Political pressure seems to be mounting for yuan appreciation. [0] Figure 1 depicts the stability in the USD/CNY nominal exchange rate over the past year.

Figure 1: USD/CNY nominal exchange rate, period average (blue, left scale); log trade weighted nominal value of the CNY (teal, right scale); log trade weighted real value of the CNY (red, right scale). "Revaluation" denotes the CNY revaluation in July 2005; "Lehman" denotes the Lehman bankruptcy in September 2008. Sources: St. Louis Fed FREDII, IMF, International Financial Statistics.

Note that even as the CNY has been effectively fixed against the USD, it has depreciated against a broad basket of currencies. This is true in both nominal and real terms.

At the same time, it is interesting to look at recent developments in trade flows, in particular the trade balance.

Figure 2: Chinese trade balance, in billions of USD, annualized (blue), and 12-month moving average (red). "Revaluation" denotes the CNY revaluation in July 2005; "Lehman" denotes the Lehman bankruptcy in September 2008. Sources: IMF, International Financial Statistics, and ADB.

Keeping in mind distortions in the trade flows due to the lunar new year, it does appear that there's been a stabilization in the Chinese trade balance, as predicted by the IMF. Nonetheless, it's of interest to see what is doing the bulk of the adjustment -- exports or imports (keeping in mind a lot of the imports are incorporated into exports).

Figure 3: Chinese exports (blue) and (imports), in billions of USD, annualized. "Revaluation" denotes the CNY revaluation in July 2005; "Lehman" denotes the Lehman bankruptcy in September 2008. Sources: IMF, International Financial Statistics, and ADB.

It strikes me with exports recovering on a year-to-year basis, now is the time for an RMB appreciation. I have little insight into the thinking of the policy authorities in China, so let me turn it over to someone who does. Arthur Kroeber of Dragonomics, a business consulting firm based in China, agrees that the time has come for a change in the currency stance, and further argues for a discrete revaluation, as opposed to a resumption of gradual appreciation:

...the gradual appreciation of 2005-08 was problematic: because the renminbi moved only one way, lots of international capital flowed into China to play the apparent one-way bet. Inciting huge capital inflows at a time when Beijing is already battling the strongest inflationary pressure in years is unappealing.

Logically, the way around this is to start with a very quick appreciation of at least 10 per cent to take the one-way-bet calculation out of the market.

There is a strong case for making a move soon. The longer China waits, the more criticism it will attract for its undervalued exchange rate.

The criticism is likely to come to a head in March— when the US Treasury will need to make its determination about whether China is a currency manipulator—and April, when the G-20 next meets.

Mr. Kroeber has an interesting article in the most recent issue of China Economic Quarterly [not online] where he argues that the labor market tightening is a plus for labor income and hence consumption. That means the policy authorities in China have the space to allow for an yuan appreciation (which is in any case more desireable than constraining growth solely by money and credit restraint, as I argued here three years ago).

How much of an impact would a given appreciation have? Recalling that GDP (in China and Rest-of-world) matter, as do supply capacity, recent partial derivatives/elasticities are discussed in this post.

I would be remiss if I did not mention Eswar Prasad's recent testimony before the US-China Commission on the inter-relationships between China, the US and the world economy: see here. As per his usual work, it's an excellent and finely nuanced assessment of the current situation.

Additional Econbrowser posts on China here.

The United States is in a unique historical position. People on top are doing extraordinarily well, but in the real world the middle class is collapsing.

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Over 600 General Motors dealerships scheduled to lose their business with the beleaguered automaker are getting a second lease on life, however, some are not so sure that they want it.

EconomyInCrisis.org 2010 -->

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Given all the recent discussion implying that unemployment compensation increases job search time, and that is an unequivocal bad, I've been meaning to write about the benefits of unemployment compensation. That job search time goes up as a result of unemployment compensation is not necessarily bad if it leads to better matches between workers and employment. And there are other benefits of unemployment compensation as well, but Raj Chetty has this covered already in an interview from the January 2009 AEA meetings on Vox EU so I'll turn it over to him:

