Stumbling and Mumbling

Mervyn's luck

Wasn't Gordon Brown amazingly farsighted? That's the unusual thought prompted by today's inflation numbers.
They show that CPI inflation is running at 2.1%, just 0.1 percentage points above its current target. However, RPIX inflation is 3.2%, 0.7 points above the old target. The gap between the two rates, at 1.1 points, is the highest for three years.
This means Gordon Brown's decision to change the inflation target back in 2003 has proved most fortunate for the Bank. With inflation only trivially above its target, the Bank can easily justify cutting base rates. However, had the Bank been lumbered with the old target, it would have a much harder job cutting rates without looking as if it were panicking.
But why is inflation so different on the two measures? Partly, it's because CPI excludes housing costs such as rent and house prices. Also, it's because of a formula effect. The CPI uses a geometric average whereas the RPI uses an arithmetic one. This means the CPI, in effect, gives less weight to prices which have risen a lot.
However, neither of these explain why the gap between RPIX and CPI has risen so much in the last few years. The reason for this lies in what National Statistics calls "other differences" (table 10 of this pdf), such as differences in weights and goods sampled. Two years ago, these added 0.3 percentage points to the CPI relative to the RPIX. Today, they are taking 0.4 percentage points off.
For example, the CPI gives a weight of 2.9% to audio-visual equipment, prices of which have dropped 13.5% in the last year according to its measure. The RPI gives this just a 0.8% weight, giving less deflationary pressure. The CPI reports that alcoholic drink prices have risen just 0.4% in the last 12 months. The RPI measure puts the rise at 2.5%. The RPI reckons clothing prices have dropped 1.7% in the last year. The CPI thinks they've fallen 4.8%. CPI says furniture prices have risen 2.4%; RPI says 4.3%. CPI says package holidays' price have risen 1.1%; RPI says 2.6%.
Now, I'm not saying there's anything fishy here. The notion of a "true" rate of inflation is an absurdity. All macroeconomic aggregates are theoretical constructs, not pictures of reality.
Instead, I'm just saying that Mervyn King - and the government - have been remarkably lucky, in that the change in the inflation target has made it much easier to justify cutting rates now.
At the time, King said (pdf) that it was possible to argue that the change in the target represented a "small increase" in the target.  Maybe it wasn't so  small, after all.

A terrifying thought

Will Hutton writes something really alarming:

I know at least one central banker who spent the summer reading JK Galbraith's Great Crash.

This is scary. Surely, any central banker worth his job should have been re-reading The Great Crash.

A liquidity trap?

Are we in a Keynesian-style liquidity trap? That's one question raised by the small reponse of money market rates to Wednesday's promise by central banks to pump more cash into the markets.
The idea here is straightforward. As Keynes said, it is possible that:

Liquidity-preference may become virtually absolute in the sense that almost everyone prefers cash to holding a debt which yields so low a rate of interest. In this event the monetary authority would have lost effective control over the rate of interest.

This might describe what's happening now. Banks' desire to cling onto cash is so absolute that promises to increase the money stock have little impact upon interest rates; as Willem Buiter says, uncertainty about counter-party risk is paralyzing lending and making banks sit on cash. Monetary authorities have therefore lost control of the interest rate. Or at least stock markets fear that they have - hence their poor response to central banks' announcement.
Which is weird, because we normally think of liquidity traps happening (if they do so at all) when interest rates are low rather than around normal levels as they are now.
So, what's the solution? One possibility is just to wait.  Once banks have worked out exactly what their losses on sub-prime debt is, their precautionary demand for cash might dwindle, sending Libor down.
But there's another possibility. Maybe rates haven't responded much to central banks' promise because banks fear that the cash injection will be withdrawn once conditions look like stabilizing. If this is the case, central banks might have to heed Krugman's advice, to commit to being irresponsible, to continue to pumping money into markets after it's necessary.   
This means they face a nasty trade-off. On the one hand, restoring money markets to health requires that they raise banks' profit expectations, by offering lots of cheap money. But on the other hand, this raises not just the threat of inflation, but serious moral hazard problems.

