There can be no doubt that Greenspan, primarily through his low interest rate policy but also through the negative effects of his various bailouts, was responsible for the housing bubble and therefore the current slump. While the Community Reinvestment Act and the activities of Fannie Mae and Freddie Mac aggravated the crisis, their role was only minor. FULL ARTICLE

Even as Greenspan is condemned and blamed for the economic crisis, not just at the Ludwig von Mises Institute but also at the Ayn Rand Institute, the “libertarian” Cato Institute now rushes to his defense (nor is this the first time Cato praises Fed policy )and argues that Greenspan pursued a “tight” (!?!) monetary policy and so can be credited with low inflation and a dampening of the business cycle.

As for low inflation, I guess that’s true if you define low as lower than under Robert Mugabe or even Arthur Burns. But America’s inflation rate under Greenspan was consistently higher than in almost all other major industrial countries and almost all Fed chairman’s before Arthur Burns. What about dampening the business cycle? That is definitely not true, because first of all certain structural factors unrelated to monetary policy have caused business cycle fluctuations to decline and secondly, as I’ve pointed out before, while Greenspan’s radical 2001 rate cuts probably made the 2001 recession milder than it otherwise would have been, the result of this was pnly to postpone and to further aggravate these problems. The extremely deep downturn America is facing now is a direct result of these rate cuts and as this will be a really deep slump, a and so claiming that Greenspan has “dampened” the business cycle is a bizarro world assertion.
In the report, the Cato authors David Henderson and Jeffrey Hummel, note that by 2006, money supply growth had fallen sharply compared to 2001, regardless of whether your preferred measure of money supply is M1, M2 or MZM. That is true, but that certainly does not somehow prove that Greenspan’s interest rate cuts wasn’t responsible for the bubble. The housing bubble by all measures started in 2001. Before that, the level of house prices, construction activity and mortgage debt was reasonable by historical standards. But then during 2001, house prices and mortgage debt started to suddenly rise above 10%-during a recession when they usually decline. And unusually enough for a recession, residential investments increased. Normally residential investment is the most cyclical component of GDP, falling even more than business investments during slumps. But during the 2001 recession, it actually rose even as business investments slumped. This would clearly suggest that the surge in money supply helped kick start the housing boom. That money supply growth had fallen sharply by 2006 is also very consistent with the link to the housing bubble, since residential investments reached its peak during Q4 2005. Other indicators of the housing bubble such as housing prices and mortgage debt continued to increase a bit longer, but given the lags in monetary policy that is still consistent with the monetary explanation.

They then argues that the fact that many parts of broader money supply measures M2 and MZM lack reserve requirements somehow mean that the Fed can’t control them . That is true in the sense that the Fed doesn’t decide on the exact money supply increases in their meetings. As I’ve explained before, money supply is a residual factor of the interest rate that the Fed sets and the various other factors that affect interest rates. Or more correctly, the other factors that would have affected interest rates if the Fed hadn’t fixed it. Now that the Fed has fixed it, these other factors instead affect money supply. But, by fixing interest rates at a certain level the Fed is ultimately responsible for the increases in the money supply and it could have controlled it if it had targeted it instead of interest rates. Furthermore, during the latter part of the housing bubble, money supply increases arguably understated the Fed’s role. The reason for that is that because the low interest rate set by the Fed caused a downward pressure on the U.S. dollar, foreign central banks that wished to avoid seeing their currencies appreciate relative to the dollar started to buy U.S. securities, and so helped keep down U.S. interest rates without any increase in the U.S. money supply.

Henderson & Hummel then asserts that the Fed does control the monetary base. But while it is true that the Fed could potentially control it -like it could with the overall money supply- the fact is that it doesn’t as long as it is interest rates that they target. The monetary base as they note consist of two components: currency in circulation (paper and metal cash) and bank reserves. They themselves immediately note that the quantity of currency in circulation is determined by domestic and foreign demand for it. And they further note that these days (or more correctly, until mid-September) currency in circulation constitutes more than 90% of the monetary base. But they appear to believe that bank reserves by contrast are, or were, directly determined by the Fed.

