If you read anything today, read the Wolf

I wish I had the ability to put it as clearly as he does.  Government deficits are the mirror image of saving elsewhere; dealing with the government deficit requires that some other part of the economy takes over the savings burden.  Above all, the hopeless hysteria about blame for the deficits gets it badly wrong.

The deterioration in the fiscal position is a result of the cutback in the private sector’s spending, not a cause of it. Not surprisingly, the fiscal deterioration is also biggest where the private sector has cut back most: in the post-bubble economies.Of course, governments could have tried to tighten fiscal positions in the teeth of the crisis. All that would have done is turn the recession into a depression. As a result, they would also have transformed part of the structural fiscal deficit into a cyclical one. This might well have lowered the private sector surplus, but only by destroying private income even faster than spending.

I am very interested to read that even a convinced Libertarian like Megan McArdle is willing to look at EVIDENCE when asking whether the government deficts are the problem or the solution.  That is because she is BRIGHT:

I join with Messrs Yglesias and Krugman in a number of points:

• The current budget deficit is not causing our economic problems.  There may be other administration policies that are contributing, but this is not one of them.
• Demand for government bonds is robust
• There are good and powerful reasons to run a deficit in the current recession

But she goes on to explain why a naive reading of the bond market’s low spreads is unwise.  She is right: markets can have a sudden stop, and convincing them NOW that we have a good plan for the FUTURE is extremely wise.  I don’t think we should cut the deficit yet – but as for talking about spending cuts, hell yeah.  That’s why you should come along to our conference on 12th November (see last post).

 

Max Utility

Probably about time to explain what the title of this blog means. Max utility is short for “maximum utility”, a fundamental principle in both economic theory and certain philosophical schools. I’m neither an economist nor a philosopher. But in this principle lies an interesting intersection between these two seemingly very different modes of thought as well as with a third key concept (and perhaps the secret subject of this blog), efficiency.

First to explain a few terms. In economic theory, utility “is a measure of the relative satisfaction from, or desirability of, consumption of various goods and services.”1 In short, a measurement of the benefit, happiness, satisfaction, etc. that someone gets from objects or activities. It’s commonly assumed that people will seek to maximize their own utility, meaning they try to make their life as pleasurable as possible, at least by their own definition of pleasure. Much of economic thinking is built on the idea that the purpose of commerce (economic activity) is to increase the utility of the people who engage in it. Ideally, our system is designed to “maximize” utility meaning that all people are getting as much satisfaction as is possible. This state can be described as “Pareto efficient”. A situation is said to be Pareto efficient if there is no way to rearrange things to make at least one person better off without making anyone worse off.2 While not everyone would agree that this is the best goal to pursue, almost all would agree that it is best to avoid situations that are not Pareto efficient. If you can increase someone’s satisfaction without decreasing anyone else’s, it’s hard to argue against making the change.

Of course, a key weakness of much of economic theory is that it attempts to define everything in economic terms; reducing notions of happiness or satisfaction to dollars and products. While I wouldn’t look to economics to guide us necessarily to a better world (I doubt many would argue they’ve been doing a good job of that lately), it does have tools and concepts that can aid in that pursuit. Economics does not do a great job of explaining what our goals should be. However, it can do an excellent job of figuring out how to prioritize issues, allocate resources, and build systems that will effectively and efficiently achieve our goals.

On the subject of goals, utility is most often associated with the philosophical school of thought known as utilitarianism. Utilitarianism is based on the idea that “moral worth of an action is determined solely by its contribution to overall utility: that is, its contribution to happiness or pleasure as summed among all people.”3 So not only is the most economically efficient course the one that maximizes satisfaction, it is also the most moral course of action. While mostly referenced to the work of John Stuart Mill, this concept may be most widely known as expressed by Spock in his declaration that “the needs of the many outweigh the needs of the few, or the one.”4 While logic would seem to demand this course of action, in its simple form, it does lead to some counter intuitive moral demands. If two people are dying of kidney failure, am I morally required to sacrifice my life and donate both kidneys based on the idea that two lives are worth more (and create more utility) than one? There are attempts, such as rule utilitarianism, to modify simple utilitarianism to account for these logical extremes.5 I’m no expert or visionary. I don’t think simple utility maximization can always tell us the most efficient or moral course of action. Arguments on morality have, and likely will continue on indefinitely. So I’m content to say that all other things being equal, pursuing the course that maximizes the happiness and satisfaction of all people seems like a good place to start.