The rate cut and Knightian uncertainty

Here's a paradox. On the day the Bank of England cuts base rates because "conditions in financial markets have deteriorated", the Royal Bank of Scotland announces that its losses on sub-prime mortgages have been a mere £1.25bn - loose change for a bank that size.
Which raises the question. Why have such trivial losses - Barclays were similar - caused such havoc in money markets; before today's cut, one-month Libor was a full percentage point above the base rate?
The answer is that banks' are reluctant to lend to each other not because they are potless, but because their precautionary demand for cash has soared. They fear further losses on mortgage derivatives, and are holding cash as a reserve against this.
The obvious source of further losses is simply the continued downturn in the US housing market. But there are two less obvious ones. 
One is a principal-agent problem within banks. Many CDOs are illiquid, which means that "mark to market" valuation can become "mark to fantasy." Traders have wiggle room in valuing them, depending on what copula you use (pdf). I suspect that quite a few have wiggled on the high side, hoping to grab one last Christmas bonus before jumping. Because banks' top bosses are less knowledgeable than their juniors about such intricacies, they cannot be sure how great their losses are.
The second problem is that valuations of such instruments are very largely a function of confidence. Take SIVs, which borrow money to buy asset-backed securities. If credit markets are buoyant, as they were in the spring, borrowing is cheap and SIVs do well. But if markets are nervous, borrowing costs are high and so SIVs lose a lot. But the problem is that market nervousness depends upon what they think SIVs are worth. This is circular. The threat banks face is that the downward spiral will continue - loss of confidence causes losses on SIVs which cause further losses of confidence.
The message here - which isn't appreciated sufficiently outside financial circles - is that banks' problems are not hard quantifiable ones, but rather those of genuine Knightian uncertainty. What Willem Buiter said of government might also be true of banks: "The possibility that the authorities could be both truthful and competent is barely worth considering." This isn't because they are fradulent, but because some things just can't be known.

Recessions & transvestism

The sainted Mr Worstall offers us the idea that recessions cause transvestism. But I would have thought this was self-evident. There are at least four mechanisms which suggest transvestism should be counter-cyclical.
1. Real business cycle theory tells us that recessions occur when people substitute leisure for labour. If people have more leisure, they'll have more sex - so I'm told. But there's diminishing marginal utility to sex.  So there'll be increased demand for ways of spicing up one's sex life, leading to increased cross-dressing and other fetishes.
2. It takes time to be a tranny - shopping for shoes and dresses, putting on make-up. These complemetarities between tranvestism and leisure mean one would expect the former to rise in recession.
3. Insofar as recessions reflect mismatches between the composition of demand and supply, they'll encourage people to retrain. One way in which men might to this is to acquire soft skills, such as emotional intelligence. This'll lead some to become more in touch with their feminine side.
4. In recent years, there's been a strong correlation (0.61, R-squared = 36.7% since January 1996) between annual growth in US industrial production and UK equity returns. In reducing returns, a recession would stimulate interest among idiots active investors in how to become better stock-pickers. As there's lots of evidence that women are better at this than men, this too would lead some men to get in touch with their feminine side. 

Index fetishism

The Royal Institute of Chartered Surveyors tells us that house prices have fallen at their fastest rate for two years, prompting the question: so what?
By rights, I should be more interested than most in this, as I'm hoping to move in the next few months. But I don't give a damn about house prices generally. What matters to me is the price of my flat in Belsize Park relative to prices of detached houses in Oakham. And  there's so much uncertainty about my particular flat's price that any signal about it sent by average prices is swamped by noise.
Nor is it the case that aggregate house prices matter much for the general economy. As Willem Buiter points out, they're not (in aggregate) net wealth, and so should have little impact on spending. And I've said that house prices have no correlation with share prices.
So, why the interest? It's not just the English obsession with property, fuelled by Sarah Beeny, that's to blame*. What's going on is a form of fetishism - we believe artificial constructs have powers they don't in fact possess. 
But macroeconomics was never intended to have this power. Even Keynes was very sceptical about the meaning of macroeconomic aggregates. In chapter 4 of the General Theory, he wrote:

The community’s output of goods and services is a non-homogeneous complex which cannot be measured, strictly speaking, except in certain special cases...
the well-known, but unavoidable, element of vagueness which admittedly attends the concept of the general price-level makes this term very unsatisfactory for the purposes of a causal analysis.

