Thursday, July 2, 2009

Random Thoughts 02 July 2009

Random Thoughts is a regular column with the aim of providing some interesting bits and pieces but does not give a holistic picture/view/outlook.

a) Restrictive fiscal policy: the budget woes in California highlight that fiscal policy is not universally accommodative in the US. For a short overview of Furlough Fridays back - now three days a month. Amongst others, "The executive order signed by Schwarzenegger will reinstate 'Furlough Fridays', requiring more than 200,000 state workers to take unpaid leaves on the first three Fridays of each month. The move amounts to an additional 4.62 percent pay cut for state workers, bringing their total reduction in 2009 to about 14 percent because of two furlough days imposed previously. " Clearly that is a disinflationary development. The problem is not confined to California. In fact a lot of US states have to cut spending/increase taxes and thereby run a pro-cyclical fiscal policy. Discussion about further necessary support for the states by the federal government is ongoing and is likely to intesify. What is more, problems are not confined to states only as also cities face severe budgetary issues, see for example here: El Monte avoids bankruptcy after police union agrees to cuts.

b) US Monetary policy: two interesting articles by inflation doves. San Francisco Fed president Yellen remains more worried about a sluggish recovery and easing inflation pressures (see here). More interesting is one comment about future Fed tightening: 'the Fed can push up the federal funds rate by raising the rate of interest that we pay to banks on the reserve balances they have on deposit with us—authority that was granted to us by Congress last year. An increase in the interest rate on reserves will induce banks to lend money to us rather than to other banks and borrowers, thereby pushing up the federal funds rate and other rates charged to private borrowers throughout the economy. The ability to pay interest on reserves is an important tool because, as I mentioned, it’s conceivable that, even if the economy rebounds nicely, the credit crunch might not be fully behind us and some financial markets might still need Fed support. This tool will enable us to tighten credit conditions even though our balance sheet wouldn’t shrink.'
This is interesting in the sense that it generally is seen that the Fed would first shrink its balance sheet and then hike rates. But clearly they have the option to go down a different route.

Alan Blinder - a former vice chairman of the Federal Reserve - states in Why inflation isnt the danger that banks hold excess reserves and therefore Fed's balance sheet lengthening is not inflationary. I fully agree with this. With respect to future tightening, Blinder makes one interesting point: 'The possibilities for error are two-sided. Yes, the Fed might err by withdrawing bank reserves too slowly, thereby leading to higher inflation. But it also might err by withdrawing reserves too quickly, thereby stunting the recovery and leading to deflation. I fail to see why advocates of price stability should worry about one sort of error but not the other.'

c) Too much hope in the Chinese growth saves the world story? There is a lot of talk about the strength of the Chinese economy. A shift away from the export driven GDP growth model towards a more consumption-driven model of growth would be welcome. This would add to global demand and at the same time would help to reduce global imbalances (via a reduction in the Chinese current account surplus). China has the means to promote growth via macro-economic stimulus and is doing so. Despite being the world's manufacturing powerhouse, the economy seems to be back on a good growth path (However, it remains questionable whether China can divert itself towards a sustainable growth path without relying on export growth). Still, while it certainly helps, I fail to see how that alone will take the global economy out of the dolldrums in the short term as nominal GDP is just not high enough compared to the ailing advanced economies (see chart, source: IMF). The nominal GDP of the US economy alone accounts for some 25% of world nominal GDP with Japan 9% and the Euro Area 21%. With the outlook being that Japan continues its weakish growth, Eurozone trend growth to be a bit weaker than since its inception (amid the substantial structural imbalances in the so-called periphery and Spain) while the US should see trend GDP growth significantly lower than during the last years, we will have 55% of current nominal world GDP failing to deliver a significant increase in demand. China itself accounts for 9% of world nominal GDP (so it is currently the size of Japan according to the IMF). This size of 9% is just not high enough to overcome the weakness in 55% of the world economy.

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