Public finance: theory, evidence and policy, Raj Chetty Interviewed by Romesh Vaitilingam, Vox EU: Romesh Vaitilingham: ...My name is Romesh Vaitilingham, and today's interview is with Professor Raj Chetty of Harvard University. Raj ... began by giving us an introduction to the issues that arise in his research. Raj Chetty: So, I'm broadly interested in the role that the government should play in the economy, both on the side of tax policy – so, raising money to fund things like public goods and social welfare programs – and on the design of how we should be spending that money – so, how should we structure programs like unemployment insurance, various other social insurance programs, disability insurance, and so forth. ... So, let me talk about a couple of specific examples. One set of topics relates to social insurance and optimal design. In particular, take an unemployment insurance program. So, a very simple question which is important for any economy is, what's the optimal level of unemployment benefits? This is something that we're hearing quite a bit about now, especially because of the recession, questions about whether we should extend unemployment benefits in the US, how high should we set the level of benefits and so forth. So, there's a classic trade-off in this area, as with any social insurance program, which is, when you provide more insurance, you help people in a state of need. So, when they lose their jobs, they have less consumption, less income, and they're suffering, and you want to give them a transfer of that state. We think that that improves social welfare. But, the cost of doing that is that you reduce incentives to find a job, right? So, if you provide too high an unemployment insurance benefit level, you might increase the unemployment rate and thereby end up sort of hurting people on net, even though you're providing them this transfer, by lowering GDP, in essence. So, a difficult question is, you want to be somewhere between a zero unemployment benefit and a full 100% replacement of your wages, but where do you want to be in the middle? Now, traditionally, economists have had the view that you don't want to have a very high level of unemployment benefits because there's some pretty compelling evidence that when you raise unemployment benefits, people take longer to find a job, so unemployment durations go up. And that's a fairly powerful effect. A 10% increase in unemployment benefits, in various countries, has been estimated to raise unemployment durations by something like 5 to 8%, which is quite substantial. And so, from that perspective, a view emerged that, because of this distortionary cost of the program, we don't want to have a very high level of unemployment benefits. And some calculations by MIT economist Jon Gruber suggested that the optimal benefit level may be very close to zero. So, one aspect of reality that the standard model ignores that's used to make those calculations is the idea that people may not have sufficient liquidity while they're unemployed. So, a lot of calculations in economics are based on a traditional permanent income level, where people are smoothing consumption relative to lifetime income. But, when you're unemployed, that's precisely a time when you're unlikely to be able to smooth relative to permanent income because, if you think about what's necessary to be able to maintain a high level of consumption when you're unemployed, you have to be able to borrow, right? Or you have to have the high level of savings. Now, it turns out that the median job loser in the US has savings of just $150, net of unsecured debt. So, they essentially have no savings at the time of job loss. Moreover, the primary condition for being able to borrow is having a job. So, it's exactly when you don't have a job or when you're sick that you can't borrow, right? And so, now, if you consider a model where people are liquidity constrained, when they've lost their job, you get a second effect, a second reason why providing unemployment benefits might increase durations, which is what I call in this research I've been doing "the liquidity effect". And that's the idea that, if you have more cash on hand, you're not under as much pressure to rush and search and find a job, right? So, suppose you're really short on cash, you've had to drastically lower you level of consumption, and you're making a mortgage payment and you're behind your bills. You're going to do anything you can to just get a job as quickly as possible – sacrifice the quality of the job in order to put food on the table in the short run, right? Now, if I give you unemployment benefits, you're going to have a little bit more time to find the job that you like, maybe search in a less costly way. And all that is not a distortionary incentive effect. It's not that you are thinking that the net return to work is lower than it actually is. It's just that you're able to take longer, do the more socially efficient thing. Now, I go to the data, and I ask how much of the effect of unemployment benefits on durations is due to the liquidity effect, which is a socially beneficial thing, versus the moral hazard effect, which is the incentive distortion traditionally emphasized in the literature. And using various methods, basically comparing the effects of severance payments, which give you cash on hand but don't distort your incentives to the effects of increases in unemployment benefits, I conclude that roughly 60% of the effect of benefits on durations is a liquidity effect rather than a moral hazard effect. And using this type of evidence, I show that the optimal benefit level, viewed from this perspective, taking the liquidity consideration into account, is much closer to the level you see in the US – actually, 50% or something like that – and that it makes sense, probably, to extend the duration of employment benefits in a recession like this. Although you don't want to go too far, you don't want to go to a system like Sweden, which has sort of indefinite unemployment benefits. But, there's definitely significant value in having short-run liquidity provision when people face shocks. So, more broadly, this research has similar implications for health insurance, disability insurance, workers' compensation – the same kind of effects are going to arise in all of those programs. And so there are various other research studies now following up on this that look for liquidity effects in these other programs and trying to think about how they should be decided. So, that's one example of combining theory with evidence to reach a different policy conclusion. ...

