...against fictions and other tall tales

Tuesday, 29 March 2011

The Governor of the People's Bank of China discusses Chinese savings and the global trade imbalance

The Banque de France recently published an interesting article by the Governor of the People's Bank of China, Dr. Zhou Xiaochuan, in its Revue de la stabilité financière. The article discusses the causes of high Chinese savings, as well as provides some interesting insight on how to address the current global trade imbalances. It also presents an interesting view of US-China trade dynamics.

The point I found most interesting in the article was Dr Xiaochuan's refutation of the common claim which holds that the increase in US consumer credit was fueled by the high level of Chinese savings. According to the Governor, Chinese savings could not have caused US consumption to increase given that the high consumption in the US commenced in the mid-1990s whereas "the savings ratio of East Asian countries only surged after the Asian financial crisis and China’s savings ratios did not begin to increase until 2002" (p. 168). Dr. Xiaochuan's take on this matter is in line with the point I made here regarding the causes of the high household debt burden in the US.

Wednesday, 23 March 2011

Canada's federal budget: a note on tax cuts, deficit reduction and export growth

Canada's 2011 federal budget was announced yesterday. It includes a number of measures aimed at lowering taxes for individuals and businesses. In a slack economy such as Canada's, tax cuts (especially for individuals) can be helpful from the standpoint of demand and purchasing power because they help move the economy toward a fuller utilization of existing capacity. The problem, however, is that the budget also calls for significant reductions in expenditures as a way for the government to return to a balanced budget by the year 2015. Needless to say, such expenditure cuts would only act to offset (read eliminate) any improvement in aggregate demand achieved through the proposed tax reductions.

The strategy behind the government's plan to return the budget into a balanced or surplus position is reminiscent of the strategy used by the federal government in the early 1990s as part of the deficit reduction initiative that followed the 1990-1991 recession. Take, for instance, the current strategy aimed at eliminating the deficit by reducing program expenditures: this is the famous "program review" of the 1990s all over again. In the 1990s, this strategy seemed to have worked quite successfully given that the federal deficit transformed into a surplus within only a few years. Will it work this time? I'm doubtful of it. Here are a few reasons why.

First, it is important to keep in mind that in the 1990s the US dollar strengthened after President Clinton announced on 19 April 1995 that the US "wants a strong dollar". This change in US exchange rate policy resulted in the rise in the value of the US dollar against other currencies. The ensuing depreciation of the Canadian dollar provided a huge boost to Canada's exports, and helped Canada achieve several years of consecutive current account surpluses. Today, the chance of such a scenario repeating itself is unlikely given that President Obama has publicly pledged to significantly cut the US trade deficit by 2015. To the detriment of Canadian exports, President's Obama's goal is only achievable if the value of the US dollar remains weak against other major currencies. Also, it is important to note that the current large inflow of foreign investments into Canada is contributing to further strengthen the Canadian dollar. This too is jeopardizing the country's export potential.

Second, as discussed in this post, the federal government's success in reducing its deficit and achieving budget surpluses in the late 1990s was in part made possible by the economic growth resulting from the increased indebtedness of Canada's household sector. Today, we are facing a much different situation, as Canadian households are slowly in the process of reducing debt and increasing savings.

Under these circumstances, the only way the federal government can eliminate its deficit is if there is a reversal in the financial positions of the corporate sector and household sector (see chart below). Such a situation would involve the household sector returning to its traditional role of being primary lender to the rest of the economy and the corporate sector resuming its role in fostering growth by increasing its level of investment and activity in the economy.

Friday, 18 March 2011

Was the rise in household indebtedness caused by low interest rates?

