 20% income tax cut.  I have not read through them yet.

But is it money?

( Brother Steve says that I use too many abbreviations.  PDVSA stands for Petróleos de Venezuela, S.A.  It is Venezeula's state oil company.  Venezuela is the world's 5th largest oil exporter and arguably has the world's largest proven oil reserves (see here). )

Here is an article on Venezuelas general level of indebtness and here Morgan Stanley predicts that Venezuela could default on its debts in 2013 due to its precarious financial situation.   Earlier this year the presidents of both Finland and Switzerland wrote to Hugo Chavez requesting that Venezuela pay its debts to a Finnish-Swiss engineering company.  More on Hugo Chavez paying suppliers with debt rather than with money.

So my question is in what ways in Venezuelan debt "money"?  When most people hear the word "money" they think of currency.  But what about bank deposits (aka demand deposits)?  Certainly that is money too?

Economists defines "money" as any object which serves as a (1) a medium of exchange (2) a store of value and (3) unit of account.  Different objects have different degrees of "money-ness" - meaning how well the object fulfills the three requirements of money.  Economists have defined a number of different monetary aggregates ranked in order from most to least money-ness.   The below are taken from here

(1) M0 = currency held by the public

(2) MB (monetary base) = M0 + deposits held on record by the federal reserve for banks.

(3) M1 = currency held outside of banks + demand deposits at banks + travelers checks + other checkable deposits

(4) M2 = M1 + most savings accounts +  money market accounts + retail money market mutual funds, + CDs < 100K USD.

There is also M3, MZM, M4-, M4, and L each including a different group of objects or accounts. Where you set the dividing line for what is an is not money is a bit arbitrary.  It really depends on what you want to measure.

So how well do Venezuelan government bonds fit the three criteria for money?

Are Venezuelan government bonds a medium of exchange?  Can you exchange them directly for goods and services?  Probably nowhere - not even in Venezuela.

Are Venezuelan government bonds a unit of account?  No.  Products are not denominated in Venezuelan government bond units.

Are Venezuelan government bonds a store of value?  This is where US Treasury bills and notes have some claim to being money as they are pretty good store of value.  And if you are afraid of inflation then US government TIPS.  But do Venezuelan government bonds hold their purchasing power?  It depends on what units they are denominated in.  If they are in Venezuelan bolivars then probably not very well.  Venezuela's inflation rate is somewhere between 20% and 30% (here and here) so I guess that depends on what coupon rate they are paying on the bonds.  But I would say no.  If PDVSA is handing out these short term Yankee bonds (ie dollar denominated bonds) then maybe - so long as you are certain that they won't default on you like Morgan Stanley is suggesting they may.

Maybe I should try doing this.  When my next rent bill comes due I will give my landlord a twenty year bond and see how well that works.

The fabric of our lives

In 2010-2011 the price of Cotton surged from 0.70 USD / lb to over 2.20 USD / lb.  At the time the run up in prices was attributed to flooding in Pakistan (world 4th largest producer), poor harvest in China (the worlds largest cotton producer and consumer), supply problems in Greece and Brazil, and India restricting exports to protect their domestic textile mills (see here here here).

When the ICE #2 Cotton contract for March 2011 expired a squeeze ensued.  When a future contract expires the party with the short futures position is obligated to deliver the physical product in return for the final settle price for the futures, and the party with a long futures contract is obligated to pay the final settle price for the futures in return for the physical product.  Each cotton contract is for 50,000 lbs of #2 grade cotton.  As the supply outlook got worse and worse during February 2011 the shorts (who had less supply than they originally expected) had to get out of their contracts by getting a long position.  This bid up the price of the futures and a squeeze was on.

In the spring of 2011 US farmers moved more farmland into cotton production (see here) and prices subsequently fell.  Its not clear that that was the whole cause of the drop though. 

Last week the US cotton industry asked the federal government for help.  The issue revolves around both the supply side (farmers) and the demand side (textile mills) defaulting on contracts - which has led to a breakdown in the forward market for cotton.  When the price of cotton ran up in 2010 farmers who had made previously agreed to supply cotton for around 0.70 USD / lb reneged on their contracts so they could instead deliver into the spot market for 2.20 USD / lb.   Now with prices having collapsed back to near 0.85 USD / lb textile mills in Asia are reneging on contracts that they agreed to during the price spike - and instead are going to the spot market for supply.  Foreign countries appear to be siding with the mills and now the US suppliers are asking the US government to pressure them to enforce contracts.

