Krugman Still Believes In A Free Lunch

http://krugman.blogs.nytimes.com/2009/09/28/crowding-in/

There are so many things wrong with the above analysis.

The article is about how, in times like these, when we are ‘living is special conditions’, crowding out happens in reverse. That is, the government spending our money, when we don’t want to, actually makes us better off, not just now but also in the future. ie more consumption now leads to more consumption later. Of course this is not and cannot be true because it violates the first rule of economics: There is no such thing as a free lunch.

Regardless of whether or not he/she has a PhD or not, always be wary of an economist who tries to say that the 'it’s different this time' with regards to economic theory. True (Austrian) economic theory does not change, and when Keynesians use words like ‘crowding in’, ‘liquidity trap’, ‘paradox of thrift’ and ‘animal spirits’ it’s usually because they don’t understand what is really going on.

Krugman’s second point really sums up his lack of understanding:

(2) Crowding out: when it runs deficits, the government competes with the private sector for funds, so deficits crowd out private investment, which reduces potential growth.

It isn’t just funds that the private sector competes with the public sector for. When the public spends our money it uses up resources, (land, labour, capital), which prevents the private sector from employing them more efficiently. For a more in depth analysis of why public sector stimulus is no free lunch visit here:

http://www.riskwatchdog.com/2009/06/11/a-return-to-logic-a-critique-of-the-krugman-lecture-series/

Without fiscal spending, investment does take place, just at a lesser rate than is needed to make use of all the idle resources. It’s not only that the productivity of government-sponsored investments are below what could be hypothetically achieved by the private sector, it is that these ‘investments’ (more like consumption in reality) would hinder investment by the private sector now and in the future. Assuming that there is no crowding out in the present period (i.e. assuming that private demand does not fall as people expect higher taxes in the future and that Treasury yields do not rise due to the excess saving), I have no issue with the claim that higher fiscal spending makes a country better off in the present by raising demand. As an example, having masses of unemployed workers who could be contributing in some way makes no sense in the present. It’s obvious that the more we spend right now the better off we are right now, we don’t need Krugman to tell us this. The problem is we do not live in just one period. While I know that my ‘excess’ saving is not improving my wellbeing in this period, I am doing it because it will improve the discounted net present value of my future wellbeing. This is as true for an economy as it is for an individual.

Seeking Safety In Aussie Bonds

Despite the current re-flation attempts by the world's monetary policymakers, I still see deflation as the overriding theme going forward, owing to private sector deleveraging. With this in mind, Australian long duration bonds look particularly attractive for a number of reasons:

1. Yield Looks Attractive:
The current yield on the Australian 10-year bond is an attractive 5.4%, having risen from a low of 3.7% in December 2008, and is back to levels seen in 2006 when the global credit binge was in full swing. The nominal yield compares with the trailing dividend yield of 4.2% for Australia's ASX200 equity index.

2. Public Sector In Credit, Private Sector In Turmoil:
At the end of 2008, the Australian government was actually a net creditor, with net assets of roughly 7% of GDP. While the figure is likely to deteriorate this year as a result of the fiscal stimulus measures, the government's net debt ratio is still expected to remain in balance. This is extremely rare in today's world, and compares very favourably with Japan (95%), Italy (90%), and the US (60%) according to OECD figures.

By comparison, Australia's private debt burden is massive. Having peaked at roughly 165% of GDP in 2008, it has since fallen to around 150% and remains at twice the level seen at the start of the Great Depression. While government handouts have helped support private sector demand so far this year, a major private sector deleveraging process has begun, which will see savings rates rise for years to come. Indeed, the household saving ratio rose to 3.6% in Q209, continuing the uptrend seen since 2002 when the rate reached a low of -4.0%. This should continue rising towards the long-term average rate of 7.6%, with an overshoot highly likely. This could make for a perfect storm in the long-term government debt market.

3. Prudent Policy Limits Inflation Risk:
Unlike in the US and UK, where there is a huge risk that policymakers will continue to try everything they can to devalue their currencies to combat the ensuing deflationary forces, the Reserve Bank of Australia (RBA) is likely to continue acting relatively prudently. The Australian government has also been less willing to assume the debts of the corporate sector than the US and UK governments, which should keep gross debt levels low over the coming years. The government, which has run surpluses in its fiscal accounts for the past decade, will run a nominal fiscal deficit of 'just' 4.6% of GDP this year, way below the double-digit levels of the US and the UK. The relatively low willingness to take on more debt should continue to drive down perceived default risk at a time when other developed world governments are facing heightened default concerns.

JGB Bull Run Nearing An End?
One way to hedge the near-term risk would be to take a bearish stance on Japanese 10-year government bonds, as we see increasing potential for yields here to rise over the medium term.
I know I am not the only ones over the past decade to suggest that the bull market in Japanese government bonds could be ending. However, given the continued deterioration in the economy, this is becoming increasingly likely. Indeed, it is not inconceivable that Japan's balance of payments surplus could turn to a deficit, such is the weak outlook for global demand, which would likely force the Japanese government to offer higher interest rates on its debt in order to entice savings from overseas. On the contrary, we could also see Australia's current account deficit flip to a surplus as the private sector pays down the external debt it has accumulated from decades of current account deficits. This would add to the forces driving down long-term yields.

Australia More Creditworthy
Supporting my view that Australian long-term bonds will outperform those of Japan going forward is the current 10-year bond interest rate differential. At 411bps the spread is historically high and we believe that it is nearing its cyclical peak. What is more, given that the CDS market is currently pricing in a higher default risk in Japan than in Australia (and rightly so), this highlights the attractiveness of the current sovereign bond spread in terms of default risk.

Hayek About To Be Proven Right

As I write my first blog post the US dollar is strengthening and everything else priced in it is weakening, particularly stocks. This is a theme that has continued since last night, when it was revealed that the Fed would slow down its mortgage backed securities and agency debt purchase programme. If they are true to their word (and don’t announce an even bigger monetisation programme), this trend of asset price deflation will continue for a long time to come.

It seems that traders are better schooled in Austrian economics than I gave them credit for, having clearly read Hayek’s work - specifically, his contention that when monetary stimulus is slowed, never mind being withdrawn, recession-like symptoms in the economy emerge. I think he is about to be proven more right than even he would have wanted. The global economy (in particular the US and the UK) is in dire straights (more on this later) and we remain stuck in the early stages a depression that will play out in its entirety regardless of the actions of the Fed or anyone else. The reason is too much debt and too much malinvestment, and all the policy efforts so far have done is delay the day of reckoning, while ensuring that it will be even harsher than it would otherwise have been.

http://www.amazon.com/Tiger-Tail-Keynesian-Legacy-Inflation/dp/0932790062