But that is simply not true, nor has it been true. And I find it astounding that they and many other professional economists don’t seem to understand the dynamics of how the monetary base was determined. The dynamics of bank reserves have recently changed radically for reasons I explained here, but before this recent upheaval bank reserves were for years basically constantly unchanged at roughly $70 billion. Henderson & Hummel takes this as evidence that the Fed’s interest rate moves mimicked fluctuations in the natural interest rate. Just how Greenspan and his associates could have been so remarkably skillful in predicting movements in the natural interest rate is not made clear, but I guess they figure that Greenspan was the great maestro and so was perfect.

But as I pointed out in a response to a article from Robert Murphy (who is usually a lot more insightful than Henderson & Hummel), bank reserves are not determined by the Fed, and this is especially true after the 1994 reforms they themselves mention that allows banks to “sweep” money from demand deposits (with reserve requirements) to savings deposits and money market funds (without reserve requirements). Instead, above the necessary minimum reserves required by the amount of money that they for various reasons must continue to classify as demand deposits, banks have complete discretion to determine how much reserves they want to hold. And before the upheaval that began in September this year, banks had every reason to minimize reserves to the legally required level. The reason was that they could always count on immediate liquidity infusions from the Fed in the case of a liquidity crisis. Meanwhile, as bank reserves yielded zero, they had strong incentives to recycle all cash infusions into the money markets or into loans. Meaning that the quantity of bank reserves was unaffected of how tight or loose monetary policy was, and so was useless as a indicator of that.

To summarize, the report demonstrate a complete lack of understanding of monetary economics dynamics. So here we have leading self-described libertarian think-tank who hires economists who don’t understand the dynamics of monetary economics and who by their own admission in the report can’t come up with any explanation of the current crisis to produce a report with the purpose of defending a government institution from the allegations that it rather than the free market is responsible for the crisis. Am I the only one who think there is something wrong with this picture?

[Cross-posted at my personal blog]

On LRC today I analyze the role of speculation vs. government policies in causing the high price of oil and other commodities.

Today on LRC I explain why America really is in a recession and has been so since at least November last year despite the seemingly positive growth (Which as I explain really isn’t positive). So if you haven’t already read it, do it now.

Thorsten Polleit argues in case of Misesian apriorism (praxeology) within economics at the this web site. The article has many good points and should for that reason be read, but I have two problems with it.

First of all, it bases the case for praxeology on Kantian epistemology. A better case can be made using Aristotelian/Objectivist epistemology, like Murray Rothbard did, and like I did in my University essay in Theoretical philosophy(not online).

Secondly, in my experience, neoclassical micro economic theory or New Classical or New Keynesian macro economic theory is not particularly empirical. They are at least as aprioristic as praxeology, and in one sense they are in fact even more aprioristic.

While Kantian and Aristotelian/Objectivist Austrians will argue over whether the origin of the praxeological axioms can be viewed as empirical or not, they are certainly empirical in the sense that we do meet them in applied form in our daily experience. I for example act daily, face a scarcity of time and other resources, and face a uncertain future, and thus face opportunity costs in every action I take, but ultimately choose one action based on my assessment of what will be most beneficial for me, and so on.

By contrast, neoclassical micro economic theory is to a large extent completely disconnected from the empirical reality that real people face. Instead, it ludicrously asserts that economic action can be described as functions of differential equations and various other advanced mathematical functions such as Lagrange multipliers and matrix algebra.

These advanced mathematical functions have absolutely nothing to do with the actual economic reality we see, and so will at best once they’ve been translated again into English (or other verbal languages, such as Swedish) simply come to the same conclusions that we already knew before we performed these equations. Often however, these mathematical equations are worse than useless in enhancing economic understanding, they in fact necessitate the adoption of a false description of reality. One example of this is the focus on equilibrium (a focus necessitated by the fact that the first order condition of a Lagrange multiplier is that the partial derivative is zero, which in this context translated into English means that no further economic gains can be made, or in other words that equilibrium is reached), which in turn means that there are no room for one of the key elements of economic reality, namely entrepreneurship.

Thus, while the praxeology of Austrian economics means a aprioristic understanding of actual economic laws, the mathematics of neoclassical economics means a aprioristic understanding of….well, advanced mathematics. But it does not in any way help you gain a deeper understanding of the subject matter economics is supposed to be about, namely the causal relations of real world economic life.

More or less the same thing is true for New Classical macro economics (including Real Business Cycle models) and to a only somewhat lesser extent also New Keynesian macro models.