Also last week the CFTC handed out some of the largest fines for position limit violations that I can recall.  Surprise surprise ...for speculation in cotton during 2010-2011.  Last week the CFTC fined Sheenson Investments Ltd 1.500MM USD, JPMorgan Chase Bank 0.500MM USD, and ANZ Banking Group Ltd 0.350MM USD all for violating cotton position limits in 2010-2011.

How much of the price run-up was due to speculation and how much was due to farm supply versus mill demand?  It does appear that world stocks of cotton were lower at the end of 2010 than they had been since 2003.  And in the 2009-2010 marketing years mill usage was higher than production (which is why stocks fell).  But it also does not appear that stocks were unusually low.  Maybe it was a scare and maybe speculators.  Cotton..The fabric of our lives
 

Kurds on the Way

Reuter's reports the Kurds expect their first oil payment from Baghdad next week.  

"The autonomous region's exports will resume in October at 200,000 barrels per day and continue at that rate until the end of 2012, then rising again, Hawrami told reporters at an energy conference in Istanbul...By 2015, we are looking at 1 million barrels per day. We're on track, regardless of whether exports stop again," he said.....Increased production from Kurdistan, as well as from oilfields further south controlled by Baghdad, in the coming years means that Iraq needs a new pipeline to Turkey to handle combined output that could reach 6 or 7 million barrels per day (bpd), Hawrami said."

6MM bpd would make Iraq the world's fourth largest producer behind Russia (10MM bpd as of 2011), Saudi Arabia (8.8MM bpd) and the US (7.8MM bpd) and well ahead of Iran (4.1MM bpd).   Add to this that an enriched Kurdish region could lead to renewed calls for an autonomous Kurdistan carved out of Turkey, Syria, Iran, and Iraq - and Iran can't be pleased with this development.  Map of Kurdish regions.

IO-Hugo

Reuter's reports Hugo Chavez is now paying suppliers with IOUs.  Why?  Because he needs all of the revenues from PDVSA to fund Venezuela's social programs.  Can you tell that I am not fond of this guy?

PFG Worst

Reuters has an in-depth article about Russell Wasendorf Sr. - the owner of Pergrine Financial Group who stole  ? 200MM USD ? from his customers accounts to fund his own lavish lifestyle.  In my mind this is way way worse than the MF Global blowup.  In the case of MF Global, Jon Corzine's trade showed bad judgement and risk management.  And as MF Global was on its last legs fighting to survive customer funds got co-mingled with house funds.  It is not clear if the co-mingling was intentional or not - but it does not appear to have been deliberately malicious.  But in the PFG case it is clear.  Wasendorf was stealing from his customers and lying to the regulators to cover his tracks.  Perhaps this goes without saying - I don't see anyone coming to Wasendorf's defense.

However nearly as distasteful is the attempt by some members of Congress to use these (and other) financial melt-downs as reasons to attack the CFTC and its SROs.  Both CFTC and NFA are overextended - and underfunded.  And the people it hurts most are those who participate in the futures and derivatives industry.  They may not think it does but it does.  If end-users (read hedgers) don't feel that they are getting a fair, transparent, and safe market then they will not participate.  And if the end-users don't participate then there is no market.  I am not saying that I agree with every rule the CFTC come up with but I certainly do not doubt their sincerity in wanting to keep a fair and orderly market.

For full disclosure:  PFG was once my customer.  I did not like them much and I think we eventually kicked them out.  But I don't really recall why.

What We Need is More Milton Friedman (and Less Ayn Rand)

Matthew O'Brien has an article in the Atlantic commenting on Rep. Paul Ryan's crazy ideas about monetary policy.

 "Back in 2005, Ryan explained that one person informed his thoughts on monetary policy: Ayn Rand. In a great catch by Dave Weigel of Slate, Ryan said that he "always goes back to" Francisco d'Anconia's speech from Atlas Shrugged when he thinks about the Fed. The speech in question consists of a rant against paper money and an ode to gold -- in other words, it's just a hop, skip, and a jump from this to Ryan's championing of a commodity-backed dollar. But even that makes more sense than Ryan's suggestion in a 2010 interview with Ezra Klein that the Fed should raise rates to help the economy."

