But in order to be able to contribute whatever it can, the Fed must be able to speak with clarity and credibility.

TO BE NOTED: From Econbrowser:

"The first votes are in

The Federal Reserve can't be entirely pleased with markets' reaction to its announcement on Wednesday of quantitative goals for purchases of long-term assets.

The Fed's objective in this quantitative easing is to move the inflation rate back into positive territory. Let's begin by reviewing the new consumer price index data that were also released on Wednesday by the Bureau of Labor Statistics. These numbers show further modest movement away from a deflationary tendency prior to any actions by the Fed. The seasonally adjusted February CPI was 0.4% higher than in January, which would be a 4.8% annual inflation rate if sustained for a year. Although that's plenty for one month, it nevertheless is still substantially smaller in absolute value than the drops seen in October through December.

Month-to-month percent change (monthly rate) in seasonally adjusted headline CPI. Data source: FRED.

That leaves the seasonally unadjusted CPI just 0.2% above its value from February 2008.

Year-over-year percent change (annual rate) in seasonally unadjusted headline CPI. Data source: FRED.

If we leave out food and energy, the February increase (+0.2% monthly) implies an annual inflation rate of 2.4%,

Month-to-month percent change (monthly rate) in seasonally adjusted core CPI (excludes food and energy). Data source: FRED.

and the year-over-year core inflation rate now stands at 1.8%. Both of these last two numbers are a bit below what I think the Fed should want to see, but they continue to offer comfort that we had been moving away from the deflation threat before the Fed's announcement.

Year-over-year percent change (annual rate) in seasonally unadjusted core CPI (excludes food and energy). Data source: FRED.

In discussing the Fed's announcement of its plan for quantitative easing, I wrote:

What will be the indication that we've done all we can with this tool? I would urge the Fed to be watching the exchange rate and commodity prices quite closely for an indication that the deflation tide has turned.

Exchange rate (euros per dollar). Source: Yahoo Finance.

Percent change in commodity prices between March 17 and March 20

aluminum	+6.4
coffee	+6.8
copper	+4.1
corn	+3.9
cotton	+3.2
gold	+4.0
lead	-1.7
silver	+6.3
tin	-0.4
wheat	-0.4
zinc	+0.3
crude oil	+3.9

That's why I doubt the Fed was pleased to see the dollar fall 5% against the euro last week. The Fed wanted everybody to wake up and notice that deflation is no longer on the table, but it's another thing if markets run off in the other direction fearful that a major inflation is coming. Notwithstanding, the dollar's move at the end of the week only served to undo an appreciation over the first part of the year, an appreciation that may have been unwelcome and unwarranted.

Prices of a number of commodities also zipped up about 5% on the news. Again this is a disturbing development, but again it still leaves the prices of many commodities below where they started the year, as the graph below demonstrates.

Value of prices of assorted commodities relative to value at start of year (Jan 2, 2009 = 100). Data source: WSJ commodity cash prices, via Webstract.

Commodity prices are quite sensitive to the level of real economic activity. If we had been about to repeat a global Great Depression with attendant significant U.S. deflation, maybe $35 oil could be justified. And if the Fed has now successfully communicated that's not going to happen, a commodities rebound might be quite appropriate.

But I think we also have to worry about whether this might be the start of a replay of what we saw a year ago, when excessively expansionary Fed policy provided fuel for commodity price speculation. In January of this year, Fed Chair Ben Bernanke offered this ex post appraisal of the Fed's policy in early 2008:

The [FOMC's] aggressive monetary easing was not without risks. During the early phase of rate reductions, some observers expressed concern that these policy actions would stoke inflation. These concerns intensified as inflation reached high levels in mid-2008, mostly reflecting a surge in the prices of oil and other commodities. The Committee takes its responsibility to ensure price stability extremely seriously, and throughout this period it remained closely attuned to developments in inflation and inflation expectations. However, the Committee also maintained the view that the rapid rise in commodity prices in 2008 primarily reflected sharply increased demand for raw materials in emerging market economies, in combination with constraints on the supply of these materials, rather than general inflationary pressures. Committee members expected that, at some point, global economic growth would moderate, resulting in slower increases in the demand for commodities and a leveling out in their prices--as reflected, for example, in the pattern of futures market prices. As you know, commodity prices peaked during the summer and, rather than leveling out, have actually fallen dramatically with the weakening in global economic activity. As a consequence, overall inflation has already declined significantly and appears likely to moderate further.