One of the most frequently cited explanations for the increased indebtedness in the US prior to the financial crisis has been the easing of monetary policy by the US Federal Reserve following the bursting of the dot.com bubble. Take, for instance, the following comments made by economist John B. Taylor in 2009:
The classic explanation of financial crises is that they are caused by excesses -- frequently monetary excesses -- which lead to a boom and an inevitable bust. This crisis was no different: A housing boom followed by a bust led to defaults, the implosion of mortgages and mortgage-related securities at financial institutions, and resulting financial turmoil. Monetary excesses were the main cause of the boom. The Fed held its target interest rate, especially in 2003-2005, well below known monetary guidelines that say what good policy should be based on historical experience. Keeping interest rates on the track that worked well in the past two decades, rather than keeping rates so low, would have prevented the boom and the bust. (my emphasis)
This explanation makes for a simple, plausible story. However, it completely disregards the fact that the rise in household indebtedness started well before the Fed adopted an easy stance on policy following the bursting of the dot.com bubble. The chart below makes that very clear. As you can see, the level of household financial obligations as a percent of personal disposable income (green line) started its upward trend in the mid-1990s, well before the steady decline in the fed funds rate (blue line) following the 2000-2001 recession.

If anything, it could be argued that the low interest rates actually helped to offset the rising household debt burden and reduce its rate of growth during those years (notice the indebtedness indicator remains fairly stable between 2001 and 2004 when the rate is low). In other words, there is a strong case to be made that, contrary to what mainstream economists have been saying, higher rates would have actually accelerated the increase in the debt burden of households rather than act as a disciplining influence on household spending behavior. Such an outcome would have been much more likely. In fact, this is exactly what occured when the Fed sharply raised its rate starting in 2004 in an attempt to restrict borrowing. As you can see from the chart, the debt burden resumed its upward trajectory following the rate hike. The rise in the debt burden only reversed course once the crisis hit.

A much better explanation for the rise in US household indebtedness is found in this article by economists Reuven Glick and Kevin Lansing of the Federal Reserve Bank of San Francisco. According to Glick and Lansing, it was primarily supply-side factors such as "the greater availability of credit cards and home equity loans, the growth of subprime lending, the spread of exotic mortgage products and other changes that over time served to relax consumer borrowing constraints" rather than low interest rates and other demand-side factors that caused the uptrend in household leverage (p. 3). The authors base their conclusion on the strong correlation between the increase in credit availability and the rise in household debt in the US since the 1960s.*

This explanation appears much more adequate because it enables us to understand why a similar uptrend in household leverage was also noticeable in countries such as Canada where the monetary authorities did not pursue rates as low as the US Fed in the first half of the last decade.

All that being said, the low interest rate environment did present the monetary authorities with a challenge in terms of how best to address the problem of increased household indebtedness. On the one hand, raising interest rates entailed the possibility of increasing the debt burden even more (which is what happened). On the other hand, central bankers' ideological aversion toward regulating the banking industry led to a situation in which the monetary authorities chose to overlook one of the most (if not the most) sensible solution to the problem of rising household indebtedness: establishing more stringent loan standards.

NB: Although they are outside of the direct purview of the monetary authorities, the other policy options available to governments to address the problem of indebtedness in the private sector are to pursue fiscal policy measures aimed at sustaining growth and employment, as well as to make substantial improvement in net export demand (by depreciating the currency or otherwise). For more on these policy options, I recommend the following article by Dimitri Papadimitriou et al: "Is Personal Debt Sustainable", Levy Institute, November 2002.

*The last four paragraphs of this entry were added on March 20, 2011.

Tuesday, 15 March 2011

The proposed American Infrastructure Financing Authority: loan availability isn't the problem, insufficient spending is

In this article, we read that Senator John Kerry is about to introduce legislation that would create a federal financial authority (the American Infrastructure Financing Authority) whose sole purpose would be to provide seed funding for "commercially viable" infrastructure projects. The funding would be provided in the form of loans consisting of no more than 50 percent of the total investment.

In one way, the idea would be a good one if the US economy was riding somewhere mid-point along the business cycle. But the economy is nowhere near such a point. Rather, with real long-term interest rates (i.e. interest rates on inflation-protected bonds*) as low as they are today, the US should simply be borrowing massively and investing the amounts on growth-inducing projects, such as building or improving infrastructure, as well as in areas such as education and energy-efficient technologies.