It is true that non-Austrian economists usually, apart from having substituted real economic theories for mathematics, also do empirical research, in the form of econometric regression analysis. While I completely reject the usefulness of things like Lagrange multipliers in understanding economic reality, I am actually contrary to many other Austrians, open to a limited degree of usefulness of econometrics. The reason is that while praxeology helps us understand the causal connections of real life economic experience, it does not say anything about how applicable different applied phenomena’s are in today’s economic reality. And as the purpose of economics is to help us understand the economic reality we actually face, not just the economic reality we could conceivably face, one must analyze the actual data to see how applicable various causal connections. And econometrics can have a limited degree of usefulness in that task, as long as one is aware of the limitations of econometrics. Namely that first of all, an econometric study is just a local study of a particular data series, not necessarily applicable to other data. For example, during one period of time changes in interest rates may have had a very large impact on investment activity, but during another period of time it will only have a very small impact. Similarly, while a certain causal factor may be very important in one country, it may be of lesser importance in another country. And secondly, one have to take even this local result with a grain of salt, as it is impossible in practice to statistically control for all other conceivable causal factors. Understanding these limitations, econometrics can have a limited usefulness in understanding the relative importance of different causal factors. However, if one does not understand these limitations and try to apply econometric results in radically different contexts then the ones where they were derived, then it could reduce, and not enhance, our understanding of the economic reality we face.

But the point here is that in the distinction of aprioristic versus empirical, Austrian and non-Austrians do not differ in any radical way. Both rely on both aprioristic theory while also performing empirical analysis of actual economic events. The main problem with non-Austrian economics, is that they have substituted actual economic causal relations for mathematical functions, a problem which is greatest in the aprioristic version of non-Austrian economics.

One of the hottest (if not the hottest) intra-Austrian debates today is between what is sometimes referred to as deflationists and inflationists/stagflationists. This is not a policy debate of course, as all Austrians is anti-inflation, but rather a debate about whether the current recession will be associated with deflation or inflation. Examples of deflationists are Frank Shostak, Mike Shedlock and Gary North while examples of stagflationists include me, Antony Mueller and Peter Schiff. The dispute is largely originated in a dispute over the definition of the money supply. I have already dealt with that issue extensively (see for example here, here and here ) so I will not repeat this here. Instead, I will focus on the appeal made by the deflationists to the development of the monetary base, which have been largely stagnant for the latest year.

The implicit or explicit argument from the deflationists appear to be that 1)The Fed controls the monetary base, so it is a good reflection of how tight its policy is 2) The monetary base determines the money supply, so the stagnant monetary base implies a stagnant money supply. Yet both of these assertions are simply wrong, at least given the current financial structure.I have actually once answered the monetary base argument before. At that time I pointed out that more than 90% of the monetary base is made up by what in monetary statistics is called currency in circulation, which is to say paper notes and metal coins held by the public. And I also pointed out that the amount of currency in circulation is determined by public preference for making payments using notes and coins versus making electronic transactions. In the U.S. this is also determined by demand in high inflation third world countries for using dollars as means of payments instead of local currencies. Most likely the stagnant amount of currency in circulation reflects the trend towards a cashless society as well as growing repatriation of previously exported dollar notes and coins due to the distrust of the dollar that the decline in its purchasing power has caused.

I also illustrated that point by pointing out that during the inflationary boom of the 1920s, the monetary base was stagnant. By contrast, the monetary base soared during the deflationary depression of the 1930s, as bank collapses caused people to prefer to hold money in the form of cash instead of deposit money.

However, I now realize that this response was unsatisfactory in one aspect. Namely, because my focus on the currency in circulation part of the monetary base seemed to imply that the other part of the monetary base, bank reserves, do in fact have the characteristics that the deflationists claim. That’s not what I meant, although now I realize that the post was written in a way which could reasonably be interpreted that way. And as I see Robert Murphy write a whole article focusing on bank reserves as a proxy for monetary conditions it is clear that the issue must be addressed. So I will now clarify: bank reserves are in today’s system basically irrelevant too, both as a proxy of Fed policy and of monetary conditions.