To paraphrase Albert Einstein, it is insane to continue to do the same thing and to expect different results. It is time for a change, therefore, time to abandon the failed policies of the past.

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Fernanda Viégas and Martin Wattenberg are research scientists in IBM’s Visual Communication Lab. Their blog is called Visual Hint.

I liked the way they depict a year of color in Boston, FlickrFlow:

via kottke

While it may not be obvious at the time, a dramatic change in economic circumstances can have its upsides and downsides.

On the upside, because fewer people can afford to drive, the number of people who die in traffic accidents is falling. According to preliminary data from the National Highway Traffic Safety Administration, both the number of fatalities and the fatality rate hit record lows in 2009.

On the downside, more people are apparently trying to scam insurers to make up for what they have lost. According to McClatchy, 

a recent survey of 37 state insurance-fraud bureaus by the Coalition Against Insurance Fraud found that the recession "appears to have had a significant impact on the incidence of fraud" last year. On average, the bureaus reported increases in case referrals and new investigations in all 15 categories of fraud the survey covers.

Any others -- especially positives -- worth mentioning?

The Journal does yeoman’s job finding banks that have cash to lend:

“U.S. banks posted a 7.5% decline in 2009 in total loans outstanding, the steepest percentage drop since 1942, according to the Federal Deposit Insurance Corp. Consumer lending fell by 3.8% as roughly 7,200 banks and credit unions pulled back on mortgages, credit cards and other loans . . .

Across the country, thousands of other banks and credit unions also are bucking the just-say-no mentality that dominates the headlines. In the wake of the financial crisis that saddled banks with huge losses, the largest 10% of banks by asset size shrank their consumer lending by 4.7% last year, tightening the spigot on loans that aren’t backed by the government.

At many smaller banks and credit unions, though, cash continued to flow. Consumer loans grew nearly 3% at financial institutions that fall in the bottom 50% of the industry in assets, according to the Journal’s analysis of financial-institution data filed with regulators. Some smaller banks and credit unions continued to ramp up their business in mortgages, auto loans and credit cards and gain from the pain of their larger rivals.”

The one thing these lenders all have in common: Their balancde sheets are not festooned with all manner of garbage loans carried at fraudulent levels due to the corrupt rule change Congress foisted on FASB.

These smaller lenders are the only thing standing between a Japan like lost decade or two, and financial health.

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click for larger map

courtesy of WSJ
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Source:
Where to Find the Money
RUTH SIMON and MAURICE TAMMAN
WSJ, MARCH 13, 2010
http://online.wsj.com/article/SB10001424052748704869304575110073746360224.html

The media reported on a 0.3 percent rise in retail sales in February, which was described as a surprisingly strong result compared with the consensus expectation of a 0.2 percent decline. However, the news was not as good as this may appear, since January's sales data was revised down by 0.4 percent. In other words, the sales volume reported for February was almost exactly in line with the consensus estimate, even though the January number is less than had previously been believed. (There does appear to be some upward movement in non-auto sales.)

--Dean Baker

In the L.A. Times, Don Lee examines the potential rebound of U.S. manufacturing.

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Just in case you thought there was any confuction about which way the Goldman propaganda wheel turns: "Investors we met this week remain bullish in both outlook and positioning, consistent with our view. We expect S&P 500 to rise to 1300 by mid-year (+13%), before ending 2010 at 1250 (+9%)." So it was spoken and so it shall be. Amen.

Click here for the full weekly gospel.

 

AttachmentSize Weekly Kickstart 3.12.pdf373.61 KB

The AFL-CIO Now trumpets “Time to Take Tough Action Against China Currency Manipulation.”