Also, I want to add a word on this notion that the funds be limited to "commercially viable" projects. Let's not forget that the private sector is rarely compelled to invest in projects resulting in positive externalities (i.e. benefits that everyone can enjoy). Governments, however, are much better positioned to do so given that governments can count as profits these types of widely-shared, collective benefits associated with large, public infrastructure projects.

* Rates on inflation-protected bonds rates are a good measure of the private cost of borrowing to start new businesses or expand existing ones.

Saturday, 12 March 2011

Low national savings are not detrimental to the economy

In this article, economist Daniel Gros will have you believe that Americans should be concerned about the decline in the US national savings rate since the start of the recession. According to Gros, "what matters for a country is not only what households save, but the national savings rate, i.e., the sum of savings of households, the corporate sector and the government". Unfortunately, this is not necessarily always the case. As the subprime crisis and the ensuing recession have taught us, the financial balance of households is a key factor in ensuring a good functioning economy. As we've discussed before (here and here), within a sector, all balances net to zero. Assuming a constant foreign sector balance, the government must spend (by incurring a deficit) in order for the private sector to save, by definition. In other words, government (deficit) spending funds private saving (i.e. the sum of corporate and personal savings). This should be viewed as an "iron law" of national accounting. Therefore, next time you hear about the low US national savings rate, remember that, at the moment, it represents a boon to households and the US economy rather than a sign of fiscal deterioration.

Charts 1 and 2 show that high national savings do not necessarily translate into increased personal savings. For instance, the high US national savings of the mid-to-late 1990s did nothing to improve the personal saving rate at the time. In fact, if you look close enough, you'll notice that the 20-year peak in national savings that occured in 1998 corresponds with a large drop in the personal savings rate.

As for Gros's concern about the possible reaction of international capital markets to the low US national saving rate, my view is that there is little, if any, cause for worry. Chart 3 shows that the large increase in government expenditures (i.e. negative government saving) in recent years has had minimal impact on US interest rates (for instance, on 10-year Treasuries). As explained recently by PIMCO's Paul McCulley in an excellent commentary:
Today, the putative bond market vigilantes are not wrapped around the axle about fiscal deficits in fiat currency countries [...]. Indeed, their sovereign bonds are in great demand at low yields, just as should logically be expected when the developed world private sector is running ever larger financial surpluses. Fiscal deficits are not crowding out private sector borrowing because the private sector doesn’t want to borrow. Rather, fiscal deficits are facilitating the private sector’s desire to save more, delevering their balance sheets. Remember, the government sector’s liability is the private sector’s asset! (PIMCO, July 2010, p. 3) (my emphasis)
I could not have summed it up better.

Chart 1: National Savings (% of GDP), US, 1990-Present

Chart 2: Personal Saving Rate, US, 1990-Present

Chart 3: Net Government Saving and 10-year Treasury, US

Friday, 11 March 2011

US 2010Q4 Flow of Funds Accounts released

One of the more important elements in the US Flow of Funds Accounts is that consumer credit has increased significantly, rising from a negative rate in 2010Q3 to a positive one in 2010Q4. Business credit has also risen, signalling the start of an improved momentum for expansion in the remaining part of the year.

Thursday, 10 March 2011

The US should use its oil reserves to stabilize oil prices

How is the world's largest economy and oil consumer to cope with the current oil supply disruptions resulting from the turmoil in the Middle East? This question is especially important to consider given the significant amount of uncertainty surrounding OPEC's current spare oil production capacity. As a result, reporters and commentators are asking whether the US should tap into its oil reserves to supplement the global supply of crude oil and mitigate the risks associated with unknown oil prices and supplies moving forward.