Bernanke seemed here to be taking the position that since the Fed got the long run correct-- the end of 2008 brought strong disinflationary pressures and commodity prices collapsed-- it was OK to ignore the commodity price boom of early 2008. I disagree with that assessment. In my opinion, the oil price increase of 2008:H1 was highly destabilizing for the economy and a key factor that turned an economic slowdown into a recession. One of the lessons for monetary policy that we should draw from the recent behavior of real estate and commodity prices is that the Fed can't ignore the consequences of its actions for speculative prices, even if (or perhaps, particularly if) that speculation reflects a basic misreading of fundamentals. If commodity speculators are erroneously about to declare the bull game is back, that in my mind would be a development that would require the Fed to scale back its plans for quantitative easing.

How would I handle that in practice? I think the best strategy is for the Fed to lay all its cards on the table face up, telling everybody exactly what it is hoping to achieve and how it is going to do it. The Fed needs to communicate that it's not going to allow the price level to fall, but it's also not going to allow runaway commodity prices. So why not announce a specific target of, say, 2-3% for headline inflation, which implies a direct commitment that the Fed will become more cautious if it observes a response to its actions of items such as oil and food? This could be accompanied by statements from Fed officials along the lines that they're watching commodity markets and exchange rates closely for an indication that quantitative easing has accomplished all it set out to do.

All this requires acknowledging from the outset that there is only so much the Fed can accomplish in this situation, a premise that in my mind has considerable merit. But in order to be able to contribute whatever it can, the Fed must be able to speak with clarity and credibility.

If the moves we saw in exchange rates and commodity prices this week are the end of the story, then I think all is well. But if they are the beginning of a new trend, the Fed will need to react."

"I like to boil things down to the very basics whenever I am trying to learn something new"

Another marvelous post from Paul Wilmott:

"A friend of mine, you may know him, you certainly know ‘of’ him, has called for the return of a couple of economics Nobel Prizes. It’s Nassim Nicholas Taleb, in case you didn’t know. (I mention his name because it may increase the number of times this blog is read thanks to Google!) I’m not fussed one way or the other whether or not they get to keep their prizes, I don’t really see much difference between their work and that of many of the others awarded the economics Nobel. (Yes, I know, it’s not a proper Nobel, blah, blah, blah, Bank of Sweden, blah, blah, we can take that much as read!) Or even those awarded the prize in other fields. The Nobel Prize for Literature seems to be political (political meaning either greasy pole, or as in politically correct), the Peace Prize is downright perverse, so the Economics Prize is no different for being pointless. In contrast, we probably all respect laureates in medicine, chemistry and physics for mostly decent work that has stood the test of time.( WE ALSO HAVE FEWER OPINIONS ABOUT THESE AWARDS. SCIENTISTS IN THESE FIELDS MIGHT FIND THEM MORE DISTRESSING. )

Economics is a queer subject. I like to boil things down to the very basics( THE CORRECT METHOD ) whenever I am trying to learn something new, doing research or teaching, as the students on the CQF can attest—think of some of my stranger analogies, guys! But this doesn’t work with economics. Starting with a couple of blokes in a cave, one of whom has just invented the wheel, try to imagine the exchanges that take place and how that turns into General Motors. No, it makes my brain hurt. No matter how much red wine I’ve drunk it doesn’t seem to work.

And I’m supposed to be clever. Why am I incapable of understanding economics, a straightforward enough subject that it’s even taught in schools?

My failure led me to think about economists, as opposed to economics, and they’re much easier to figure out. This is how it works. An economist starts with a few axioms, ones that bear a vague similarity to a small part of the human condition under restricted situations and in an idealized world. (You get my drift here?)( I AGREE COMPLETELY ) From those axioms follows a theorem. More often than not this will be a theorem based upon rational behaviour. That theorem gets a name. And that’s the point I identify as being the problem: The jargonizing of complex ideas based upon irrelevant assumptions into an easily used and abused building block on which to build the edifice of nonsense that is modern economics( ECONOMICS HAS ITS USES. BUT POLITICAL ECONOMY IS WHERE THE ACTION REALLY IS ).

Small assumption by small assumption, the economist builds up his theories into useless gibberish. By acceptance of each step he is able to kid himself he is making progress. And that’s why I struggle with economics. It is not mathematics where, barring mistakes, each step is true and indisputable and therefore you can accept it, even forget it, and move on. And others can do the same, using everyone else’s results without question. This you cannot do in a soft science( EVER ). I’ve mentioned this in another blog, beware of anyone talking about ‘results’ in finance or economics, it says more about them and their perception of the world than it does about the subject( I AGREE ).