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From Tom Abate at the San Francisco Chronicle: Financial leaders dissect meltdown "What is quite shocking," [John Lipsky, a senior official of the International Monetary Fund] said, is how inadequate the world's regulatory supervisors were in curbing the lax lending standards at the heart of the housing and credit bubbles. Shocked? Hmmm ...

The U.S. has not had a coordinated national industrial policy in decades, and each new Congress simply puts the issue on the back burner. EconomyInCrisis.org 2010 -->

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Since we are on the topic of men, business, and regulations, Yves Smith points us to a relevent avenue for thought:

Indefensible Men.

The Implications of Velocity
March 12, 2010
By John Mauldin

The Velocity of Money
Our Little Island World
GDP = (P) x (T)
P=MV
A Slowdown in Velocity
Dallas and Thoughts on the Economy

This week we do some review on a very important topic, the velocity of money. If we don’t understand the basics, it is hard to make sense of the hash that our world economy is in, much less understand where we are headed.

But before we jump into that, I want to let my Conversations subscribers know that we have posted a recent conversation with two hedge-fund managers, Kyle Bass of Hayman Advisors [and his staff] here in Dallas and Hugh Hendry of the Eclectica Fund in London. Our discussions centered on what we all think has the potential to be the next Greece, but on a far more serious level. It was a fascinating time.

Then next Wednesday we will post a Conversation I had with George Friedman of Stratfor fame, and then the following Wednesday a Conversation that I just completed with Dr. Ken Rogoff and Dr. Carmen Reinhart, the authors of This Time Is Different.

For new readers, Conversations with John Mauldin is my one subscription service. While this letter will always be free, we have created a way for you to “listen in” on my conversations with some of my friends, many of whom you will recognize and some whom you will want to know after you hear our conversations. Basically, I will call one or two friends each month and, just as we do at dinner or at meetings, we will talk about the issues of the day, with back and forth, give and take, and friendly debate. I think you will find it very enlightening and thought-provoking and a real contribution to your education as an investor.

And as you can see, I can get some rather interesting people to come to the table. Current subscribers can renew for a deeply discounted $129, and we will extend that price to new subscribers as well. To learn more, go to http://www.johnmauldin.com/newsletters2.html. Click on the Subscribe button, and join me and my friends for some very interesting Conversations.

The Velocity of Money

The Federal Reserve and central banks in general are running a grand experiment on the economic body, without the benefit of anesthesia. They are testing the theories of Irving Fisher (representing the classical economists), John Keynes (the Keynesian school) Ludwig von Mises (the Austrian school), and Milton Friedman (the monetarist school). For the most part, the central banks are Keynesian, with a dollop of monetarist thrown in here and there.

Over the next few years, we will get to see who is right about debt and stimulus, the velocity of money, and other arcane topics, as we come to the End Game of the Debt Super Cycle, the decades-long cycle during which debt has grown. I have very smart friends who argue that the cycle is nowhere near an end, as governments are clearly increasing debt. My rejoinder is that it is nearing an end, and we need to think hard about what that end will look like. It will not be pretty for a period of time. The chart below shows the growth in debt, both public and private.

But the end of this debt cycle involves more than just debt reduction. There are a number of ideas we have to get our heads around, including the velocity of money. Basically, when we talk about the velocity of money, we are speaking of the average frequency with which a unit of money is spent. To give you a very rough understanding, let’s assume a very small economy of just you and me, which has a money supply of $100. I have the $100 and spend it to buy $100 of flowers from you. You in turn spend $100 to buy books from me. We have created $200 of our “gross domestic product” from a money supply of just $100. If we do that transaction every month, we will have $2400 of annual “GDP” from our $100 monetary base.

So, what that means is that gross domestic product is a function of not just the money supply but how fast that money moves through the economy. Stated as an equation, it is P=MV, where P is the nominal gross domestic product (not inflation-adjusted here), M is the money supply, and V is the velocity of money. You can solve for V by dividing P by M. By the way, this is known as an identity equation. It is true at all times and all places, whether in Greece or the US.

Our Little Island World

Now, let’s complicate our illustration a bit, but not too much at first. This is very basic, and for those of you who will complain that I am being too simple, wait a few pages, please. Let’s assume an island economy with 10 businesses and a money supply of $1,000,000. If each business does approximately $100,000 of business a quarter, then the gross domestic product for the island is $4,000,000 (4 times the $1,000,000 quarterly production). The velocity of money in that economy is 4.

