Chart of the week: Eurozone inflation not likely to pick up

Summary: EA inflation remains subdued and below target

What the chart shows: The chart shows euro area (EA) inflation, headline, core (excluding food and energy) and trimmed mean (excludes the fastest and slowest changing items) as twelve-month changes.

Why is the chart important: Ultra-low interest rates and loose central bank policies – including ‘money printing’ in a number of countries – have raised concerns that inflation could take off in the near future. While there almost always is an upward pressure on inflation in modern societies, recent inflation developments and broad money trends (which is a key indicator of future inflation) show that there is little or no risk of a near-term surge in inflation. In the year to June, EA inflation remained below the ECB’s target of ‘below but close to 2%’ for a fifth consecutive month. Moreover, excluding the impact of food and energy, inflation has been below target for five years. As long as EA domestic demand remains weak and even for some time after it has picked up (given the slack in the EA economy), inflation will also remain quiescent.

Despite its problems, QE might be right

John Butler has a great piece in yesterday's City A.M. making the case against central bank interest rate interference. He uses the devastating insights of Ludwig von Mises and Friedrich Hayek to show why central planning cannot work rationally for basic epistemic reasons. His example is of the Soviet shoe industry, constantly providing surfeits of boots in summer and sandals during winter.

Absent a pricing mechanism to match supply and demand, there was invariably either a glut or a shortage. And even when there was a glut, there were plenty of summer shoes, but a shortage of winter boots. By contrast, the largely capitalist West, responding to real price signals in real markets, did a pretty good job at producing, in sufficient quantities, a range of shoes that customers wanted, that fit, that they could afford.

Butler argues that in the significantly more important financial markets, which coordinate plans about saving and investment, together determining the future's capital structure, the same rules apply. We need real prices to convey information and organise society into a rational economic order. He claims the monetary policies of many countries—cutting headline interest rates and buying hundreds of millions of bonds—distort market interest rates (the most important prices in the economy) and thereby drive capital to be used in suboptimal ways.

I think there's a problem with his approach. Going with the title of this post—isn't it possible that the free market interest rate is below zero? German bund yields have fallen below zero several times during the Euro crisis, despite no central bank engaging in any major programme to buy them up. In times with few good investment opportunities, lots of funds (saving rates have boomed during the bust), and lots of worrying risky areas, it makes sense that some safe assets would see crashing rates. Bond yields can fall below zero even in a zero inflation or deflationary environment, but that's not true for many of the myriad interest rates in a modern economy. There is a zero lower bound on most rates, that is, no one would accept a nominal rate less than zero, as they could usually change the money into cash and put it under their mattress. But quantitative easing raises inflation expectations (and inflation), allowing real rates to go below zero, potentially clearing some otherwise stuck markets.

Now this isn't necessarily telling on Butler's argument. It might be that sometimes rates need to fall below zero, potentially justifying inflation above zero, but the QE needed to achieve this inflation distorts markets in general more than it benefits in these cases. Other things being equal, the extra demand from bond purchases means higher prices and lower yields on those bonds, and this would be expected to hit all substitute assets. This seems to hold even if the other effects of extra QE (higher inflation and demand growth (NGDP growth) expectations) work in the other direction, or even exactly balance out the demand effect of QE. Compared to the hypothetical situation where the central bank boosts growth expectations without buying up bonds, assets will be more expensive, or yield less.

Funds will look cheaper to firms than they "actually are" in the sense of their social cost as approximated by the information that would have been contained in the relevant market interest rates. Firms will tie up slightly more productive capital in improving capacity when society as a whole would seem to prefer slightly more devoted to consumption. This mispricing of loanable funds seems like it would have distortionary effects, with the size of the efficiency loss depending on the responsiveness of the supply of deposits and the demand for investment to their prices.

Before this starts to sounds one-sided against QE, there is one (big) consideration to take into account—the extra inflation and demand growth expectations that asset purchases create don't just help some interest rates adjust, but also create the space for a vast number of relative price moves. Labour markets tend not to clear after demand shocks because wages take a long time to adjust downwards. The price of avoiding any interference could be deep, ongoing recessions. So a prudent central banker may need to risk some misallocation of resources into investment if they wish to avoid the probably worse cost of punishing unemployment and slashed living standards.

Allister Heath lays out his Mark Carney wishlist

In a video out this morning, City A.M. editor Allister Heath calls on Mark Carney to bring the Bank of England into the twentieth century by reforming regulation to emphasise greater interaction with the financial sector, opening up its culture to something less dictatorial, and monetary policy to something more like Nominal GDP Targeting or a Productivity Norm.

