The news from Europe, particularly from within the eurozone, seems all bad.  Interest rates on Italian government debt continue to rise.  Attempts to put together a “rescue package” at the pan-European level repeatedly fall behind events.  And the lack of leadership from Germany and France is palpable – where is the vision or the clarity of thought we would have had from Charles de Gaulle or Konrad Adenauer?

In addition, the pessimists argue, because the troubled countries are locked into the euro, there are no good options.  Gentle or even dramatic depreciation of the exchange rate for Greece or Portugal or Italy is not in the cards.  As a result, it is hard to lower real wages so as to restore competitiveness and boost trade.  This means that the debt burdens for these countries are likely to seem insurmountable for a long time.  Hence there will likely be default and resulting global financial chaos.

According to the September 2011 edition of the IMF’s Fiscal Monitor, 44.4 percent of Italian general government debt is held by nonresidents, i.e., presumably foreigners (Statistical Table 9).  The equivalent number for Greece is 57.4 percent, while for Portugal it is 60.5 percent.  And if you want to get really negative and think the problems could spread from Italy to France, keep in mind that 62.5 percent of French government debt is held by nonresidents.  If Europe has a serious meltdown of sovereign debt values, there is no way that the problems will be confined just to that continent.

All of this is a serious possibility – and the lack of understanding at top European levels is a serious concern.  No one has listened to the warnings of the past three years.  Almost all the time since the collapse of Lehman Brothers has been wasted, in the sense that nothing was done to put government finances on a more sustainable footing.

But perhaps the pendulum of sentiment has swung too far, for one simple and perhaps not very comfortable reason.

There is no way to have just a little debt restructuring for Italy.  If Italian debt involves serious credit risk – i.e., a nonzero probability of default – then all sovereign debt in Europe will need to be repriced, downwards.  There is a notion that Germany will remain a safe haven, but even that is far from clear.  According to the IMF, gross government debt in Germany will be 82.6 percent of GDP at the end of this year (Statistical Table 7 of the IMF’s Fiscal Monitor; the net government debt number for 2011, in Statistical Table 8, is 57.2 percent).  Reports of German fiscal prudence have been greatly exaggerated.

There is no way that the German policymakers or the German public will do well in the event of a major sovereign credit disaster.  Credit would tighten across the board.  German exports would plummet.  The famed German social safety net would come under great pressure.  If Germany had to call in the International Monetary Fund for advice, even informally and behind the scenes, how would that feel?

And they have an alternative – allow the European Central Bank to provide “liquidity” support across the board to the troubled governments.

There are many things wrong with this policy – and it is exactly the kind of moral hazard-reinforcing measure that has brought us to the current overindebted moment.  None of us should be happy that Europe – and the world – has reached this point.

Among others, the bankers who bet big on moral hazard – i.e., massive government-backed bailouts – are about to win again.  Perhaps the Europeans will be tougher on executives, boards, and shareholders than the Obama administration was in early 2009, but most likely all the truly rich and powerful will do very well.

But if your choice is global calamity or – effectively – the printing of money, which would you choose?

The European Central Bank has established a great deal of credibility with regard to keeping inflation at or close to 2 percent.  It could probably offer a great deal of additional support – through creating money – without immediately causing inflation.  And if the ECB is providing a complete backstop to Italian government debt, the panic phase would be over.

None of this is a lasting solution, of course.  Europe needs a proper fiscal center – much as the United States needed in 1787 and got under Alexander Hamilton’s policies from 1789.  Hamilton remains a controversial figure in US history but when he took over the US was in default and the credit system was almost completely broken.  Some centralized tax revenue and control over fiscal deficits

Mr. Berlusconi stood in the way of all this.  There is no way that the other Europeans would trust him to tighten Italian fiscal policy.  But if he is really gone from power – and we should believe that only when we see it – there is now time and space for Italy to stabilize and, with the right help, find its way back to growth.

Of course, if the ECB provides unconditional financial support to Italian or other politicians who refuse to bring their deficits under control, then we are heading for another Great Inflation.

An edited version of this post appeared this morning on the NYT.com’s Economix blog; it is used here with permission.  If you would like to reproduce the entire post, please contact the New York Times.