Later economists, though, lost this scepticism. And the costs of doing so were high, as Hayek pointed out, most strongly in A Tiger by the Tail. Macroeconomic aggregates, he said, "conceal the most fundamental mechanisms of change" - namely, relative prices, which tell people what to buy and sell. Keynesian policy-makers in the 60s and 70s, he said, had fuelled inflation and unemployment by believing they could tweak macroeconomic aggregates to maintain aggregate demand, when in fact they had lost sight of the most important way to maintain employment, which is to ensure the price system is sufficiently flexible.
Although Hayek won that argument, his lesson has not entered our culture - hence our continued obsession with aggregates.
Why is this? Partly, I suspect it's because macroeconomic numbers give journalists easy copy. But could it also be that they help give policy-makers the illusion that the world is controllable?
* Ms Beeny is probably responsible for some of the rise in house prices in recent years. Many of us, when we look at her, think about finishing off a semi.

Oil: a recession threat?

James Hamilton's got a great piece on the question of the impact of high oil prices on the US economy. I'd add one thing. This chart (inspired by this and this pdf) shows that between 1973 and 2003 there was a close relationship between the  real oil price and unemployment around 12 months later. High oil prices led to recessions, low ones to booms.
However, since around 2002-03, this relationship seems to have broken down.
This casts doubt upon  some the of reasons Olivier Blanchard and Jordi Gali give (pdf) for why the economy has (so far) coped will with high oil.
Sure, the economy is less dependent upon oil now than in the 70s, monetary policy is more credible and there's less real wage rigidity. But these are all gradual developments. They didn't suddenly emerge in the early 2000s. And yet the simple correlation between oil and unemployment did suddenly break down then.
So, here's my theory. For the most part, this rise in oil prices has been very different from previous ones. They were, generally, the result of supply shocks: the aftermath of the Yom Kippur war, the Iranian revolution, the invasion of Kuwait. This rise, however, has been the counterpart of a favourable supply shock. Oil has risen since 2002 largely because of strong Asian economic growth. But this growth has supplied cheap goods to the west, and so helped boost real incomes and hold down inflation and interest rates.
The adverse effect of oil prices has been masked by this bigger, beneficial, effect.
And here's my worry. Perhaps further rises in oil prices (or some part of the latest rise) might be due to supply constraints, rather than strong demand: the Energy Watch group claim (via) that oil supply has already peaked.
Can the economy cope as well with supply-induced price rises as it did with demand-induced ones?

House prices: could they fall?

How likely is a slump in the UK housing market? Recent news tells us less than you might think.
First, the Times reports a 0.1% fall in Hometrack's house price index with:

House prices fell for the first time in two years this month, sending a shudder through millions of homeowners.

Not through me, it didn't. The oldest cliche in economic punditry is that you mustn't read much into one month's data. This is a cliche because it's true.
Over the last 10 years, Nationwide and HBOS's house price indices (which have longer track records than Hometrack's) have risen by a monthly average of 0.9%, with standard deviations of 0.8 and 1.4 percentage points respectively. This means that you'd expect the Nationwide to report a house price fall one month in seven, and HBOS to report a fall one month every five, even if prices are on a firm upward trend. A monthly fall, in itself, tells us nothing. What was that I was saying about news being noise?
But what about the news that mortgage approvals have hit a two-year low? Doesn't this point to falling prices?
Not yet. This chart shows that there is indeed a good correlation (0.72, R-squared = 52.2%) between mortgage approvals and annual changes in house prices (HBOS's measure)  in the following 12 months.
But the thing is that approvals, at 102,000, aren't yet low enough to point to falling prices. The post-1987 relationship says this points to prices rising 9.7% in the next 12 months (the standard error is 6.6 percentage points).
The belief that house prices will fall significantly, then, owes less to the news than to our Bayesian priors: the possibility that high ratios of prices to earnings are unsustainable; the prospect of tighter lending critera and lower City bonuses after the summer's financial crises, and so on.
Are these priors right? Well, put it this way - I hope to trade down soon. 

