recession odds

Greenspan mentioned that there is about 1/3 probability that the country will head to recession this year (2007). Can he be wrong? No. He must be right. What he is saying is there is 2/3 probability the country will not head to recession this year. Whether there is a recession oor not, he is always right, depends on 1/3 or 2/3 you emphasized.

It is very interesting the media only pay attention to the 1/3 part, did not realize the whole statement is the country is unlikely (2/3>>1/3 ) head to recession.

So, the question is not how likely, but will or will not. I tend to lean on the will side...

Invisible hand vs Monopoly II

If Mankiw is right, I would guess he thinks

Senate kills bid to import prescription drugs

is also a result of invisible hand...

Invisible hand vs Monopoly

Mankiw in his Blog advertises his textbook. Fair enough...but he mentioned:

"If you would like a copy and are not a professor eligible for a free one, you will have to rely on the invisible hand of the market to satisfy your cravings."

The price seems not driven by invisible, but visible hands: a good network between the publishers, the authors, and the high lobbying effort them to prevent price competition through imports. Simple examples are kill the second hand market every few years. Tell me why do we need a new edition of Introduction to Calculus book every few years? Tell me why you need an updated edition for many economic books? Tell me why you are able to sell at more than 50% discount for non-US edition in non-US countries but still making a profit? Tell me why most US online book store refuse to sell the non-US edition with identical contents? Tell me if you are not overpricing.

With almost perfectly inelastic textbook demand by students, the network is able to maintain high profit for long time. Poor students...

Please do you claim the price of your textbook is governed by invisible hand. It is govern by a few groups of people by exercising their monopoly power!!

What is it about Polish people and lines?

A few days ago in Steven D. Levitt Blog, He hypothesizes that one possible explanation why Poles so good/rude to cut into a line is:

"With so many years of shortages, the rewards for becoming an expert line cutter were much greater in Poland than in the U.S. So they did perfect standing in lines — perfection means being able to cut in front of people and feel no guilt."

It sounds strange to me. If the hypothesis is true, we should also expect the cost of losing the place in line is very high (again due to many years of shortages). This means those already in line will try every effort to prevent being cut into...so, two force will somehow counteract each other. It is not obvious why cutting in line is so often.

An experiment may be look at the line cutting within the tourist area (where people in line did not face shortage in the past) versus the line cutting in the local area. But two problems are 1. mostly likely, the price in the tourist area may be high enough that line may not often exists. 2. not many locals in the tourist areas.

Mexico interest rate surprise

The rate hike is surprising. The statement is to reinforce the bank's credibility.

The motivation is pretty obvious that the bank wants to reverse the inflation expectation. Currently the expectation is at the upper bound of the target. Here is a few questions we need to look at.

1. Inflation expectation is formed through many different channels. Most cases, it is formed from the inflation history. Of course, there are two ways to have inflation. Supply shock or demand shock.

A. Demand shock is the loosing monetary policy. Mostly due to fiscal pressure on the central bank financing. This was typical in EM in the past, and some EM today. In this case, the bank has an important role to convince the public that printing money to finance the fiscal deficit is not an option. That is one reason we have the inflation targeting institute or an independent central bank. Also under this case, inflation is driven by the government. As governemnt does not change every month, inflation expectation is formed as a response and tends to be sticky.

B. Supply shock on the other hand is not a direct result of policy failure. It is the weather or some global factor that the government/central bank has limited tools to counteract. In this case, inflation expectation tends to be short term and less sticky. In some sense it is more likely to be adaptive, adapted to a few month in the past. Market observes inflation yesterday tends to think it will be similar today because the transition probability for weather switch from one day to another is low. In other words, if the inflation figure drops today more than expected (due to demand slow down for example), expectation tends to adapt and adjust downward fairly quickly. Also because of that, the effect of central bank hike is smaller as the source is inflation is not from government. This seems what is expected in Mexico.

2. Anyhow, rate hike is real today. what will be next? I think the rate cycle (if there is) should be done. Inflation expectation should go down partly because of this rate hike, but more importantly, the diminishing of the supply shock. Of course, if there is another unexpected supply shock, the story will be different, but that is not the baseline.

3. The real concern is if the real economy response to the interest hike. The economy is cooling down. The uncertainty between the weak US growth and Mexico economy is high. If Mexico faces external sector slow down, and if domestic economy response negative to the rate hike, the effect will not be pleasant. This paves the way for interest rate adjustment.

Rising threat of Protectionism

What will be the impact of rising impact of protectionism?

I think that we need to go back a step to ask why there is a dollar weakness. We agree that is driven by current account deficit, which I personally think is internally driven as a reflection of private and public negative savings. The private and public negative savings are made in the US. In some sense the monetary policy in the private sector and the fiscal policy in the public sector. Global liquidity effect on paper assets also plays a role. The dollar has been supported by capital inflow which by definition is external driven.

The thought process of trade protectionism is how this may affect the link mentioned.

There is no reason that protectionism will have any significant impact on public saving. It is very hard to imagine the tariff collected from import will be significant in any measure.

On private saving, there are two things to think about. One is the overall level, the other is the substitution. With tariff and if the price actually rose, it is a matter of elasticity whether the US consumers will spend more or less. Indeed, I tend to believe that private business is able to adjust their productions to pass the tariff barrier. Unless there is a global protectionism, I would guess the level impact will not be large. One example is the US has placed a high tariff on wood imported from China for a while. What we see is that a number of furniture firms have switched from wood to leather or metals. The substitution effect may be more important from buying imported goods to domestic goods. I am not sure how big the effect will be, but it is very hard for me to imagine the US has competitive advantage in most consumer goods nowadays. In this sense, the impact on the public and private saving sides will not large.