15% of Ohio Rs are Delusional

15% of Ohio Republicans Say Gov. Romney is More Responsible Than Pres. Obama For Killing Bin Laden

47% of Ohio Republicans are "not sure".  Ok I can at least rationalize the "not sure"s.  Maybe you think Pres. Obama had zero impact on the killing of Bin Laden, and since "equal" is not an option you go with "not sure".  Even that seems like a bit of a stretch but I guess its possible.  I wish there were a follow up essay question for those who answered Gov. Romney was more responsible to explain what his role was.  Original poll is here.

What was the purpose of asking a question like that in an opinion poll?  To demonstrate that 15% of Ohio Republicans are delusional?  Mission accomplished.

Later Note:  ok I guess if you think that Pres. Obama impeded the killing of Bin Laden then Gov. Romney doing nothing could be interpreted as being more "responsible" for killing him.  But by that definition 300MM US citizens would also be more "responsible".

Another Late Note:  I wonder how many delusional folks there are running around in Ohio?   According to the Census Bureau as of Nov 2010 Ohio had a population of 8.6MM of which 5.6MM were registered voters.  According to Gallup 40.5% of Ohioans self identify as either Republican or lean Republican.  (In Ohio you do not declare a party when you register to vote.)  PPP gave a choice of D / R / Independent or Other and 37% selected R so that is pretty close to what Gallup shows.  So that would mean there are approximately 15% * 40.5% *5.6MM = 340,200 delusional Ohioans.  Yeah..having gone to college in Ohio and I could believe that.

More On Merrill Pro Error

BofA Unit Said to Lose Millions on Options Error 
(same story here)

"Bank of America Merrill Lynch on Friday sustained a loss approaching $10 million because of an error handling a controversial type of stock-option trading, according to people with knowledge of the issue.  An operational error within the banking group's Merrill Pro unit was behind the problem, these people said, though clients of the business weren't affected. The error has since been corrected, they said. Bank of America Merrill Lynch is a division of Bank of America Corp. BAC -0.87%   ...The error was seen tied to "dividend trades" that have stirred controversy in the options industry in recent years, according to traders...Trading data released Friday morning indicated that about 24% of the call options on the SPDR ETF weren't exercised, signaling a likely "mistake or clearing error" in processing dividend trades in the contracts, according to Henry Schwartz, president of Trade Alert. "

Was the story of the error in error?

Earlier today a breaking news story came across CNBC's website (the brick red bar across the top of the page) that Merrill Pro had an operational error having to do with un-exercised calls which had cost the firm an estimated $10MM.  There was no link to a story and I no longer see any reference to this story on their site anymore.  Perhaps it was an erroneous report or perhaps we will see more of this story tomorrow.  Fortunately I screen-shot the page at the time.  And there is also a great shot of Rick Santelli turning into the Incredible Hulk.

Which is Worse?

Why is the GOP So Furious With Ben Bernanke?

"Sen. David Vitter, R-La., who supports the Senate version of the Fed-audit legislation, condemned the Fed's actions on Thursday. "Chairman Bernanke and the Federal Open Market Committee are clearly feeling tremendous pressure to bail out the economy because of President Obama's struggle to turn around the jobless numbers," he said in a statement.   "The cost of this open-ended easy money policy dramatically outweighs the short term benefits. The Fed's move today puts us on the fast track to rampant inflation and potentially a return to a world with twenty percent interest rates," he said. "  [underline is mine]

Which would be worse?
(A) he actually believes that QE3 could lead to rampant inflation and 20% interest rates.  In which case he is clearly nuts (see graphs below).
(B) he believes that QE3 could help the economy and thus increase Obama's chance of re-election.  In which case he is willing to sacrifices the public good for potential political gain ala Senate Leader Mitch McConnell

Taylor agrees with Wicksell (kind of)

The Hidden Costs of Monetary Easing - John Taylor & Phil Gramm

Is this an argument against again QE3 or an argument against all discretionary monetary policy in general?  It seems like the latter.