The reason is that there really isn’t any demand for bank reserves. To the contrary, banks do everything they can to minimize it because reserves inflict opportunity costs for them in the form of foregone interest income. In the past, banks still felt compelled to keep large reserves because of the risk of bank runs. But with the Fed providing unlimited quantities of liquidity in the case of unexpected increases in withdrawals, this is not an issue anymore. Today, the only thing preventing banks from reducing reserves to zero is formal reserve requirements and the need to have cash available for withdrawals from bank offices and ATMs. But with the banks moving away from deposits with reserve requirements such as demand deposits and instead finance its operations in for example Money Market Mutual Fund accounts (And using so called sweep operations the banks ensure that the level of demand deposits are always minimized even if customers deposit money there) that don’t have any reserve requirements the level of required reserves is declining in importance. And with the increasing use of electronic transactions, cash for customer withdrawals is also becoming less important and is at an absolute level very low. Because of this, bank reserves are increasingly disconnected from the level of money supply.

Indeed, if Robert Murphy had looked more closely at figure 1, he would have seen this point. Bank reserves in early 1990 were $60 billion as compared to $42 billion now. If bank reserves really had been a good proxy for the money supply, then that would have implied a cumulative monetary deflation of 30% during the latest 18 years. The Fed under Greenspan would, if bank reserves were really a good proxy of monetary conditions, have been the ultimate hard money institution, providing more deflationary conditions than a gold standard. Nor do the trends show any correlations with the housing bubble, as it started already in 2001 while the monetary base was flat until 2003. And after a brief upswing in 2003-04 it was basically flat after that. In other words, bank reserves have in today’s system nearly no correlation with monetary conditions.

But if the Fed performs open market operations, won’t that expand bank reserves? Well, no. While it may result in brief spikes, these spikes won’t last as the banks will lend out or invest the money the open market operations produce, either as bank loans or investments in securities. The reason why they are unlikely to keep the money more than a few days is the above mentioned fact that reserves represent opportunity costs and that it is more profitable for the banks to lend/invest. Contrary to what Murphy claimed, it is not the Fed that has moved away reserves from the systems, it is the banks themselves. If you doubt that, just check out the statistics for bank credit, which have soared in recent months.

Because the banks have the opportunity to lend/invest the money they get from the Fed and the incentive to do so, the Fed have almost no control over bank reserves. If they started to impose reserve requirements on all deposits, they could have controlled it, but as it is they don’t. Nor is it a reflection of credit conditions or monetary conditions as bank credit grows at double digit rates.

To summarize, the stagnant monetary base and bank reserves have absolutely nothing to do with interest rate policy, and is instead a reflection of the trend in the payment system to move away from currency in circulation and deposits with formal reserve requirements to deposits without reserve requirements, combined with the Fed’s promise to help all banks with unlimited quantities of liquidity if they need it. The deflationist claim that the Fed is not inflating is not only serious because it implies misleading investment advice, such as staying away from gold and buying treasuries. It is also damaging because it implies that Bernanke is actually mimicking market conditions (something which Murphy actually explicitly wrote in his article), thus effectively destroying all opposition to Bernanke’s inflationary policies. Unwittingly, the deflationists are thus serving Bernanke.

I tried to post this as a reply to the criticism of my criticism of Frank Shostak’s money supply definition that the person calling himself Newson posted under Frank’s most recent article. It strangely disappeared so that’s why it’s posted under a new post (slightly reformulated since it is a new post rather than a comment under a post):

First of all, I am not the only Austrian economist who thinks that Shostak’s definition of the supply of money is too narrow. None other than Murray Rothbard argued for a broader definition, and argued against Shostak’s view that for example savings deposits shouldn’t be considered money.

http://mises.org/rothbard/austrianmoneysupply.pdf

As for Mark Humphrey’s argument (“For example, shares in a money market mutual fund are an investment acquired by the owner in exchange for money.”) about how setting Money Market accounts involve giving up cash, I find that argument to be very strange. Any bank account holding means giving up cash, so that argument would leave us with a ultra-narrow money supply definition where only cash (as in notes and coins) would be money. And the argument about potential losses is also strange considering that 1) such losses virtually never occurs 2) There’s no guarantee that holders of notes and coins won’t lose their money due to physical destruction 3) Even if there was such a distinction it wouldn’t be relevant as there’s nothing about the essentialist definition of money that mentions this issue.

The key factor to consider regarding what is and what isn’t money is whether or not it can be used as a means of payment in a similar manner as cash. If it can-it is money, if it can’t isn’t. That is why MZM is the best definition of money.