But what if our businesses get more productive? We introduce all sorts of interesting financial instruments, banking, new production capacity, computers, etc., and now everyone is doing $100,000 per month. Now our GDP is $12,000,000 and the velocity of money is 12. But we have not increased the money supply. Again, we assume that all businesses are static. They buy and sell the same amount every month. There are no winners and losers yet.

Now let’s complicate matters. Two of the kids of the owners of the businesses decide to go into business for themselves. Having learned from their parents, they immediately become successful and start doing $100,000 a month themselves. GDP rises to $14,000,000. In order for everyone to stay at the same level of gross income, though, the velocity of money must increase to 14.

Now, this is important. If the velocity of money does not increase, that means that (in our simple island world) on average each business is now going to buy and sell less each month. Remember, nominal GDP is money supply times velocity. If velocity does not increase, GDP will stay the same. The average business (there are now 12) goes from doing $1,200,000 a year down to $1,000,000. The prices of products fall.

Each business now is doing around $80,000 per month. Overall production is the same, but divided up among more businesses. For each of the businesses, it feels like a recession. They have fewer dollars, so they buy less and prices fall. So, in that world, the local central bank recognizes that the money supply needs to grow at some rate in order to make the demand for money “neutral.”

It’s basic supply and demand. If the demand for corn increases, the price will go up. If Congress decides to remove the ethanol subsidy, the demand for corn will go down, as will the price.

If Island Central Bank increases the money supply too much, you will have too much money chasing too few goods and inflation will rear its ugly head. (Remember, this is a very simplistic example. We assume static production from each business, running at full capacity.)

Let’s say the central bank doubles the money supply to $2,000,000. If the velocity of money is still 12, then the GDP will grow to $24,000,000. That will be a good thing, won’t it?

No, because with the two new businesses only 20% more goods are produced. There is a relationship between production and price. Each business will now sell $200,000 per month, or double their previous sales, which they will spend on goods and services, which only grew by 20%. They will start to bid up the price of the goods they want, and inflation sets in. Think of the 1970s.

So, our mythical bank decides to boost the money supply by only 20%, which allows the economy to grow and prices to stay the same. Smart. And if only it were that simple.

Let’s assume 10 million businesses, from the size of Exxon down to the local dry cleaners, and a population that grows by 1% a year. Hundreds of thousands of new businesses are being started every month and another hundred thousand fail. Productivity over time increases, so that we are producing more “stuff” with fewer costly resources.

Now, there is no exact way to determine the right size of the money supply. It definitely needs to grow each year by at least the growth in the size of the economy, the population, and productivity, or deflation will appear. But if money supply grows too much then you have inflation.

And what about the velocity of money? Friedman assumed the velocity of money was constant, and therefore he stated that inflation is always and everywhere a function of the supply of money. And it was, from about 1950 until 1978 when he was doing his seminal work. But then things changed.

Note that nothing Friedman says contradicts the equation MV=PT, if you assume constant velocity. Almost by definition you get inflation if the money supply grows too fast.

Let’s look at two charts sent to me by Dr. Lacy Hunt of Hoisington Investment Management in Austin (and one of my favorite economists). First, let’s look at the velocity of money for the last 108 years.

Notice that the velocity of money fell during the Great Depression. And from 1953 to 1980 the velocity of money was almost exactly the average of the last 100 years. Also, Lacy pointed out in a conversation that helped me immensely in writing this letter, that the velocity of money is mean reverting over long periods of time. That means one would expect the velocity of money to fall over time back to the mean or average. Some would make the argument that we should use the mean from more modern times, since World War II; but even then, mean reversion would result in a slowing of the velocity of money (V), and mean reversion implies that V would go below (overcorrect) the mean. However you look at it, the clear implication is that V is going to drop. In a few paragraphs, we will see why that is the case from a practical standpoint. But let’s look at the first chart.

Now, let’s look at the same chart since 1959 but with shaded gray areas that show us the times the economy was in recession. Note that (with one exception in the 1970s) velocity drops during a recession. What is the Fed response? An offsetting increase in the money supply to try and overcome the effects of the business cycle and the recession. P=MV. If velocity falls then money supply must rise for nominal GDP to grow. The Fed attempts to jump-start the economy back into growth by increasing the money supply.