Would it be a good idea for the US government to use some of its strategic oil reserves? Given the uncertainty regarding the additional spare capacity and the substantial risks associated with higher oil prices moving forward, it would indeed be wise for the US to sell in the market some of the oil it has accumulated in its strategic petroleum reserve (SPR). Not doing so could jeopardize the recently revitalized recovery. More precisely, tapping into the SPR would reduce the risk that the global economy derails into another recession, and it would ensure that the price of oil and its derivatives remain stable until the events in the Middle East subside.

In his book The Keynes Solution (New York: Palgrave, 2009), post-keynesian economist Paul Davidson explains the benefits of using such a policy when the risk of commodity inflation looms. According to Davidson,
...commodity price inflation occurs whenever there is a sudden and unforeseen change in demand or available supply for delivery in the near future [and] can be avoided easily by an institution that is not motivated by self-interest but instead wants to protect society from inflationary pressures. Preventing commodity price inflation requires the government to maintain an inventory of the commodity as a buffer stock to prevent changes in demand and/or supply from inducing significant price movements. A buffer stock is nothing more than some commodity shelf inventory that can be moved into and out of the market to buffer the market from disorderly price disruptions by offsetting previously unforeseen changes in demand or supply as they occur. (p. 69)
Currently, the SPR has a capacity of over 725 million barrels of oil that can be drawn down at a rate of 4.4 million barrels a day. These amounts are more than sufficient to cover the shortage of approximately 1.5 million barrels a day caused by the disruptions in Libyan oil supplies. In fact, it would not even be necessary for the US to replace all of the oil affected by the shortage, as half of that amount would probably be sufficient to return the price of oil to a more reasonable level that is consistent with current growth trends.

Of course, such a strategy would only be temporary since there is no reason to believe that the supply disruptions will be permanent. In 1990 and 1991, during Desert Storm, the US sold some of its reserves to stabilize prices for short periods with great success. The result was that the price of crude oil remained quite stable during that period. A similar strategy should be followed today. The uncertainty surrounding OPEC's oil production capacity represents at this time simply too great a risk to the US and other world economies, including China, a country that stands to be severely affected by any future slowdown in the US and Europe.

From a legal standpoint, the US is fully authorized to use the SPR at this time. In accordance with the Energy Policy and Conservation Act, the SPR can be drawn down if the increase in the price of oil is "likely to cause a major adverse impact on the economy".

On a final note, it is worth mentioning that this policy would actually be profitable to the US government given that the oil would be sold at the ongoing market price. According to the US Department of Energy, the average price paid for the oil in the reserves was $29.76 per gallon.

Tuesday, 8 March 2011

Memories of IS/LM

Here's my first penciled depiction of the diagram made famous by John Hicks. I still like the model's clarity. However, one of its major flaws is it holds that growth-inducing government deficits lead to increases in interest rates. We'll deal with this issue in a later blog entry, but for now, I should specify that the proposition linking government deficits to higher interest rates is not applicable to countries with a fiat monetary system and a floating exchange rate (e.g. US, Canada, Australia, Japan, UK, etc). More precisely, this is the case because the short-term interest rate in these countries is not set by the market: it is under the near-total control of the country's central bank. For more information, I recommend the following article by Bill Mitchell.

Music break 2

Can't think of a better track with the word oil in the title. Thank you Pato Banton.

Monday, 7 March 2011

The economy's financial flows are a closed system

In the previous post, I mentioned that the sectoral balance approach is based on the premise that the government deficit is equal to the private sector's surplus, and vice versa. Just to be clear, this does not mean that we must disregard the inflow and outflow of funds to and from the foreign sector. Quite the contrary, the foreign sector plays a key part in Canada's economy. Take, for instance, the chart below depicting net lending for each sector of the economy since 1990 (double-click on chart to expand). In the chart you can see that the foreign sector supplied significant funds for investment to the Canadian economy in the early 1990s, in 1998, and again starting in 2008. During most of the period between 1996 and 2007 (1998 being the only exception), it was Canadian savings (i.e. government surpluses and corporate savings) that contributed to financing foreign borrowing.