As for Eric Lansing’s argument. that claim Shostak’s unspecified definition correlate in some unspecified way better with some unspecified economic indicator without explaining why this unspecified correlation is relevant. Even setting aside the very un-Austrian nature of this argument ( While Shostak and Rothbard (and I) disagrees about how money should be defined, all agree that correlation to some economic aggregate isn’t a valid way to settle the issue), any inductive empirical claim must meet some minimum quality standards that his argument certainly didn’t meet. Including 1) How the variables are defined 2) Why the alleged relationship if real is relevant 3) In what way they correlate and with what timelag 4) Which source back up that claim. If and when Eric or some one else is able to answer that, please return to this debate.

As late as 1999, oil was trading at $10 per barrel and gold at $250 per ounce, down from their nominal peaks in 1980 of $39 and $850 respectively. And that’s not even adjusted for the fact that the value of a dollar was a lot lower in 1999 than in 1980.

Many pundits at the time argued that prices would continue to go down. The Economist had a cover in March 1999 entitled “Drowning in Oil” where it argued that oil would continue to fall well below $10 per oil. And gold was of course deemed a barbarous relic which would continue to fall in price as central banks continued to dump it.

That forecast from The Economist turned out to be one of the worst in economic history — on a par with Irving Fisher’s stock-market forecast in 1929 — because just a few weeks later the price of oil started a new upward trend. As this article is written, gold is trading at over $800 and oil at $95. FULL ARTICLE

Alan Greenspan is in the news a lot currently because of the release of his new book. I haven’t read the book. Nor will I read it if it means that I have to buy it or if reading it means that Alan Greenspan in any other way will financially benefit from it. Enriching a hypocritical fraud like Greenspan goes against my principles.

To see why he is a hypocritical fraud, just see his denial of his guilt in creating first the tech stock bubble and then the housing bubble. First he claims that he tried to prevent the tech stock bubble by raising interest rates, but failed to do so. The truth is that the late 1990s stock rally started in 1995 after the Fed signaled that the wave of rate increases in 1994 was over and might be partially reversed. And partially reverse it did, cutting it from 6% in June 1995 to 5.25% in January 1996. While they did raise to 5.5% in April 1997, they then in the autumn of 1998 started a series of rate cuts, from 5.5% to 4.75%.

And more importantly, the Fed’s role in fueling stock bubbles doesn’t necessarily come through direct rate cuts, but in its direct and indirect role in preventing the increase in interest rates that a free money market would automatically push through in the case of any increase in relative preference for stocks. The double digit growth rates of the MZM and M3 measures of money supply during the late 1990s indicates a strong role of the Fed sponsored monetary system in suppressing interest rates.

He similarly denies his role in the housing bubble by pointing to how long term interest rates did not rise after the rate increases in 2004-2005. This is dishonest for more than one reason. First of all, the housing bubble started already in 2001, when he pushed through rate cuts of an unprecedented magnitude, from 6.5% to 1.75% in a mere year. Secondly, because of the increased popularity of adjustable rate mortgages, short-term interest rates were just as important as long-term interest rates. Thirdly, movements in market interest rates always tend to precede movements in the fed funds rate as market interest rates is really the future average fed funds rate during the duration of the bond.

If really long-term interest rates were determined only by global liquidity, then how come long-term interest rates are only about 1.5% in Japan and 6% in Australia? This is all the more telling given the fact that Japan has a very high budget deficit and a huge public debt, while Australia has a budget surplus and a very small public debt. Clearly, the interest rate differential between Australia and Japan is a result of different expected future central bank interest rates.

And long-term interest rates did in fact rise from 3.3% in June 2003, when the deflation scare made everyone believe interest rates would stay low for long, to 4.7% in June 2004 when the Fed had already signaled the start of a series of rate increases. That long-term interest rates didn’t rise further after that merely reflected that the series of rate increases after that was priced in by the markets.

Why doesn’t any journalist confront Greenspan with these facts? Are they really all that clueless? And why doesn’t anyone confront Greenspan with what he himself wrote about the origin of asset price bubbles back in 1966? Quote from Greenspan’s “Gold and Economic Freedom”:

“When business in the United States underwent a mild contraction in 1927, the Federal Reserve created more paper reserves in the hope of forestalling any possible bank reserve shortage. More disastrous, however, was the Federal Reserve’s attempt to assist Great Britain who had been losing gold to us because the Bank of England refused to allow interest rates to rise when market forces dictated (it was politically unpalatable). The reasoning of the authorities involved was as follows: if the Federal Reserve pumped excessive paper reserves into American banks, interest rates in the United States would fall to a level comparable with those in Great Britain; this would act to stop Britain’s gold loss and avoid the political embarrassment of having to raise interest rates. The “Fed” succeeded; it stopped the gold loss, but it nearly destroyed the economies of the world, in the process. The excess credit which the Fed pumped into the economy spilled over into the stock market-triggering a fantastic speculative boom.”