Welcome Mark Carney, now here's what you need to do

Today Mark Carney becomes the new governor of the Bank of England, gaining oversight not only of UK monetary policy, but also financial regulation, as part of the Bank's newly-expanded responsibilites. When George Osborne revealed he had managed to persuade Carney to take on the role there was great fanfare and excitement. This was firstly because the Canadian economy has performed relatively well through the recession and secondly because Carney has shown himself open to innovations in central banking, though he has not implemented any in his time at the helm of the Bank of Canada.

Carney talked up the benefits of targeting the level of demand in the economy—though only for exceptional times—in a recent speech. And one would expect that the chancellor, for the £870,000 he has agreed to pay Carney, is open to significant change, notwithstanding the insignificance of the minuscule changes he himself made to the BoE's remit in the budget. Put together, these facts give cause for some optimism for someone like me, who supports targeting the level of demand.

So instead of speculating on what the superstar economist actually will do, I will outline the basics of what Mark Carney should—and could do:

I.  Target levels instead of rates—this means bygones are not expected to be treated as bygones, and market actors do not worry about worse-than-expected outcomes because the central bank has committed to sorting them out

II. Target NGDP (demand) instead of inflation—this means supply moves don’t lead to the wrong sorts of tightening or loosening of monetary policy, also means demand is stabilised directly, instead of an arbitrary part of the outcome of demand; stable demand means no recessions caused by nominal factors and no unsustainable booms

III. Target the forecast instead of the outcome—this is what matters for expectations, which are basically all that matters for employment contracts, loan/debt contracts, investment etc. etc. Expectations are the key, so it’s insane to ignore them

IV. Target market, not internal forecasts—set up an NGDP-linked bond, like the RPI-linked bond, and target the spread between the vanilla bond and the linked bond to get an objective idea of where to aim. Guesses where people have skin in the game are systematically better than the relatively costless estimates produced by private consultancies and the Bank’s internal team. But even if they’re wrong it doesn’t matter because expectations are all that count, and the spread between the bonds IS the market expectation. Driving that to a particular point is success, regardless of what happens.

In general the road ahead must be one of rules and discipline, not the translucent discretion of nine unelected barons.They must keep demand steady so we can focus on improving the supply capacity of the economy, and so there is no excuse for fiscal stimulus, with all its flaws. If you still need convincing, read Scott Sumner's 2011 Adam Smith Institute monograph "The Case for NGDP Targeting".

The pain in Spain

Yes, yes, I know that this Keynesian explanation for everything is all the rage at present. If only we artificially pumped up demand then everything would be just tootsie and fruit loops once again. However, hard as it may be for some to understand there really are structural problems in economies as well. For example, Scott Sumner tells us about Spain:

Note that during the depression of the early 1990s (when Spain still had its own currency) their unemployment rate rose from 16% to 24%. I don’t recall if they devalued during that cycle, but they certainly had the ability to devalue. And of course what’s striking about that period is not so much that Spain’s unemployment rate rose by 8 percentage points, but rather that it only fell to 16% at the peak of the previous boom! To say Spain has structural problems with its labor market would be an understatement.

We can see the evidence right there: even in boom times the Spanish unemployment rate was uncomfortably high.

And it isn't just Spain either: most of Southern Europe (which, in this formulation, includes France) is suffering from the same problem and we see a little bit of it here in hte UK. Simply the ever increasing regulation and thus rigidity of the economy means that the "natural" rate of unemployment keeps rising. Ratchet by ratchet with each turn of the business cycle wheel.

This isn't a problem that can be solved by Keynesian means: this is one that calls for reform of the supply side of the economy. All of which is really just a prelude to one of my favourite points about said economy and its structure. Yes, there are most certainly cycles in it and it could well be that certain actions will help smooth out the swings in such cycles. But that isn't the end of the job at all: it's also necessary to look hard at the underlying structure and to see whether there are, perhaps as a result of our smoothing exercises, structural problems that also need resolution.

Globalization drives cultural diversity

Donald Boudreaux recently reposted this 2010 essay on the impact of globalization on culture. Globalization is not about 'just stuff', he says, it's about increasing diversity by allowing different parts of different cultures to mix:

A century ago, there were no internationally franchised restaurants in Paris, France or, for that matter, in Paris, Texas. A century ago, residents of neither Omaha, Nebraska nor Birmingham, England could find sushi restaurants near their homes; today, sushi restaurants are all over the Western world. A century ago, blue jeans were not the international fashion that they are today. A century ago, the typical man's business suit worn by New York lawyers and London bankers was not widely worn in Africa and Asia, as it is today. In many ways, global commerce has indeed made the world more homogeneous.

