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December 16, 2007

The US Economy Causing Confusion
by Gerard Jackson

Bernanke has now cut rates three time in the last three months. Given Bernanke's Keynesian instincts it was always on the cards that he would go for cuts. The real question is how far will he go. Some commentators are urging him to cut rates further. The origin of this dangerous advice comes from the inverted treasury yield curve, with short term rates now at 4.25 per cent as against 4 per cent for long term rates. Now what these people are really saying is that Bernanke should force rates down below 4 per cent.

Interest is a price, and like other prices it is determined by supply and demand. This has led to the egregious view that interest is the price of money. It is not: it is the price of time¹. In an unhampered time market interest rates would be uniform. Hence short term rates would equal long term rates. If the former rose funds would be withdrawn from long term bonds etc and invested in short term funds -- and vice versa -- until rates were once again equalised.

Central banks are the only reason why short term rates are always deviating from long term rates. This brings us back to those who are urging Bernanke to continue cutting rates. In order to keep the yield curve positive the Fed would have to pumping money into the economy. The word for this is inflation. Eventually the economy finds itself sliding into recession and probably facing a negative yield curve -- the very things this monetary policy is supposed to prevent. So what we have here is a recipe for maintaining the boom-bust cycle.

Taking a closer look at the economy we find that the resilience of labour markets -- despite layoffs in building and financial services -- has surprised many analysts and commentators. It shouldn't have. I have been stressing for sometime that during a boom the aggregate demand for labour will continue to rise even when other areas of the economy are shedding labour. It is largely forgotten that during the latter part of the Clinton boom manufacturing suffered a severe contraction even as the unemployment rate continued to fall. The lesson is clear: beware of aggregates.

And speaking of manufacturing, we find that factory orders rose somewhat last month. In addition there has been a rapid increase in productivity. It is important to bear in mind the fact that manufacturing is a reliable harbinger of recession.. (The reason for this is to be found in the nature of interest). In earlier articles I made the point that the falling dollar could prolong the boom by increasing the demand for US goods.

This is now happening: exports are growing at an annual rate of about 15 per cent. It goes without saying that this situation is not sustainable. Nevertheless, while it continues US manufacturing will be stimulated. Considering that the US produces most of its own capital goods it is highly unlikely that these inputs will have a significant effect on costs in the near future. The lesson here is a simple one: keep an eye on manufacturing and commodities.

There is some concern that if oil-producing countries drop the dollar it will collapse and send the economy into recession. Those who sweat over this scenario overlook the fact that ultimately a currency is demanded for its purchasing power. Although there is actually no way that we can calculate purchasing power parity² it should be self-evident that if a country's currency is forced below its PPP this will be reflected in the price of foreign exchange. In short, the increased demand for US products and domestic assets will force the dollar back up until the exchange rate (the price of currency) reaches equilibrium.

Investment advisor Gary Shilling, president of A. Gary Shilling & Company, has publicly argued that the US is already in recession. He is completely out of order here. I suspect this is a case of reading far too much into consumption figures. Without exception, Wall Street types focus on consumer spending. It is argued that Shilling accurately predicted the last recess. So did I but that in itself does not mean my economic thinking was correct. On certain occasions we have all been right for the wrong reasons.

Jim Rogers, co-founder with George Soros of the Quantum Fund, is another one who thinks he has a deep understanding of monetary affairs. So deep in fact that he stated that "Bernanke is an idiot." Moreover, one should invest in China and not US dollars. First and foremost, no one should ever invest -- at least long term -- in any currency. Secondly, Rogers' criticism is a bit rich considering that -- like Bernanke -- he and Soros also subscribe to Keynesian nostrums. Right now China's money supply is expanding at about 20 per cent per annum. This is not good for foreign investors.

Also overlooked is that China has huge twin surpluses, i,e., surpluses on her current and capital accounts. What makes this situation unique is that there is no record of any other country running twin surpluses of such magnitudes and for as long as China has. Perhaps someone should point out to Mr Rogers that these surpluses are a sign of a severe monetary disorder that ties in with the People's Bank of China's dangerously loose monetary policy.

America's currency problems are due to bad economics. So long as central bankers refuse to jettison their faulty theories about the nature of money, interest rates and capital America and the rest of the world will be plagued by recessions and international monetary crises.

¹ Mainstream economic theory argues that the rate of interest is determined by the rate of time preference on one hand and productivity on the other hand. But the mainstream theory would come to the same conclusion.

² Purchasing power theory states that the exchange rate between one currency and another are in equilibrium when their domestic purchasing powers at that rate are equalised. This definition has led economists to commit the error that purchasing power parity is found by dividing the relevant price levels. Chi-Yuen Wu exposed the fallacy of this doctrine.

If the term purchasing power refers to the power of purchasing commodities, which are not only similar in technological composition, but also in the same geographical situation, the theory becomes the classical doctrine of comparative values of moneys in different countries and is a sound doctrine. But unfortunately the term purchasing power in connection with the theory sometimes implies the reciprocal of the general price level in a country. While so interpreted the theory becomes that the equilibrium point for the foreign exchanges is to be found at the quotient between the price levels of the different countries. That is, as we shall see, an erroneous version of the purchasing power parity theory. (Chi-Yuen Wu, An Outline of International Price Theories, George Routledge & Sons LTD, 1939, p. 250).

Gerard Jackson
BrookesNews.Com

Gerard Jackson is Brookes economics editor.

Copyright © 2005-2008 Gerard Jackson

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