In the chart you can also see the deterioration in the financial position of the household sector since 1992. In the decades prior to 2000, the traditional role of the household sector was to lend funds to the rest of the economy. However, since 2002 the role of primary lender has now been taken over by the corporate sector. The chart also shows that the deterioration in the household sector and the rise in the corporate sector's financial position coincided with the rapid reduction in the government sector's deficit position.

The chart is also useful for showing how the deficit (surplus) of one sector is always offset by at least one other sector's surplus (deficit). Take, for instance, the year 2001. In that year, foreign sector borrowing (net lending deficit) equaled the sum of the government and corporate sector surpluses. A similar situation also occurred in 2003 when the only sector with a surplus (corporate sector) equaled the sum of the net lending deficits of the household and foreign sectors. This also occurred earlier in 1994 and 1995 when government sector borrowing equaled the sum of the net lending surpluses of all the other three sectors. As Statistics Canada explains in this study,
Surplus sectors net lend to other sectors, and deficit sectors net borrow from other sectors...At the economy-wide level, the sectors' net lending or borrowing positions sum to zero - such that all aggregate saving has been allocated to aggregate investment. (p. 6)
So what does this all mean? Well, for starters, it means that government deficits are not always harmful. On the contrary, government deficits can be essential for a healthy economy. In the early 1990s, it was the large government deficits that enabled the household sector to stay in a surplus position while Canada was a net borrower to the foreign sector. Since 2009, Canada has witnessed a similar dynamic: the large government deficit is helping the household sector improve its financial position in the context of an economy facing a massive combined foreign sector and corporate sector surplus.

Sunday, 6 March 2011

Provinces with lowest debt-to-GDP ratios have the most vulnerable household sector

TD Bank recently released an interesting report identifying British Columbia and Alberta as the regions with the most financially vulnerable household sectors in Canada. The assessment is based on a comparison of the household sector in each province or region using standard financial indicators, including the debt-to-income ratio, share of households with a high debt-service ratio, personal savings rate, debt-to-asset ratio and home price-to-income ratio. Among other things, the report highlights that BC and Alberta have household sectors with the highest average debt-to-income and debt-service ratios.

But does TD's assessment give us the full picture? And is it a coincidence that out of the four regions deemed to be most vulnerable in the report, three of these regions also happen to be the provinces with the lowest government net debt in Canada? Probably not. This is especially apparent when you look at the financial situation in each province using a stock-flow consistent approach to macroeconomics.

The sectoral balance approach is useful in this regard because it takes into account the financial status of the various sectors of the economy at the macro level. Based on the insights of economists John Maynard Keynes, Hyman Minsky and Wynne Godley, this approach provides a useful lense for understanding why households in BC and Alberta are now in a precarious financial state.

The sectoral balance approach is based on a simple premise derived from standard double-entry accounting: the government deficit equals the non-government surplus and vice-versa. This means that, assuming no changes in the trade account, government deficits add funds to the private sector (household and corporate sectors combined) while government surpluses do the opposite by removing funds from the private sector.

In the case of BC and Alberta, years of government surpluses have led these provinces to reduce their net debt down to 14.7 and -9.6 percent of GDP respectively (Alberta has a negative net debt or surplus). Given the average provincial net debt currently is over 25 percent, it is clear that, from a sectoral balance standpoint, BC and Alberta are the provinces where government surpluses have gone the furthest in diverting funds away from the private sector.

Also, given that a large portion of the provincial debt is held by foreign investors, the strict policy of retiring public debt has resulted in a significant outflow of funds away from the government sector and the provincial economy as a whole. This outflow of funds means less investment, less public services and reduced purchasing power for households in the face of rising housing costs and decreased lending activity by banks. Considering also that the corporate sector balance in Canada is currently very high, it is easy to understand why the household sector in these provinces are facing difficult times.