So where do these concepts get us? They both build a worldview on the notion of efficiency. A system (moral or economic) that has inherent waste cannot fully maximize the satisfaction of its members. And this may be the most important lesson for us in the near future. The 20th century will be remembered for many things, but one feature that underlies many of them is the abundance of resources. Industrialization built a world unlike any seen before, and truly did pull vast numbers of people out of difficult, dangerous, low-utility lives. But many of these advances were built on the assumption of inexhaustible resources. When you assume that supplies of oil or water are infinite, the commodity is priced solely at the cost of extraction, not its “true” value, and you create a system that wastes more than it uses. When you assume that pollution has zero cost, the economic system will ignore it when trying to maximize utility and we’re beginning to see how far off we may have gone with that single miscalculation. Some blame capitalism itself for the problems we are now waking up to. It’s not difficult to see their point, though they often fail to show evidence of a better system. But like all logic based systems, it will only give you a valid answer if you set up valid assumptions. Otherwise, it’s ‘garbage in – garbage out’.

I believe we can use the power of capitalism, the free market, and notions of utility to pursue a better way. Input the true costs, limits, needs, and benefits into your calculations and I think we do have a chance to construct a system that actually does increase the average happiness of ALL people and not just those who have gamed or learned to manipulate the system to their benefit.

In the future I hope to explore ways that I think we can do that. Hopefully I’ll inspire some ideas or generate discussion that will lead to other good directions.

——————————————————————————————————————————————

1) http://en.wikipedia.org/wiki/Utility
2) http://wilcoxen.maxwell.insightworks.com/pages/225.html
3) http://en.wikipedia.org/wiki/Utilitarianism
4) http://www.imdb.com/title/tt0084726/quotes
5) http://en.wikipedia.org/wiki/Rule_utilitarianism

The Great Carry Trade III: Nouriel Roubini Frets about US and a bit on Japan

When I used to frequent the Internet Chess Club they’d often use a message something like: “A hush descends as Grandmaster So-and-so enters the room.” Well, I feel the same reaction should greet Professor Nouriel Roubini’s entry into the discussion of the Great Carry Trade. It’s worth hanging on the Professor’s every word…

Roubini notes that:

“…while the US and global economy have begun a modest recovery, asset prices have gone through the roof since March in a major and synchronised rally. While asset prices were falling sharply in 2008, when the dollar was rallying, they have recovered sharply since March while the dollar is tanking. Risky asset prices have risen too much, too soon and too fast compared with macroeconomic fundamentals.

So what is behind this massive rally? Certainly it has been helped by a wave of liquidity from near-zero interest rates and quantitative easing. But a more important factor fuelling this asset bubble is the weakness of the US dollar, driven by the mother of all carry trades. The US dollar has become the major funding currency of carry trades…”

Roubini, characteristically, worries most about the unwinding of the dollar carry trade.

I don’t know, I think there is a wrinkle here, which is that the US dollar can’t actually depreciate, not fully, anyway, because of China’s dollar peg. Therefore it hasn’t got so far to snap back in a panic. Sure, there can be some unwinding if the market suddenly perceives emerging markets to have become overvalued, more risky or growth less certain. This damping of the dollar’s movement makes dollar-funded carry trades less risky than they would be otherwise. This is not good, because it will allow bubbles to inflate even more than would otherwise be the case.

Roubini writes as if carry trading investors are making a currency gain by borrowing dollars, over and above emerging currency and other market movements. That’s only true if your accounting currency is neither dollars, nor, say, sterling, which is hardly appreciating nor going to appreciate against the dollar (and also appears to meet the criteria for a carry-trade funding currency). In fact, it’s only really true if your investors want euros or possibly yen at the end of the day, though one wonders why they don’t just borrow in those currencies to reduce the risk, if they believe a flight to safety would favour the dollar.

Since the dollar’s decline is primarily taking place against the euro, it follows, incidentally, that as I argued last time, the next phase of the game will be characterised by a eurozone trade deficit as well as a US and (not that it’s very significant to the rest of the world) a UK one.

Martin Wolf worries – to a very deferential Tech Ticker audience – that eventual US rate rises will have a dramatic effect. Sure. But – since interest rates do most of their work in curbing inflation through their effect on the foreign exchange rate – that simply means they won’t have to rise very much, doesn’t it? Of course, this will help to fuel further borrowing in US…

It might be worth comparing the dollar carry trade to the yen carry trade. The crucial difference is that the yen carry trade was/is inherently risky, because the yen has, for decades, been undervalued, given Japan’s persistent trade surplus (increasing again in 2009).