The other side of the coin is the capital inflow financing. Capital inflow financing is a function of investor’s confidence on the US (yield and investment environment) and the foreign countries’ domestic concern. Protectionism will not be positive on the US investment environment. In the 1980s, when the trade tension between the US and Japan, we saw Japanese companies has put FDI in the US to smooth the relationship. In that sense, it is positive to the dollar. Do we expect this will happen again today when every low labor cost countries are opening up? I could guess the impact will not be as big as in the past decades. By the end, the portfolio flow is much larger than the FDI. For example, net foreign-owned assets in the US in 2006 were 1.76 trillion, while net foreign FDI inflows were $183.6bil, or less than 10% of total capital inflow. (BEA data)

The last thing is what will be the reaction of foreign countries? One reason why the foreign government continues to buy the US treasury is to support domestic employment, as the US government claims it is the exchange rate subsidy. Now, if the tariff is effective to switch employment from EM back to US, what is the motivation to continue buying the treasury? What this implies is that if tariff is effective, trade deficit will be improved, a positive to the dollar. At the same time, capital inflow will slow down, a negative to the dollar. Of course, there is the timing problem. If trade is improving but foreign governments do not act, it will be positive to $, and vice versa. One thing to bear in mind is the foreign governments consist of many players, that they do not coordinate their policies. If the US put a tariff on buy treasury buyers like China, China’s action can affect the market easily, but not the case if the tariff is on Costa Rica for example. So, if tariff is effective in affecting the trade flow, it is likely that the capital account will respond accordingly. Again, this case seems not likely as it is hard to see the competitive advantage of domestic US industry in consumer goods.

The worst case will be the broad protectionism creates a rise in risk aversion, but I am not sure this will benefit the US economy. This will be a loss-loss situation for all.

Latin America Trip

I have been in Latin America in the past two weeks. My first destination was Chile, followed by Argentina, Brazil, Peru and Colombia. The trip is very fruitful, but very exhausted. Two weeks have passed in a flash. I am now on the way back home.

Different countries have different economic development. The impression from the trip is that all countries are booming. All countries, to a different extent, are able to maintain their fiscal discipline. Argentina, Brazil, Peru and Chile all have primary fiscal surplus. Colombia is a bit behind with manageable deficit. This is a big contrast in the 1980s when the government spending is highly correlated with external environment.

Another important observation is that the growth is not limited to a small subset of economic sectors. Chile, Peru and Colombia, for example, the growth is quite diversified, from their traditional commodity export to retail, manufacturing, telecommunication, etc. This seems the current favorable external environment somehow passes through into domestic economy. One explanation is that the world really has a lot of liquidity. With economies are driven largely by private sector, high liquidity is channeled to the productive sectors. The government spending restraint also minimizes the crowding out effect.

This does not mean the countries are totally insulated from shock. One very clear problem in my mind is all their currencies are undervalued. Government intervention is the norm everywhere. There are two problems. One is sterilization is not complete, which means sooner or later, inflation will show up in the domestic economy. If this happens, the most affected group will be the poor, as most of them are not able to hedge the inflation risk. This is particularly important as history tells us that social unrest has been a hidden bomb in the Latin region. Last year’s Peru experience is still in our mind.

On the other side of the same coin, huge rise in international reserve expose the central bank on exchange rate valuation effect. If the world continues to be smooth and if the US continues to be fiscally irresponsible, the continuation of dollar depreciation is inevitable. If dollar in one day lost its attractiveness as a vehicle currency, these countries’ assets will be greatly affected. In some sense, the US now having a free lunch; or precisely the cost of the free lunch is paid by other countries.

The second problem I think is even more worrisome is all countries is very protective to their export sector. This suggests that they are not confident on the domestic economy. Every developing country wants to move to the developed world. Every developed economy is driven by domestic component, and most likely letting its currency floats freely. I don’t see this is the case in any of the Latin economy. The typical argument from the central bank or the ministry of finance is they concern their export sectors, or in short the Dutch Disease. Theoretically sound, but seems not practically right. The Dutch Disease argument relies on high entry barrier. This seems not too important for Latin’s manufacturing industries. But the end, the undervalued currency hinders the transformation to a high value added sectors. This is quite a bad thing in the long run.

In the sense, the government should spell a clear message that FX intervention is transitional, including the intervention magnitude over time. It seems so far there is no clear message out there. The market may think that is transitional not because of the government commitment, but the government capacity. Although the eventual outcome may be FX appreciation, the dynamic is very different. Under the first case, the market will have full information on the FX trend, and export sector are able to plan its transformation in an orderly fashion. Rational expectation suggests that volatility will tend to low. In the second case, market needs to estimate the capacity of the central bank, from inflation data, from interest rate data, etc. export sector will put more efforts on lobbying the government. Speculation will be high, and so is the FX volatility.

I recalled there are a number of countries in the past are able to move from pegged regime to floating regime without triggering a crisis. More importantly, all of them switched their regimes under the good time. This is the time for the Latin America. Making it overvalued or undervalued will eventually be problematic. It is important to let the FX go before the end of the good times. Today, with the exception of Argentina, all countries are doing well. Private sector is moving forward, and business confidence is high. Hyperinflation is a history.

With high international reserves, with fiscal balance and with favorable monetary condition, it is time to let it float. Let the market determine which industry should stay, which should let go. Let the financial market develops under the market condition. Most of those countries are not small open economy, they need their domestic demand determines the economy, not the export sector.