Not so long ago Alan Greenspan famously said he had found a flaw in the “critical functioning structure that defines how the world works.” “I don't know how significant or permanent it is but I have been very distressed by that fact.” Ohmigod! His naivety and lack of self knowledge is staggering( TRUE ). He has fallen into the same trap as other economists. By believing the theories he has believed the axioms on which they are based. The edifice of nonsense has collapsed on top of one of its builders.

You beautiful, complex, irrational people! Please, promise me that you will continue to violate every axiom and assumption of economics, maybe not all the time, that would be too predictable, but now and then, just so as to keep those pesky economists on their toes!

Greenspan also said that risk models and econometric models are still too simple( OTHER WAY AROUND ). Lord, help us!

Let me tell you a story.

A decade or so ago I was browsing through the library of Imperial College, London, when I happened upon a book called something like “The Treasury’s Model of the UK Economy.” It was about one inch thick and full of difference equations. Seven hundred and seventy of them, one for each of 770 incredibly important economic variables. There was an equation for the rate of inflation, one for the dollar-sterling exchange rate, others for each of the short-term and long-term interest rates, there was the price of fish, etc. etc. (The last one I made up. I hope.) Could that be a good model with reliable forecasts? Consider how many parameters must be needed, every one impossible to measure accurately, every one unstable. I can’t remember whether these were linear or non-linear difference equations, but every undergrad mathematician knows that you can get chaos with a single non-linear difference equation so think of the output you might get from 770. Putting myself in the mind of the Treasury economists I think “Hmm, maybe the results of the model are so bad that we need an extra variable. Yes, that’s it, if we can find the 771st equation then the model will finally be perfect.” No, gentlemen of the Treasury, that is not right. What you want to do is throw away all but the half dozen most important equations and then accept the inevitable, that the results won’t be perfect( TRUE ).

A short distance away on the same shelf was the model of the Venezuelan economy. This was a much thinner book with a mere 160 equations. Again I can imagine the Venezuelan economists saying to each other, “Amigos, one day we too will have as many equations as those British cabrones, no?” No, what you want to do is strip down the 160 equations you’ve got to the most important. In Venezuela maybe it’s just one equation, for the price of oil.

We don’t need more complex economics models. Nor do we need that fourteenth stochastic variable in finance. We need simplicity and robustness( TRUE ). We need to accept that the models of human behaviour will never be perfect( HUMAN AGENCY EXPLANATION ). We need to accept all that, and then build in a nice safety margin in our forecasts, prices and measures of risk( TRUE ).

Happy New Year!"

And to you as well.

"In fact, they are in the nature of swindles. "

Skidelsky on the New Straits Times:

"ECONOMICS, it seems, has very little to tell us about the current economic crisis( TRUE ). Indeed, no less a figure than former United States Federal Reserve chairman Alan Greenspan recently confessed that his entire "intellectual edifice" had been "demolished" by recent events. Scratch around the rubble, however, and one can come up with useful fragments. One of them is called "asymmetric information".

This means that some people know more about some things than other people. Not a very startling insight, perhaps. But apply it to buyers and sellers. Suppose the seller of a product knows more about its quality than the buyer does, or vice-versa. Interesting things happen -- so interesting that the inventors of this idea received Nobel Prizes in economics.

In 1970, George Akerlof published a famous paper called The Market for Lemons. His main example was a used-car market. The buyer doesn't know whether what is being offered is a good car or a "lemon". His best guess is that it is a car of average quality, for which he will pay only the average price.

Because the owner won't be able to get a good price for a good car, he won't place good cars on the market. So the average quality of used cars offered for sale will go down. The lemons squeeze out the oranges.

Another well-known example concerns insurance. This time it is the buyer who knows more than the seller, since the buyer knows his risk behaviour, physical health and so on.

The insurer faces "adverse selection", because he cannot distinguish between good and bad risks. He, therefore, sets an average premium too high for healthy contributors and too low for unhealthy ones. This will drive out the healthy contributors, saddling the insurer with a portfolio of bad risks -- the quick road to bankruptcy.

There are various ways to equalise the information available -- for example, warranties for used cars and medical certificates for insurance. But, since these devices cost money, asymmetric information always leads to worse results than would otherwise occur.