In case you haven’t already read it, see my analysis of the American health care system which exposes some of the lies of Michael Moore by pointing out that it is far better compared to other countries’ health care systems than he would have you believe and that it’s real shortcomings is due to government intervention.

One myth upheld even by many people who has a basically sound outlook on monetary issues is the view that an inverted yield curve (where short term interest rates are higher than long term interest rates) will cause a recession. It is a well known fact that the yield curve tends to invert just before recession, so therefore many people have concluded that the inversion of the yield curve is a causal factor behind the recession.

The implication of this is that the sharp increase in long-term bond yields (up more than 50 basis points) the last 2½ months is actually bullish for the economy!But why would it cause a recession? Well, because supposedly banks raise funds whose cost is determined by short-term interest rates while the interest rates of their lending is determined by long-term yields. And so, if the yield curve inverts, banks will find it unprofitable to lend, ending credit expansion.

In reality, this picture is for the most part misleading. Most lending to households are in mortgage debt, which is usually financed by the issuing of bonds with the same maturity as the mortgage (In adjustable rate mortgages, it is in short-term debt, but then the interest income for the bank will rise too if short term rates rise) Moreover, banks do not always raise deposit rates by as much as the central bank rate and often they lend with adjustable rates. All of which make the causal recessionary link very weak, at best. And whatever link there is, is likely to be more than overwhelmed by the negative effects that rising long-term interest rates have on mortgage lending, stock prices and other parts of the economy. This makes a rise in long term rates bearish for the economy even if it makes the yield curve slope more positive.

So, if it is not a causal factor, why are recessions usually preceded by an inverted yield curve? This is simply because long term yields are fundamentally determined by future short term interest rates. Otherwise, people could make large arbitrage profits by borrowing with short term interest rates and lending in long term interest rates (or vice versa). And as short term interest rates are at their highest during the cyclical peak, they will be above the cyclical average during those peaks, which in turn means that short term interest rates will be above long term interest rates at those points. However, this assumes that the markets will successfully predict the cyclical peak in interest rates. If they think they have peaked, but inflation and the economy for some reason unexpectedly accelerates, then a recession will not follow an inverted yield curve.

The case of Australia is particularly interesting in this context. The yield curve has been inverted almost all of the time since late 2004. Yet as I reported yesterday, Australia’s economy has not only not slipped into a recession, but is enjoying very strong growth. Of course, this is again mainly a result of the sharp increase in demand for Australian commodities from China. But this is not just a case of a third factor (the commodity boom) preventing the outbreak of a recession. The inverted yield curve is in fact combined with double digit monetary growth, illustrating that an inverted yield curve need not be associated with tight monetary conditions.

In short: an inverted yield curve tends to be associated with recessions because they reflect market expectations of an imminent peak and reversal of central bank interest rate increases. But they are not a causal factor behind recessions (at least not to the extent they reflect lower long term yields) and so rising long term yields are not bullish for the economy.

It seems increasingly clear that we will see a US recession this year. The main reason for this is that the housing bubble that fueled the recovery of the last few years has essentially burst. Yet there are increasing signs that the worst is yet to come. Much of the housing bubble was financed by so-called subprime mortgages, mortgages to people with a low credit rating. Subprime mortgages were encouraged greatly by the government, with the Federal Reserve providing a cheap source of credit and with Bush encouraging it as part of the “ownership society” that he envisioned. FULL ARTICLE

In a previous post I discussed how Robert Samuelsson absurdly tried to attribute the tech stock and housing bubbles to lack of inflation rather than existence of inflation.

Now he seems to have realized how “excess liquidity” (the source of both the tech stock and housing bubbles) was the result of the policies of the Fed and other central banks.