But look more closely. While the differences between Paris, France and Paris, Texas are fewer than they were in the past, the cultural richness of each of these places today is far greater than it was just a few years ago. For a resident of Paris, Texas, circa 2010, the richness of the cultural smorgasbord available to him or her right at home is vast. A Texan can stay in town and dine on Vietnamese, Italian, or Greek food—or on barbeque. A Texan can listen to German symphonic music or medieval chants or Irish dance music or Edith Piaf—or country and western. A Texan can buy French neckties, English raincoats, and Italian scarves—and cowboy boots. Likewise a Parisian can choose croissants or New-York-style bagels. A mere century ago—even thirty years ago—the cultural diversity of both places was much less than it is today.

It's easy to be annoyed at the 'touristification' of a place like Thailand, but what that really means is more people get to experience somewhere they would only be able to imagine visiting fifty years ago. Perhaps it's no coincidence that this complaint usually comes from the people who can most easily afford foreign holidays and expensive exotic meals in their home cities. I'm tempted to say that they should check their privilege.

Boudreaux's piece is worth reading in full.

The rise and fall of the Gold Standard

George Selgin, prominent monetary theorist and blogger at Freebanking.org, who recently gave an excellent talk at the ASI on "good deflation", wrote a history of the gold standard in the USA, explaining that there is no one narrative or theme throughout the history, with the fortunes of gold rising and falling with the times. While he pokes holes in some of the common garden arguments against a return to gold he also has his own reasons for distrusting a new regime founded on the yellow metal:

The claim that the real price of gold has become too volatile to allow that metal to be relied upon as a standard, for example, overlooks the extent to which gold’s price depends on the demand for private gold hoards, which has become both very great and very volatile precisely because of the uncertainty that fiat money regimes have inspired. The claim also overlooks the tendency for a metal’s price to become more stable as it becomes more widely adopted as a monetary standard.

Nor is it the case that there is not enough gold in the United States to support a new gold standard. According to Lawrence White, the Treasury’s gold stock, assuming that it is indeed what the Treasury itself claims, would at an official gold price of $1,600 per troy ounce be worth almost 20 percent of 2012 M1, making for “a more than healthy reserve ratio by historical standards.”

There are, however, some more compelling reasons for doubting that a return to gold would prove worthwhile. One is the prospect that any restoration of the convertibility of dollars into gold might be so disruptive that the short-run costs of the reform would outweigh any long-run gains it might bring. A second compelling reason has to do with the specific disadvantage of a unilateral return to gold. Here, once again, it must be recalled that the historical gold standard that is remembered as having performed so well was an international gold standard, and that the advantages in question were to a large extent advantages due to belonging to a very large monetary network.

Finally and perhaps most importantly, it is more doubtful than ever before that any government-sponsored and -administered gold standard would be sufficiently credible to either be spared from or to withstand redemption runs.

Read the whole thing.

The costs of regulation and why we're not creating enough jobs

We all know that regulation has benefits. We all also know that regulation has costs. The usual political mantra is that the costs are minimal while the benefits are huge. That may not in fact be true:

Regulation’s overall effect on output’s growth rate is negative and substantial. Federal regulations added over the past fifty years have reduced real output growth by about two percentage points on average over the period 1949-2005. That reduction in the growth rate has led to an accumulated reduction in GDP of about $38.8 trillion as of the end of 2011. That is, GDP at the end of 2011 would have been $53.9 trillion instead of $15.1 trillion if regulation had remained at its 1949 level.

It's worth thinking about that for a moment. Each individual American, the society as a whole, would be three times richer than they are if there had not been that explosion of regulation of the economy since WWII. That sort of increase in wealth buys quite a lot of people harmed by the lack of regulation.

But it's possible to use this to explain a disturbing feature of today's problems as well:

Why the change? The arguments rooted in technological developments sound like this: "Technologies like the Web, artificial intelligence, big data, and improved analytics—all made possible by the ever increasing availability of cheap computing power and storage capacity—are automating many routine tasks. Countless traditional white-collar jobs, such as many in the post office and in customer service, have disappeared. W. Brian Arthur, a visiting researcher at the Xerox Palo Alto Research Center’s intelligence systems lab and a former economics professor at Stanford University, calls it the “autonomous economy.” It’s far more subtle than the idea of robots and automation doing human jobs, he says: it involves “digital processes talking to other digital processes and creating new processes,” enabling us to do many things with fewer people and making yet other human jobs obsolete.