Markets versus growth

Norm rightly criticizes George Monbiot for hoping we get a recession. But there's a wrinkle here that both are missing - that recessions only inflict material hardship upon minorities. In Coping with Recession, Paul Gregg and the late Paul Geroski showed that in the 1989-91 recession 10% of firms accounted for 80% of the gross fall in sales and 85% of the gross fall in employment.Roughly half of firms expanded employment.
Even if we ignore George's arguments, recessions actually benefit many people not just because economic activity grows in many places, but also because they reduce inflation which helps almost everyone.
The hardship which recession imposes is not so much material as psychological. Recessions are bad not because they make us poorer but because they make us fearful. And this fear, as Benjamin Friedman shows, has nasty effects upon social attitudes.
This means much of the harm done by recessions could be avoided by better pooling of risks - by having insurance products that insure people against downturns in particular industries or occupations. Robert Shiller has, brilliantly, shown how.
The costs of recession are, therefore, costs of having missing markets.
But the same's true for the costs of growth, described by George (which were in fact better put by John Stuart Mill in para IV.6.5 here). Take his example, noise. This is a problem (largely, partly?) because there isn't an adequate market in noise or quiet. If people had well-defined and protected property rights in the right to quiet, they could in principle sell it if the price were high enough. The noise that results from economic growth - I write this to the sound of builders in the flat below - would then only exist if it benefited everyone. That is, if the noise maker could pay enough to compensate others for his noise; if property rights could not be well-defined, a similar result could be obtained by a Pigovian tax upon noise-makers.
In this sense, the debate about the desireability or not of aggregate growth perhaps misses the point. The point is that markets are inadequate.
If George wants to make a stronger argument against capitalism, he'd point out that many capitalists' (and goverments') commitment to free markets is fictitious - they are not interested in creating markets that would benefit the poor and vulnerable.

The ideological crisis of capitalism

The bail-out of Northern Rock raises the question: just how much of a crisis is this for the wider economy?
Certainly, at least three financial indicators point to a sharp slowdown in the UK economy. Swap spreads, the US yield curve (pdf) and the interbank-base rate spread have all had some predictive power for UK activity in the past, and all three point to falling manufacturing output in the next two years. Indeed, lower bank share prices themselves might be a portent of slower growth too.
However, recessions are a normal feature of capitalism, and possibly not a very damaging one (pdf). And we might not even get one. Company profits are generally very high. At worst, that should limit the cutbacks in jobs and capital spending. And at best it could keep the economy ticking over, and save us from this.
Instead, I suspect the biggest crisis might be an ideological one, not a material one - because the stories the more dogmatic defenders of free markets tell no longer seem  so plausible, in three ways:
1.  Capitalism is not as stable and self-sustaining as it seems. It needs the state to step in sometimes to protect it.
2. The big wages of some hedge fund managers and bank bosses are not a reward for great skill in judging risks, but are instead just luck; if you stand where money is flying around, some will stick to you. Indeed, what stands out from Hedge Fund Research's data is that, even before this year's troubles, many funds did worse than cash; as Pommygranate says, they're just fee machines.
3. The "stand on you own two feet" attitude is markedly absent. Everyone seems keen to blame someone else: ratings agencies, excessively cautious banks, freak events, whatever. Few are saying: "yup, I lost money; it's my own fault." The personal responsibility so beloved of rightist commentators when they write about sink estates seems lacking in the City too.