I was on vacation last week (far from Jackson Hole) when Ben Bernanke gave his widely anticipated speech. The media (see the Times, for example) seemed to focus mainly on his criticisms of the political branches and economic policymaking, which were accurate enough. But in my opinion, Bernanke drew the wrong lessons from those observations.

He was very clear that the problem today is unemployment, not inflation:

“Recent data have indicated that economic growth during the first half of this year was considerably slower than the Federal Open Market Committee had been expecting, and that temporary factors can account for only a portion of the economic weakness that we have observed. Consequently, although we expect a moderate recovery to continue and indeed to strengthen over time, the Committee has marked down its outlook for the likely pace of growth over coming quarters. With commodity prices and other import prices moderating and with longer-term inflation expectations remaining stable, we expect inflation to settle, over coming quarters, at levels at or below the rate of 2 percent, or a bit less, that most Committee participants view as being consistent with our dual mandate.”

He even said that we are in a situation where economic would improve the economy’s long-term performance:

“Normally, monetary or fiscal policies aimed primarily at promoting a faster pace of economic recovery in the near term would not be expected to significantly affect the longer-term performance of the economy. However, current circumstances may be an exception to that standard view–the exception to which I alluded earlier. Our economy is suffering today from an extraordinarily high level of long-term unemployment, with nearly half of the unemployed having been out of work for more than six months. Under these unusual circumstances, policies that promote a stronger recovery in the near term may serve longer-term objectives as well. In the short term, putting people back to work reduces the hardships inflicted by difficult economic times and helps ensure that our economy is producing at its full potential rather than leaving productive resources fallow. In the longer term, minimizing the duration of unemployment supports a healthy economy by avoiding some of the erosion of skills and loss of attachment to the labor force that is often associated with long-term unemployment.”

But what is Bernanke going to do about it? He declined to offer any new efforts to reduce unemployment, saying only that the Fed “is prepared to employ its tools as appropriate to promote a stronger economic recovery in a context of price stability.” And mainly he relied on the political branches to solve the country’s problems, calling not only for “good, proactive housing policies” but also for policies that would improve K–12 education for underprivileged households and lower health care costs.

I don’t think it makes sense to criticize the political system for being dysfunctional and then rely on the political system to rescue the economy. I understand that traditional monetary policy tools don’t work that well in this environment: short-term rates can’t go any lower, and lowering long-term rates won’t make companies invest if they don’t think there is demand for their stuff. But there’s always, you know, dropping cash out of helicopters.

It’s true that, in the speech that gave Bernanke the nickname “helicopter Ben,” he was talking about a tax cut—in other words, fiscal policy. But there’s always the option of increasing the inflation target from 2 percent to 4 percent while simultaneously buying long-term bonds to keep nominal rates from rising too much (so real rates come down). If the Fed can actually generate more inflation, that would function like a transfers from creditors to debtors, which would help solve the household balance sheet problems that are weighing down the economy. And there’s nothing magical about the number two: both Ken Rogoff and Olivier Blanchard have argued for higher inflation, given current economic circumstances. As Blanchard says, “There was no very good reason to use 2% rather than 4%. Two percent doesn’t mean price stability. Between 2% and 4%, there isn’t much cost from inflation.”

I’m not sure it would work; maybe even raising the inflation target wouldn’t actually increase inflation. But doing nothing is be the wrong policy conclusion to draw from Bernanke’s observations, which seem spot-on.

In a Congressional hearing today, Representative Paul Ryan (R-WI), chair of the House Budget Committee, strongly criticized Federal Reserve Chair Ben Bernanke for failing to contain the severe inflation threat posed by the Tooth Fairy.

Ryan pointed to numerous studies showing that, despite ongoing economic sluggishness, the Tooth Fairy is paying much more for children’s baby teeth than in past years. In neighborhoods such as Winnetka, Cleveland Park, the Upper East Side, and Palo Alto, children can receive more than $20 per tooth — a dramatic increase from the 25-50 cents that the Tooth Fairy paid only a decade or two ago. In the Hamptons, summertime prices for teeth can easily exceed $100, according to a survey commissioned by the American Enterprise Institute.* Because the Tooth Fairy is able to create money magically, her purchases of unused teeth (with no apparent economic value**) increase the money supply, fueling inflation. Without explicitly accusing Bernanke of participation in the Tooth Fairy’s scheme, Ryan implied that the Tooth Fairy’s higher payouts may be part of the Federal Reserve’s quantitative easing scheme.