It has always been true that technological advance destroys jobs. But it has also always been true that technological advance creates other jobs as well. There's a worry that this isn't happening in the current economy. And that first paper gives us a clue as to why. There's simply too much regulation. If the economy were three times larger than it currently is then I do rather doubt that there would be much unemployment. And even if we take their numbers as being a tad fantastical, their basic point is obviously sound. Regulation restricts economic growth. It's economic growth that produces jobs. We're not creating enough jobs thus we've not got enough growth (and do recall, growth must be above labour productivity growth for there to be any expansion in employment) and over regulation is at least a part of that problem.

So let's hang the bureaucrats in order to get the unemployed back to work.

A Hayekian argument for equality of wealth

According to Friedrich Hayek, star of interwar economics, and recently star of two excellent rap battles with his contemporary John Maynard Keynes, the type of equality that matters is equality before the law. Equality before the law—and not equality of opportunity, outcome or anything else—is absolutely central to his political philosophy. But I think his economic work, particularly his crowning achievement, "The Use of Knowledge in Society" (cited a mere 9,496 times), points to the importance of a different kind of equality.

In "The Use of Knowledge in Society" and in earlier work in the socialist calculation debate Hayek shows that scientific knowledge isn't the totality of knowledge in society. In fact, a much bigger body of knowledge—information about peculiarities of time and place and preferences—is dispersed extremely widely across individuals. The only effective way of using this knowledge is a market system. Market participants act on the information embedded in different prices, and in doing so send yet more information back in other prices. But each participants learns only what she needs to know.

The market system Hayek envisions is a great practical means of organising society to achieve high social welfare. The flaw with this system is that participants with more money get to send stronger signals than others.

Markets measure how intensely we want things much more accurately than most democratic systems, because individuals have to bid against others for desirable goods or services. But this breaks down if individuals lack equal wealth. Ten pounds spent by a pauper is likely to represent a much more intense preference than that same £10 spent by a billionaire, a millionaire, or even the average middle class homeowner. However, producers will treat these £10s the same, and the economy will be skewed towards satisfying wealthier people's preferences.

Actually, it's not as simple as that. One feature of the market system is that people get rewarded with more money income (and potentially wealth) if they choose less leisure, or a riskier or less satisfying job. These sorts of inequalities, even if they produce wealth inequalities, would not subvert the system. These individuals have paid for their higher wealth with lower utility in work—and extra wealth merely evens out the overall extent to which the economic system is tilted to their advantage.

But endowments of talent or wealth through better upbringing, genetic advantage or inheritance do subvert the system, and undermine Hayek's argument for the efficiency and rationality of the market order by counting some people's preferences as more than one.

Now, by no means am I saying it's easy to disentangle these "good" sources of unequal wealth from the "bad" sources, or even that we ought to try to do so, and then even out endowments. But I do think that the effect inequality of wealth has on the market functions as a strong—and Hayekian—reason to desire a flatter distribution.

The starting point in the immigration debate

At the Telegraph, Conservative MP Gavin Barwell says what for many Conservatives is the unsayable: that immigration is great for the economy:

Last week, the Organisation for Economic Co-operation & Development published a report which showed that immigration makes a positive contribution to the public finances of many countries, including the UK. Yes, you read that right: migrants in the UK pay more in tax than they consume in public services (that’s not true of every migrant of course, but collectively they make a net contribution). Without them, we would have to make further cuts to public services or pay higher taxes or both. . . .

We have to find a way to earn a living in an increasingly competitive world. Allowing the best and the brightest from around the world to come and study and work here can help us do that. So yes let’s make sure we have control of our borders, yes let’s tackle abuse, yes let’s talk about how many people and who we should allow to move here – but don’t let’s delude ourselves that immigration is always bad news.

And that's the point. The one point I disagree with Barwell on is when he says that "nobody is claiming immigration significantly increases" GDP per capita. Well, I am. Letting immigrants locate in rich countries deepens the potential division of labour: hiring a Tanzanian accountant to look after my firm's finances instead of doing them myself frees me up to focus on whatever I'm best at.

That minor quibble aside, I'm delighted that Mr Barwell has decided to be brave about immigration policy. While there are legitimate debates to be had about access to public services and social cohesion, the starting-point in any discussion about restricting immigration should be that restrictions make us poorer.