“The concerns over “excess liquidity” stem mainly from the low interest rate policies adopted by the United States, Europe and Japan after 2000. The aim was to avert a deep recession. The Federal Reserve cut its overnight rate to 1 percent; the European Central Bank got down to 2 percent, and the Bank of Japan actually went to zero. With low short-term rates, investors have poured money into longer-term securities with higher interest rates — government bonds, mortgages, “junk” corporate debt, bonds from emerging market countries — and into stocks. Often, these investments are financed by short-term loans at low interest rates.”

When I surfed into the Yahoo News web site Business section, I saw the headline “Bernanke challenged on inflation”. “About time that happened” was my spontaneous reaction, but of course , when I actually read the article, it instead described a rather absurd discussion between Bernanke and top Democrat Barney Frank, where Frank criticized Bernanke for exaggerating the threat of inflation. In other word, the creator of inflation is criticized for considering inflation a threat. Hmmm…….

China again raises reserve requirements of banks . This was the fourth time in just seven months that they did this. If they keep this up, fractional reserve banking might be ended in China soon!

No, not really perhaps, but it is clear that Chinese leaders are increasingly anxious to rein in credit expansion, especially since they’ve also imposed curbs on investments in specific industries, most recently auto manufacturing.

What is curious then is the refusal of the Chinese leadership to significantly accelerate the rate of yuan appreciation. The rate of yuan appreciation have accelerated somewhat, with the yuan rising 2,4% during the latest six months, compared to a 1,5% increase the previous twelve months, but it is still moving too slow. And since the underlying cause of the rapid credit expansion that Chinese leaders are now trying to rein in is the massive build up of foreign exchange reserves, reducing that build up by tolerating a higher yuan exchange rate would have similar effect in reining in credit expansion. And it would also have a lot of other positive effects, such as reducing the cost of oil and other imported goods, reducing the inevitable capital losses from a continued build up of foreign exchange while also reducing the risk of and vulnerability in the case of protectionist legislation in America and elsewhere.

And while it would perhaps reduce growth somewhat in the short term, that is no different from the effects of raised reserve requirements and investment curbs.

In my view, the most important Austrian theory is Austrian business cycle theory (ABCT). Understanding that is of enormous importance in understanding financial market movements and swings in economic growth. But although ABCT (albeit in a perhaps modified form) have gained increasing support in leading institutions and publications such as the Bank of International Settlements and The Economist, most so-called free market advocates refuse to embrace it.

The people benefiting most from that are the socialists. Whether unfair or not, America have in Sweden and other European countries become a symbol of capitalism. Socialists use America as a horror example of how bad things will be without the welfare state (which it in this debate is assumed to lack), while libertarians use America as a role model for how great things will be without the welfare state.

Now that due to Greenspan’s destructive monetary policies, America is heading towards a recession, socialists will use this as “proof” that the welfare state is needed. Had free market advocates embraced ABCT, they would have been able to counter the socialist argument, but now that they don’t embrace ABCT, they will lose the debate. Today on LRC I write on how in a similar fashion, the case for tax cuts in America will seemingly get discredited, because supply-siders refuse to embrace ABCT.

Another example of this is how in Sweden, opponents of the extensive welfare state, are seemingly discredited by the current cyclical boom. Had they embraced ABCT, they would have been able to answer the socialists, but instead they let the socialists win the debates.

Today on LRC, I explain why high taxes makes black market nannies and other black market activities necessary and why the assertion of a statist Christian leader in Sweden that black market activities constitute theft is absurd.

A few days ago, the Federal Reserve released the latest flow of funds report. It shows in short that the imbalances of the U.S. economy are getting worse than before and that the imbalances were worse before than was previously thought.Household debt for the first quarter were upwardly revised from the $11840.1 billion assumed in the previous release to $12099.3 billion. Moreover the report show that debt rose a further 2.27% to $12373.5 billion. That means that household debt reached a record 129.4% of disposable income, up from 128.3% the previous quarter (125.5% with the previous estimate of debt).

You can see in my previous mises.org articles, how the imbalances have steadily gotten progressively worse. When I wrote my first article on U.S. economic imbalances, in November 2004, the debt to income ratio was 114%. In my article on Greenspan, in December 2005 it had risen to 121%. And now it is 129.4% (when Greenspan became Fed chairman it was 77%).

Corporate debt for the first quarter were on the other hand somewhat downwardly revised, to $8468.1 billion from $8557.6 billion. But during the second quarter it rose 1.91% to $8629.7 billion.

Total private sector debt was upwardly revised by $159.7 billion in the first quarter, to $20567.4 billion. It then rose to $21003.2 billion in the second quarter.