In this chart from Hoisington, the recessions are in gray. If you can’t read the print at the bottom of the chart, he assumes that GDP is $14.5 trillion, M2 is $8.2 trillion, and therefore velocity is 1.7, down from almost 1.97 just a few years ago. If velocity is to revert to or below the mean, it could easily drop 10% from here. We will explore why this could happen in a minute.

P=MV

But let’s go back to our equation, P=MV. If velocity does slow by another 10%, then money supply (M) would have to rise by 10% just to maintain a static economy. But if we assume 1% population growth, 2% (or thereabouts) productivity growth, and a target inflation of 2%, then M (money supply) actually needs to grow about 5% a year, even if V is constant. And that is not particularly stimulative, given that we are in recession.

Bottom line? Expect money-supply growth well north of 7% annually for the next few years, or at least the attempt. Is that enough? Too much? About right? We won’t know for a long time. This will allow armchair economists (and that is most of us) to sit back and Monday-morning quarterback for many years.

A Slowdown in Velocity

Now, why is the velocity of money slowing down? Notice the real rise in V from 1990 through about 1997. Growth in M2 (see the above chart) was falling during most of that period, yet the economy was growing. That means that velocity had to rise faster than normal. Why? Primarily because of the financial innovations introduced in the early ’90s, like securitizations, CDOs, etc. It is financial innovation that spurs above-trend growth in velocity.

And now we are watching the Great Unwind of financial innovations, as they were pursued to excess and caused a credit crisis. In principle, a CDO or subprime asset-backed security should be a good thing. And in the beginning they were. But then standards got loose, greed kicked in, and Wall Street began to game the system. End of game.

The financial innovation that drove velocity to new highs is no longer part of the equation. Its absence is slowing things down. If the money supply hadn’t risen significantly to offset that slowdown in velocity, the economy would have been in a much deeper recession, if not a depression. While the Fed does not have control over M2, when they lower interest rates it is supposed to make us want to take on more risk, borrow money, and boost the economy. So they have an indirect influence.

And now we come to the policy conundrum for the Fed. They have pumped a great deal of money (liquidity) into the economy. Normally, banks would take that money and multiply it by lending it out (through fractional reserve banking at a potential 9-times factor), increasing velocity and the overall money supply. In the past, the more the Fed increased the money supply, the more banks lent.

But today bank lending is still falling at an average of 15% annually, so far this year. But what if that trend stops?

Corporations in the US have more money on hand than ever in the last 54 years. They are more productive. Their debt-to-equity ratio has been dropping by about 25% for the last 3 quarters, as they repair balance sheets. Capital spending jumped 18% annually in the last quarter. If we are not at an inflection point of rising employment, we are close to it (although we do need at least 100,000 new jobs a month to make up for increased population). And thus are the stock market bulls inspired, and we hit new trend highs weekly.

While growth this quarter will not be as robust as last, it will be fairly good for an economy with 10% unemployment. If you are a Fed governor, you have to be worried that things could turn around quicker than now seems plausible. What if corporations decided to take their cash and start investing in growth?

The last chart showed a small uptick in velocity at the end of last year. What if that is for real? What if we have turned the corner? Then the Fed will have to start taking back the money they have put into the economy, unless they want to see inflation. And indeed, that is what some Fed governors are arguing. They want to raise rates now, or at least signal that they will begin to do so soon. Note there have been a number of speeches by Fed officials of late assuring the bond market that they are aware of the problem, and that they have all the tools they need to keep inflation (and higher interest rates) at bay.