The sectoral balance approach also takes into account financial flows entering or leaving the economy. This means that, assuming no changes in the public sector balance, trade deficits decrease the private sector balance while trade surpluses increase it. In the case of Canada, the recent current account deficit has affected the provincial economies in more or less the same way, and the result has been an overall weakening in the financial position of both households and businesses in each province.

To sum up, although there are many factors that affect households' financial position, it is clear that the weakness currently affecting the household sectors in BC and Alberta is in part a consequence of the debt reduction efforts of the BC and Alberta governments in years past. The financial outflows caused by Canada's recent trade deficits and the huge funneling of funds away from households toward Canada's corporate sector have only worsened the situation.*

In a way, it is ironic that the report points to the two provinces Canadians have always been told are models of "sound" public finance (i.e. low government debt). But then again, we should have known better given that double-entry accounting is several hundred years old...

*For more on the sectoral balance approach in the Canadian context, see this excellent article by Marshall Auerback.

Saturday, 5 March 2011

Is inflation always and everywhere...a bad thing?*

It always amazes me how much people fear even the smallest increase in prices. The recent spike in the price of oil has had the effect of elevating this fear to a higher level. But is inflation really that bad? I would tend to disagree given I view inflation in the same way as economist Robert Eisner in his book The Misunderstood Economy: What counts and how to count it (Boston: HBSP, 1994). According to Eisner,
[h]igher prices hurt buyers, but they help sellers. And inflation, it must be understood, is a general increase in prices, an increase in the average of all prices, including wages and salaries...Since for every buyer there must be a seller, there is no prima facie case that moderate inflation in the aggregate, hurts more than it helps. (p.147)
Of course, we all know there are distributive effects associated with unanticipated inflation, when prices and wages and interest rates and people's portfolio (i.e. mix of investments) do not adjust. Under these circumstances, some individuals may benefit while others do not (keeping in mind that, although the distribution of income and of wealth may change, their totals are not affected). However, aside from these distributive effects, there is very little evidence that at low levels inflation acts as an impediment to growth. By the way, this is not a controversial statement only supported by small, fringe segment of the economics profession. It is a view shared by several well-known mainstream economists.

So what is moderate inflation? According to a study by economist Robert Barro, inflation as high as 10 percent has no effect at all on growth ("Inflation and Growth", Review of Federal Bank of St Louis, 1996, vol 78, no. 3). Other studies give a similar result (i.e. in that they fail to identify a statistically reliable effect of inflation on growth). See, for instance, Michael Sarel, "Non-linear effects of inflation on economic growth", IMF Staff Papers, 1996, vol. 43, March.

* The title is a pun based on Milton Friedman's dictum about inflation being "always and everywhere a monetary phenomenon".

PM Harper's Red Tape Commission

Well, I have to hand it to Stephen Harper: the recently created Red Tape Commission is a stroke of genius. Don't get me wrong, I'm probably one of the few people out there (given my particular line of work) who thinks that administrative rules and procedures (i.e. red tape) play a crucial role in ensuring that public funds and government programs are well administered. My comment pertains solely to the political strategy that lurks behind the initiative. Take, for instance, the online consultative portal that's been set up to allow citizens to rant about federal filing "irritants" (that's the actual term used in official communication) and other obscure regulatory requirements that apparently make dealing with the federal government unbearable. Such a forum will no doubt provide the governing party with plenty of fodder for politicians and reporters once the writ is dropped and the campaign is underway. In other words, the commission provides a magnificient platform for cranks and party hacks seeking to vent or share their useless, anecdotal experiences about government "red tape" and other populist views about the federal bureaucracy in general.

All this to say that the initiative is turning out to be a fairly clever use of government resources for political purposes. See for yourself by checking out some of the online submissions that have been posted on the commission's official website. If you're anything like me, you'll probably find most enjoyable (and revealing) the comments about the supposedly onerous filing requirements related to StatsCan surveys...