“But”, bullish commentators often say, you’re overlooking how household assets are rising too. But first of all, as I’ve said before, as assets ultimately derive their value from national income, they can’t keep rising faster than national income forever and so periods when they increase faster than national income, might just be followed by periods when they fall relative to national income. Debt however, will not fall in value.

And secondly, if we look at the latest numbers, we might just be seeing the start of declining asset values. Household assets for the first quarter was downwardly revised to $65712.5 billion, from the previous estimate of $66029 billion. Meanwhile growth in asset values slowed significantly and increased only 0.5% to 66044.5 billion, almost the same as the previous estimate of first quarter assets. Net worth is therefore actually lower in the second quarter than the previous estimate for the first quarter.

This means that leverage (household debt/household assets) is now at a record high of 19.3%, up from 13.9% as late as in 1999.

What’s more, the entire small increase in household assets came in housing (financial assets actually fell from their downwardly revised first quarter level). And as should be increasingly clear by now, the housing market is doing very badly, and so we should not expect any more value increases there in the short term.

All of this indicates that the U.S. economy is more vulnerable than ever, and that things therefore could get ugly when the next recession comes, which is probably very soon.

Cato Institute senior fellow, Alan Reynolds, who writes pretty good columns on non-monetary issues but who writes terrible columns on monetary issues unfortunately chose to write about monetary issues today, attacking those who “second-guess” the Fed.

In a rather typical fashion for his monetary columns, he goes out of his way to mislead people when he tries to refute those who point out that even so-called core inflation (Setting aside for the moment the issue of the relevance of that concept, not to mention the issue of the justifiability from a libertarian perspective of central banking and inflation-targeting in the first place) have accelerated :“The Fed’s critics make it sound as though the past three months have revealed an enormous spike in “core” inflation (excluding direct energy expenses and, unimportantly, food). On Aug. 2, a Wall Street Journal report said, “The price index for personal consumption expenditures excluding food and energy (PCE) … rose 2.4 percent in June compared with a year earlier, matching the fastest annual rate since 1995.” Comparing the second quarter to the first, that same core PCE index was said to have increased “at a 2.9 percent annual rate, the fastest pace in more than a decade.”…

…In reality, the core PCE index rose at the same 0.2 percent pace in April, May and June, leaving only March “elevated” at 0.3 percent. Monthly increases also averaged 0.2 percent during the first quarter and during the last quarter of 2005.”

But as surely Reynolds must know, the numbers he mentions are rounded . The actual increase was 0.225% in April (from 111.264 to 111.514), 0.23% in March (from 111.514 to 111.571), 0.24% in June (from 111.771 to 112.038). That’s a 3 month increase of 0.7%, which means a annualized increase of 2.8%. Together with the 0.3% increase in March, this means a 4 month increase of 1%, or 3% at an annual rate.

This shows how Reynolds is flat out wrong when he claims that the reason for the acceleration in the 12 month increase is due to low increase 12 months earlier.

“The reason the year-to-year core PCE deflator appeared to increase from 2 percent to 2.4 percent over the past three months had nothing to do with faster inflation this year. It had to do with unusually slow inflation last summer — just 0.1 percent from June to August. That pulled the year-to-year figure down from 2.3 percent in November 2004 to as low as 2 percent for a while, and it made last summer a tough act to beat on any year-to-year comparison.”

Here clearly Reynolds try to make people believe the uptick in the 12 month increase was the fact that the increase in June-August 2005 was so low, but in fact only June have been phased out from the 12 month number.

He later mentions the acceleration of unit labor costs but dissmisses this as a factor. But it’s not just unit labor costs. For example, The Economist’s commodity price index, which Reynolds thought was interesting during a brief period when it had fallen have risen some 28.5% in the 12 months to August 1st, while the dollar have fallen (which will reduce the downward pressure on prices from foreign competition) during the same period. It is therefore a pretty sure bet that consumer price inflation will continue to accelerate in the near future.

The so-called Swedish model has been getting great press lately. In fact, Sweden’s economic boom is wholly artificial. It will have to come to an end, and although the ensuing crisis will likely not be as deep as in the early 1990s, the seemingly impressive Swedish boom will certainly be revealed as a fraud — just as the whole story of the success of the Swedish economic model is a fraud. FULL ARTICLE