But we are in a fairly unusual situation of a reserve currency doomed to eventual decline: we can borrow cheaply in dollars because of its reserve status, but, as its status as a reserve currency diminishes, it will be seen to be fundamentally overvalued because of its trade position and the vast overhang of dollars already in foreign hands. So borrowing in dollars is something of a one-way bet – you don’t have to worry that your fortune has the Ponzi quality of depending on everyone else continuing to want to borrow in dollars. The dollar isn’t going to snap back up – notwithstanding a temporary recovery during the next major crisis – because its value is already being held up by central banks wanting to buy them. Rather, the dollar’s value can be expected to decline over time as it is replaced (by a mix) as the world’s reserve currency. Compared to the yen carry trade the dollar carry trade is a bargain, risk-wise. No wonder emerging market equities are breaking records!

Ambrose Evans-Pritchard is always an entertaining read. He writes today that the next crisis could be a Japanese default. But Japan’s trade surplus must make this unlikely. All they’ve got to do is divert some of Japan’s private savings to the public purse. Maybe a little easier said than done, of course, but there’s still plenty of scope. Of course, if they let their national debt rise from 2 to say 3 times GDP, it could start to get tricky to service…

Meanwhile, Peter Tasker worries about an asset bubble bursting in China. This seems closer to the mark. He compares China to Japan and notes that:

“If China continues to follow the Japanese template, the end of the dollar peg will be the trigger event [for the "final manic stage" of the bubble], setting off a Godzilla-sized credit binge.”

There also seem to me to be similarities with the Great Crash of 1929. We are in a fairly unusual situation of a reserve currency doomed to eventual decline, but it is not a unique situation. Didn’t the UK coming off the gold standard in 1925 convince investors that the dollar was the place to be? Blaming Churchill (who took the decision) is wrong-headed. The problem was that the peg existed in the first place, not that we came off it. It might be hitting the ground that does the damage, but the problem is trying to float in the air in the first place.

It seems to me the sooner China appreciates its currency the less painful it will be for everyone. Especially as, the longer Chinese economic growth exceeds that elsewhere, the bigger the relative size of its economy and the greater the imbalance caused by the undervaluation of its currency against the dollar. As I said when I started trying to get my head round all this, currency pegs are a very bad idea indeed. You may be able to market the buck, but you can’t buck the market.

California: Not Such A Great Deal

The Golden State Isn’t Worth It…especially compared with low-tax states like Texas:

California’s interlocking directorate of government employee unions, issue activists, careerists and campaign contributors has become increasingly aggressive and adept at using rhetoric extolling public benefits for all to deliver targeted advantages to itself. As a result, the political reality of the high-benefit/high-tax model is that its public goods are, increasingly, neither public nor good. Instead, the beneficiaries are the providers of the public services, and certain favored or connected constituencies, rather than the general population.

I’ve been telling Angelenos for 15 years now that Texas is a great place to live.  People never seemed to understand what I was talking about.  I never thought I’d see a piece in the LAT agree with me on that one.

I never saw the “high benefit” thing that this guy is talking about, either…

(Via Insty)

MRM #23

- The 1990 page House health care bill is out.

- Bloggers say the economy will still be the main issue for the 2010 midterms.

- Obama may be taking his time in deciding what to do in Afghanistan, but the American people aren’t sure about the country’s purpose in Central Asia either.

- Publishers Weekly has a list of the top 10 books of 2009.

- From The Austrian Economists, here’s a video of the “Economists” category being played on Jeopardy. Cornell econ majors: I certainly hope you’re able to answer all of these.

- Not exactly a quick reading link, but if you’ve got time, check out President Skorton’s State of the University Address.

- Like Chief Energy Economist for Deutsche Bank, Adam Sieminski ‘71, I also subscribe to The Economist for the covers.

- Just for fun: could Cornellians use personal assistants?

Ghetto Finance Fri 10/30/09: The glass is half full? WTF?

http://www.bloomberg.com/apps/news?pid=20601087&sid=amqUuq8.tRzQ

“The glass may be half full, but it’s filling slowly,” said Alan Gayle.

Me:  The glass if half full, and the government is the bartender.

Consumer sentiment is far from strong.

Me:  No shit Sherlock

Companies have to show that they have a sustainable plan.

Me:  When has this ever been a requirement for American capitalism?

Stocks will advance, but that will happen more selectively, as investors question momentum.

Me:  Stocks will advance, but please keep in mind that most of the action is completely disconnected from the economic reality of normal Americans.

Increasing consumption is not sustainable or justifiable

I was in danger of quoting nef’s Great Transition report every day last week, so I held this one over, but this is just about the perfect articulation of the make wealth history premise:

The environmental and economic crises are not separate but interconnected events. It is the high levels of debt-fuelled consumption in developed countries that have landed us with dangerously high concentrations of CO2 and put pressure on ecosystem resources… While there is a clear case for poor countries to improve their living standards, increasing consumption further in developed countries is not sustainable or justifiable. In fact, developed countries need to do the exact opposite.

Exactly.

nef have a new-look website this week, I notice. Go and take a look.