Keynes's General Theory explained

Post-Keynesian economist, Randall Wray, has authored a fabulous new working paper for the Levy Institute in which he sums up the true significance of Keynes's famous work. In the paper, Wray summarizes the central proposition of the General Theory using a quote from a previous paper he co-wrote with Mathew Forstater:
Entrepreneurs produce what they expect to sell, and there is no reason to presume that the sum of these production decisions is consistent with the full employment level of output either in the short-run or in the long-run.
According to Wray, the proposition applies whether or not there is perfect competition and flexible wages. It holds even when expectations are always fulfilled, and even in a stable environment (p. 7).

The paper also discusses the importance of money in Keynes's framework. In the General Theory, production activities both begin and end with money. As such, the purpose of production for Keynes is money itself. This means that Keynes viewed the General Theory as a monetary theory of production in which money is not neutral. Such an understanding of money is diametrically opposed to the view espoused in mainstream, neoclassical economics in which money is regarded as a simple gimmick used to facilitate transactions between different parties.

The paper is a must read for anyone interested in furthering the public interest and learning about an alternative economic paradigm better suited for addressing the economic problems of the day. It also does an excellent job at explaining the extent to which current mainstream economics is, and will remain, a repositary of failed ideas and a source of inadequate policy prescriptions.

Details about Canada's labour market since the start of the recovery

Interesting charts from StatsCan's most recent Canadian Economic Observer. It looks like full-time job expansion has pretty much stalled since 2008. So much for the "great white Canadian recovery"...But thankfully, the public sector stepped in and picked-up some of the slack by providing additional employment.

Music break 1

All this talk of protest and revolution reminds me of the tune by Brooklyn Funk Essentials "The revolution was postponed because of rain":

Friday, 4 March 2011

Saudi vs. Libyan Oil Production

So how do Libya and Saudi Arabia compare in terms of oil production? Based on recent media headlines, it sounds as though Saudi oil production wouldn't suffice if it became necessary for the Saudis to step in to make up for any possible reduction in the oil supply caused by the geopolitical problems in Libya. But looking at the data, we notice the two countries don't really compare.

According to the US Energy Information Administration, Libya currently only supplies about 1.7 million barrels a day whereas the Saudis supply over 8.5 million barrels daily (see charts 1 and 2). Also, in regard to production capacity, we see the Saudis could supply up to 12 million barrels a day (chart 3). With such a large unused capacity, the Saudis could very well fill the gap potentially created by a shortage in Libya. Thus, it seems unlikely that the world's oil supply will be highly and permanently affected by the current events in the Middle East.

Chart 1

Chart 2

Chart 3

Has QE increased loan activity in the US?

Earlier in the recovery, I recall reading that QE was partly intended to increase bank activity by enabling the monetary base to expand via the "money multiplier", the notion that an increase in bank reserves gets "multiplied" into a larger increase in the broad money supply as banks expand the number of deposits and lending activities. The money multiplier is taught in all macroeconomic intro classes. Well, it might be time to ditch the old "macro 101" textbook. Here's a graph depicting the increase in the monetary base as a result of Fed activity (including QE I and II) since 2006 (red line) and the change in the number of commercial loans in the US (blue line). As you can see, the increase in monetary base is not associated with an increase in bank activity:

Inflation scare hitting grocery stores

So a large Canadian food retailer is set to pass on the recent increase in some food prices to customers? Is this a sign that food prices are out of control? Is now the time to run to the grocery store and stock up on canned goods and bottled water? Well, based on the rate of change in food prices from previous years, it's definitely way too early to say:

Firms investing in machinery and equipment

With Canadian businesses continuing to accumulate huge levels of corporate savings (see chart 1 and 2), it's nice to see the business sector finally getting serious about investing in machinery and equipment. A recent survey by Statistics Canada also shows investment intentions rising in 2011. Also, there's no doubt the strong Canadian dollar has been a big factor in the recent increase in machinery imports.