"When the Fed must, in Chairman Ben Bernanke's words, begin "removing liquidity," by selling bonds, the external debt of the federal government will rise and the Treasury will then have to pay interest on that debt to the public. Selling a trillion dollars of Treasury bonds on the market—at the same time the government is running trillion-dollar annual deficits—will drive up interest rates, crowd out private-sector borrowers and impede the recovery...Someday, hopefully next year, the American economy will come back to life. Banks will begin to lend, the money supply will expand, and the velocity of money will rise. Unless the Fed responds by reducing its balance sheet, inflationary pressures will build rapidly.  At that point the cost of our current monetary policy will be all too clear. Like Mr. Obama's stimulus policy, Mr. Bernanke's monetary expansion will ultimately have to be paid for...The Fed softened the recession by its decisive actions during the panic of 2008, but the marginal benefits of its subsequent policy have almost certainly been small. We may find the policies that had little positive impact on the recovery will have high costs indeed when they must be reversed in a full blown expansion."

Agreed.  When the economy starts accelerating, and aggregate demand picks up, inflation may rear its ugly head (for real not imagined) and the Fed will need to tighten.  By raising interest rates the Fed will discourage private investment and consumer borrowing which will act to slow the economy down.  Slowing aggregate demand will act to stem inflation.  No argument.  Why is this anything new?  This is Wicksell 1898.  But there is nothing special about QE3 here.

The inflation hawks seem to consistently skip some important steps in the inflation process.  First high growth in the monetary base (currency + bank reserves ie what the Fed directly affects through open market operations) and reduction in the Fed Funds target rate does not necessarily lead to greater credit expansion.  It only does so if banks see creditworthy customers at the current interest rate - which may not be the case during a major recession.  These are the points made by Stiglitz Weiss and Bernanke Gertler Gilchrist.  Secondly credit only expands if there is demand for funds at any positive interest rate.  This is just Keynes liquidity trap.  Finally credit expansion does not directly lead to inflation.  Rather credit expansion leads to increased aggregate demand which in the absence of increased aggregate supply will lead to inflation.  But so long as there is significant slackness in the economy credit expansion first acts to sop up the excess capacity.  This is just basic supply and demand.

Since the financial meltdown Taylor, Cochrane, Ryan, et al have repeatedly argued that any additional steps by the Fed will lead to a disaster - mostly rampant inflation or the elusive "policy uncertainty".   Here is Rep. Ryan doubling down just last week.  OTOH Keynesians (Krugman and C.Romer) and Market Monetarists (Glasner, Sumner, et al) have argued that the Fed needed to be much more aggressive - and that with so much slackness in the economy there was little concern for inflation in the short term.   Taylor's team has been spectacularly wrong on inflation and the Keynesians and Market Monetarists have been right.  The evidence is pretty clear on this.  Will additional easing have a major impact?  That part is less clear.

Jonesin for a Change in the Jones Act

Oil and the Ghost of 1920

"The Jones Act, known formally as the Merchant Marine Act of 1920, requires that any shipment from one U.S. port to another be carried on vessels built in the U.S., owned by U.S. citizens, and operated by a U.S. crew. The restrictions, in part, reflected Washington's post-World War I desire to have a guaranteed merchant marine..."

I will be honest.  I had never heard of the Merchant Marine Act of 1920 aka the Jones Act before I read this story in the WSJ.

The point of the article is the increased supply of oil coming from Canada and Bakken to the US Gulf Coast is straining our supply of ships to carry wet freight from USGC to the refineries of the Northeast.  Some refiners have moved to using trains to carry oil east.

"John Demopoulos of Argus Media, which tracks pricing, estimates that foreign-flagged carriers could move oil from the Gulf Coast to the Northeast for about 1.20 USD per barrel, compared with 4 USD per barrel on U.S. ships...Already the Northeast refineries are turning to more costly rail transport (sufficient West-East pipelines don't exist)"

This has led to renewed calls to relax the Jones Act.  Is the act pure protectionism which advantages the Marine industry while costing consumers?  or are there real national interests in keeping the act in place.  It seems to me that the restriction that

(1) vessels be built in the US - The argument is that we need a US shipbuilding industry for the military - however the US already produces a "negligible" percentage of the worlds ships.  The world's largest ship producers are South Korea (37.5% 2011), China (33.7%), Japan (17.3%).  This seems like pure protectionism - scrap it.

(2) vessels be owned by US citizens could be revised to force ships moving freight US to US be flagged in the US and thus operate under US laws and taxing authority.

(3) operated by a US crew could be revised to require crew to fall under US labor laws and conditions.  I guess I would not be opposed to restricting employment to persons with US work authorizations - the same conditions for any worker in the US.