But then again, while there are signs that the economy may be picking up, it is a strange type of recovery. It is what I call a statistical recovery. Let’s look at this litany from my friend David Rosenberg of Gluskin Sheff. He notes that there are measures of economic health other than the stock market and GDP. To wit:

• More than five million homeowners are behind on their mortgages.
• There are over six million Americans who have been unemployed for at least six months, a record 40% of the ranks of the jobless.
• The private capital stock is growing at its slowest rate in nearly two decades.
• Roughly 30% of manufacturing capacity is sitting idle.
• Nearly 19 million residential housing units, or about 15% of the stock, is vacant.
• One in six Americans is either unemployed or underemployed.
• Commercial real estate values are down 30% over the past year.
• The average American worker has seen his/her level of wealth plunge $100,000 over the last two years, even with the recovery in equity markets this past year.
• Bank credit is contracting at an unprecedented 15% annual rate so far this year as lenders sit on a record $1.3 trillion of cash.
• Unit labor costs are down an unprecedented 4.7% over the past year, and what has replenished household coffers has been the federal government, as transfer payments from Uncle Sam now make up a record 18% of personal income (and the Senate just passed yet another jobless benefit extension bill!).”

Wow. 18% of personal income in the US is now from the US government (also known as taxpayers, current and future).

If you take away the punchbowl too soon, you risk strangling a very shaky recovery that is significantly dependent on stimulus spending, which is going to rapidly go away the second half of this year. Further, the Fed situation is complicated by the fact that taxes are highly likely to go up in 2011 (maybe the largest tax increase ever), which will put a serious strain on the economy.

I think the Fed is on hold throughout 2010 and well into 2011, as they see what effect the tax hikes, coupled with decreased stimulus, bring. Next week we will explore the potential effects of the tax hike on the 2011 economy. Stay tuned.

Let me ask for a little bit of help. I am trying to find data on the potential tax increases, and what I am finding is all over the board. In fact, I had intended to write about that topic this week, but simply don’t trust the numbers I am reading. If you have a source or RECENT paper, I would love to see it. Thanks.

Dallas and Thoughts on the Economy

What started me thinking about tax increases was the problems that so many people I know personally are having, including my kids. It is difficult watching your kids struggle with fewer work hours, the need to make car payments and buy diapers. For many, it’s cuts in pay, lost jobs, and more. Lack of health insurance is often a worry, too.

And knowing it could get worse is rather sobering. Trust me, I see the human side of the need for health-care reform, but also balance it with the need for some fiscal responsibility. We have $38 trillion in unfunded Medicare liabilities. How can we add more? Does anyone really believe that this bill being offered will actually cut spending? How do you cut Medicare by $500 billion when it is already so underfunded? Really? But what about kids and families with no insurance? Something better than what we are seeing is needed to get the problem solved. More on this next week.

I will be a panelist in the inaugural “America: Boom or Bankruptcy?” summit to be held in Dallas on March 26. There will be five of us, presenting problems (plenty of those!) and possible solutions. This promises to be a no-holds-barred, full-throttle event. It should be a lot of fun. Details at www.fedfriday.com.

It’s time to hit the send button. I have kids coming to the airport, and I want to be there. Spring break and all, and I look forward to it. Have a great week.

Your worried about the kids analyst,

John Mauldin
John@frontlinethoughts.comCopyright 2010 John Mauldin. All Rights Reserved

You cans ee what Professor Black warned about a year ago on PBS here.

Hat tip New Economics Perspectives

“I don’t want to protect institutions that are engaged in essentially speculative activity. The danger has been vastly increased by the reaction to the crisis where everybody was getting saved, to exaggerate a bit, whether they were banks, nonbanks, whether they were engaged in speculative activity or not. If they were big they got saved.”

-Paul Volcker, former Federal Reserve Chair

>
Reuters takes a fascinating look at Paul Volcker in the delightfully titled Cheap cigars, politics and the Volcker Rule.

“I don’t want to be inhibited in what I say,” he said. “I’ve been inhibited all my life. It’s time to be uninhibited.”

No one would accuse him of holding back. Volcker has criticized what he calls the “reform lite” of congressional regulatory reform proposals. And he has kept a hectic travel schedule that belies his age, in Canada one day and Germany the next, as he seeks to drum up international support for a revamping of the financial system.

The people who know him best say outspokenness is part of the package. “He doesn’t temper his remarks as much as he might have in the past,” said his daughter, Janice Volcker Zima. “In his view, he’s old and it doesn’t matter anymore. He thinks (the risk of another crisis) is really dangerous and people need to do something about it.”

Friends say the former Fed chairman was surprised when Obama named the Volcker Rule after him. The president’s fiery, anti-Wall Street rhetoric in the Diplomatic Reception Room in January catapulted Volcker into the role of populist hero.