All of this is relevant to financial markets because the "efficient market hypothesis" -- the dominant paradigm in finance -- assumes that everyone has perfect information and, therefore, that all prices express the real value of goods for sale( IT'S A MODEL ).

But any finance professional will tell you that some know more than others, and they earn more, too. Information is king. But just as in used-car and insurance markets, asymmetric information in finance leads to trouble.

A typical "adverse selection" problem arises when banks can't tell the difference between a good and bad investment -- a situation analogous to the insurance market.

The borrower knows the risk is high, but tells the lender it is low( THIS IS FRAUD ). The lender who can't judge the risk goes for investments that promise higher yields. This particular model predicts that banks will over-invest in high-risk, high-yield projects, i.e. asymmetric information lets toxic loans onto the credit market.

Other models use principal/agent behaviour to explain "momentum" (herd behaviour) in financial markets.

Although designed before the current crisis, these models seem to fit current observations rather well: banks lending to entrepreneurs who could never repay, and asset prices changing even if there were no changes in conditions.

But a moment's thought will show why these models cannot explain today's general crisis. They rely on someone getting the better of someone else: the better informed gain, at least in the short-term, at the expense of the worse informed. In fact, they are in the nature of swindles( THAT'S EXACTLY WHAT THEY ARE ). So these models cannot explain a situation in which everyone, or almost everyone, is losing -- or, for that matter, winning -- at the same time.

The theorists of asymmetric information occupy a deviant branch of mainstream economics. They agree with the mainstream that there is perfect information available somewhere out there, including perfect knowledge about how the different parts of the economy fit together.

They differ only in believing that not everyone possesses it. In Akerlof's example, the problem with selling a used car at an efficient price is not that no one knows how likely it is to break down, but rather that the seller knows well how likely it is to break down, and the buyer does not( FRAUD ).

And yet the true problem is that, in the real world, no one is perfectly informed. Those who have better information try to deceive those who have worse( FRAUD ); but they are deceiving themselves that they know more than they do.

If only one person were perfectly informed, there could never be a crisis -- someone would always make the right calls at the right time.

But only God is perfectly informed, and He does not play the stock market.

"The outstanding fact," John Maynard Keynes wrote in his General Theory of Employment, Interest and Money, "is the extreme precariousness of the basis of knowledge on which our estimates of prospective yield have to be made." ( TRUE )

There is no perfect knowledge "out there" about the correct value of assets, because there is no way we can tell what the future will be like( TRUE )

Rather than dealing with asymmetric information, we are dealing with different degrees of no information. Herd behaviour arises, Keynes thought, not from attempts to deceive, but from the fact that, in the face of the unknown, we seek safety( THAT'S THE MAIN POINT. SAFETY ) in numbers. Economics, in other words, must start from the premise of imperfect rather than perfect knowledge. It may then get nearer to explaining why we are where we are today. "

I'm wondering why he assumes that there are no laws concerning business transactions?

"Nonetheless, I’d say that in terms of strict economics it’s wrong. "

Paul Krugman helps me illustrate the difference between Economics and Political Economy. From the NY Times:

"Do we need the middle class?

Kevin Drum writes that

One way or another, there’s really no way for the economy to grow strongly and consistently unless middle-class consumers spend more, and they can’t spend more unless they make more.

This is a widely held view, and I’m as much in favor of a strong middle class as anyone. Nonetheless, I’d say that in terms of strict economics( I AGREE ) it’s wrong. There’s no obvious reason why consumer demand can’t be sustained by the spending of the upper class — $200 dinners and luxury hotels create jobs, the same way that fast food dinners and Motel 6s do. In fact, the prosperity of New York City in the last decade — largely supported off of super-salaried Wall Street types — is a demonstration that you can have an economy sustained by the big spending of the few rather than the modest spending of large numbers of people."

Of course, you know my opinion that a society without a rising Middle Class and decreasing Lower Class is not sustainable. What Krugman gives is an Economic Explanation ( Theoretical, Kantian ), while what I have just given is an explanation in terms of Political economy ( Practical, Existential )

What's The Focus On This Blog Now?

In the future, I plan to focus more on individual pieces of legislation and individual politicians ( national, state, and local ) that support or promote libertarian Democratic ideas. Right now, I'm focusing on three things:

1) The Presidential campaign.

2) Beginning to present a coherent libertarian Democratic agenda.

3) On economic issues, because that's where libertarians will have some major disagreements with our ideas.

I'd also appreciate any information pertaining to legislation and individuals that others come across.