Debt ratio increasing

Yup, Canada's debt to personal disposable income (second row) has definitely gone up since the early 1990s. It currently stands at approximately 150 percent. Some commentators claim this is normal given that personal net worth is also on the rise (see fifth and seventh row). Hmm...weren't similar comments made in the US before the subprime crisis in 2008? So you know, the rate in the US at the start of the crisis reached 162 percent. At the current rate, Canada could reach that level within 2 years (8 quarters). Another interesting trend shown on this table is the increasing share of real estate as a percentage of disposable income (last row) and the rise in the ratio of financial assets to non-financial assets (row twelve).

Thursday, 3 March 2011

Why is inflation always top priority?

My first entry was supposed to be some sort of greeting, or maybe something about the blog's name. But instead I am going to briefly address an issue that has been nagging at me for a long time: the notion that the Bank of Canada's role is limited to controlling inflation. I was reminded about this earlier this week amidst the usual buzz that occurs before the central bank announces whether or not it is going to change its target for the overnight rate. My own view is that there is something missing when reporters, commentators and experts—including the Bank's governor himself—speak as though the Bank's purpose is solely to keep a lid on consumer prices, period. What about unemployment? Or the state of Canada's manufacturing industry

Well, it turns out that there is indeed something missing from this picture. Normally, to find out more about a government agency's role or mandate, you turn to the list of legislative responsibilities contained in the agency’s enabling statute—in this case the Bank of Canada Act. In the legislation, it so happens that the opening words—the preamble—make it clear that the Bank’s legislated mandate is
to regulate credit and currency and control and protect the external value of the national monetary unit, but to also to mitigate by its influence fluctuations in the general level of production, trade, prices and employment, so far as may be possible within the scope of monetary action, and generally to promote the economic and financial welfare of Canada. (my emphasis)
Now, I think it is safe to say that, in the words of central bankers, slaying inflation is not the only game in town. So why is it that the Bank’s press releases and Mark Carney always focus on the devil of inflation rather than the equally horrible monster that is unemployment, even while the spectre of inflation is nowhere to be seen lately? Sure, the Bank's officials have had talking points handed to them recently about Canada’s low household saving rate and rising level of debt to disposable income. But how genuine are these concerns given that both these trends have existed for years?

Well, apparently, there’s more to it than legislation. The Bank also takes its lead from an inconspicuous, little-known agreement between the Government of Canada and the Bank of Canada that essentially directs the central bank to prioritize inflation-control over other alternative targets. The agreement has been in effect since 1991 and is still at the heart of the Bank’s inflation-targeting framework. Under this regime, the central bank adjusts its interest rate target based on a deviation of actual inflation rates from targets as well as on the output gap (differential between potential output and actual output). In a way, the belief underpinning this strategy is similar to the old Philips curve notion according to which inflation is said to rise if the unemployment rate gets too low. Although it may sound like a decent trade-off, I still have a hunch that under this regime the Bank shows far more concern with controlling inflation rather than to addressing unemployment.

So what is the problem, you might ask? Well, I dunno, how about for starters the fact that there is little evidence that this type of rigid inflation-targeting is effective policy. For instance, economist Pierre Fortin has been saying for years that the Bank has tended to underestimate the size of the output gap, and thus overestimate the risk of inflation. Moreover, it could be argued that the Bank somewhat violated the terms of its agreement with the Government during the 1990s given that inflation was kept below its stated target of two percent during most of that period.

But more importantly, let us keep in mind what this really means. Basically, it signifies that during the last twenty years an agreement reached between a few cabinet ministers and a handful of government officials has been trumping legislation enacted by Parliament. Imagine if the same thing happened in the US? Members of Congress would have a field day interrogating the Fed chairman about his involvement in such an agreement. Of course, such a thing would be most unlikely. But if it occured, it would make the proceedings of the US Senate Committee on Finance well worth watching.