Well worth a few minutes of your weekend . . .

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Source:
Cheap cigars, politics and the Volcker Rule
Caren Bohan and Kristina Cooke
Reuters, Mar 12, 2010 EST
http://www.reuters.com/article/politicsNews/idUSTRE62B2YN20100312

Henry Farrell:

The EMF as camel’s nose: As Charlemagne himself notes (he seems to think this supports his position: I’m not sure why), the German proposal is resulting in howls of outrage from the president of the Bundesbank and Germany’s representative at the ECB. Both of them seem to be doing their very best impressions of 19th century gold-standard ‘suffering is good’ ultras.... The international price is likely to be higher still. Germany has sought for decades to resist French calls for EU-level ‘economic government,’ fearing that any such initiative would have substantial intra-state fiscal transfers.... Now, not only are the camel’s hairy nostrils snuffling eagerly around the tent’s interior, but the front legs and the forward hump have found their way in too. What is surprising is that it is Germany, rather than France, which pulled the tent-flap open....

The IMF usually has maximal bargaining power at a country’s moment of crisis – it typically cares far less about whether the country makes it through than the country itself does, and hence can extract harsh conditions in return for aid. But – as we have seen with the Greek crisis – EU member states are far less able to simulate indifference when one of their own is in real trouble, both because member states are clubby, involved in iterated bargains etc, and because any real crisis is likely to be highly contagious (especially within the eurozone). In other words, the bargaining power of other EU member states (and of any purported EMF) is quite limited. If Greece really starts going down the tubes, Germany faces the unpalatable choice of either helping out or abandoning the system that it, more than any other member state, created. In short – any EMF, unlike the IMF, needs (a) to concentrate on preventing countries getting into trouble rather than dealing with them when they are already in trouble, and (b) deal with the fact that any country in trouble likely has significant clout in the architecture overseeing it. From my sense of the EU integration process, and of the rough bargaining strengths of the actors involved, I imagine that any final bargain will emphasize forward-looking measures, which are intended to forestall problems before they arise. Unhappily for Bundesbank disciplinarians, these are likely to rely more on carrots than sticks – it is clear from previous experience with the Growth and Stability Pact that threats of harsh punishment are not sufficient to produce virtue if these threats are not credible. We can expect moderate levels of fiscal transfers (likely ratcheting up over time), aimed at helping ease the pain of adjustment, together with admonishments (and withdrawal of goodies) for those who fail to live up to their promises.... So yes – the Greek crisis is plausibly a very significant step indeed in EU integration (whether for good or bad, I am not going to speculate, since even if I am right, it would depend heavily on the detail).

Senator Orrin Hatch, as observed by Matthew Yglesias: Hatch Sometimes Agrees With 80 Percent of the President’s Health Care Plan, Other Times Thinks It’s a Piece of Junk:

Back in September, Orrin Hatch wanted to appear reasonable on the health care issue, so in an MSNBC appearance he was willing to concede that he agreed with about 80 percent of what was on the table in an interview with Andrea Mitchell.... "[A]bout 80 percent of what they’re talking about we probably could agree on. But it’s the 20 percent where all the money is where we have a lot of disagreements, for instance, he was saying, basically, that they’re going to have a public plan, one form or another, that they’re going to have an employer mandate. […] I’m willing to work them out with him..." The current version of health legislation doesn’t really have an employer mandate and it certainly doesn’t have a public plan. So Hatch should probably be in agreement with 85-95 percent of it. That seems like a bill you’d vote for. But the Republican Party made a strategic decision to oppose health reform, so he needs to come up with a good reason to vote no. Consequently, he’s now changing his tune. “I don’t agree with 80 percent of it,” Hatch told my colleague Victor Zapanta in an exclusive interview conducted as Hatch was leaving a Chuck Grassley fundraiser, I think most of it is a piece of junk.” As with Jeb Bush on the American Recovery and Reinvestment Act, what you have is a refusal to admit that Hatch has decided to oppose the bill over what amounts to nitpicking. You never get a bill on a complicated subject that you agree with 100 percent. When you start with 80 percent agreement, and then get your way on one of your two main points of disagreement, that’s a bill you should be voting for...