Ryan pointed to Tooth Fairy-driven inflation as part of “a sharp rise in a variety of key global commodity and basic material prices” that, he said, threaten to produce higher overall inflation and reduce the value of the dollar. “The inflation dynamic can be quick to materialize and painful to eradicate once it takes hold,” said Ryan, calling on Bernanke to end the quantitative easing program and raise interest rates in order to counteract the expansionary policies of the Tooth Fairy.

Bernanke responded, “On the inflation front, we have recently seen increases in some highly visible prices, notably for children’s teeth. . . . Nonetheless, overall inflation is still quite low and longer-term inflation expectations have remained stable.” He pointed out that all measures of domestic inflation — the prices that real Americans pay for the real stuff that they actually buy — are at historic lows: core inflation of 0.7 percent in 2010, the price index for personal consumption expenditures at 1.2 percent, and average hourly earnings at 1.7 percent. He also pointed out that inflation in emerging markets is higher because those economies are growing faster and that commodity prices are always volatile. But Ryan insisted that the Fed take aggressive action against the Tooth Fairy because an unemployment level of 9 percent would fail to contain the inflationary spiral that would inevitably result from this particularly sinister form of monetary expansion, taking place quietly, in the dark, in our children’s own bedrooms.

“There is nothing more insidious that a country can do to its citizens than debase its currency,” he said, apparently forgetting for a moment that he has proposed replacing Medicare with a voucher system whose benefits are explicitly designed to grow slower than the rate of health care cost inflation.*** Ryan also apparently believes that a more valuable currency is always better than a less valuable currency, which is crazier than a kid believing in the Tooth Fairy. After all, if you’re six years old and the tooth under your pillow gets replaced by money and a note from the Tooth Fairy, then that’s physical evidence in favor of her existence. Paul Ryan seems to believe that China (like Korea, Taiwan, Germany, and France before it) is hurting its economy by keeping the value of its currency low in order to promote exports and create jobs. This fetishization of the dollar’s exchange rate is even crazier than the typical fetish, which at least attaches to some object. Paul Ryan’s fetish attaches to an abstract ratio and elevates it to moralistic terms.

* In inner-city Detroit, however, survey respondents gave answers such as, “No Tooth Fairy comes around here. Haven’t you seen nobody has a job anymore?” The AEI report concluded that the Tooth Fairy must value teeth from the Upper East Side more than teeth from Detroit.

** See the introduction to a This American Life episode for some children’s theories about what the Tooth Fairy does with all those teeth.

*** The growth rate of benefits is capped at GDP plus one percentage point. Historically health care costs have grown significantly faster. More to the point, the whole point of the Ryan-Rivlin plan is to force Medicare to grow more slowly than health care costs overall; if health care cost growth is GDP plus one percentage point or less, then converting Medicare to a voucher system provides no fiscal benefits.

Duy takes as his starting point a series of statements by Fed governors and bank presidents indicating “hawkishness,” which in central banker jargon means caring primarily about inflation, not economic growth. (“Doves” are those who care more about economic growth and jobs, although, just like in the national security context, no one likes to be known as a dove. This itself is a disturbing use of language, since it implicitly justifies beating up on poor people, but let’s leave that for another day.)

Hawks also like to talk a lot about “credibility,” which means a reputation for being willing to fight inflation. People use the word credibility in this context because the conventional wisdom used to be that national governments would not be willing to take tough steps (raising interest rates) against inflation because that would cost jobs, and hence votes in the next election. So central banks had to prove that they were willing to raise interest rates and put people out of work, even though that might be politically unpopular. Now that our Fed governors and bank presidents are accountable to just about no one, beating on their chests and proclaiming how willing they are to be tough in the face of the political winds rings a little hollow to me — especially in a “middle-class” country that considers inflation to be a greater evil than unemployment. Arguably, the situation has reversed; it has become so accepted that the primary job of a central bank is to fight inflation, despite the Fed’s dual mandate (to both fight inflation and promote stable economic growth), that fighting inflation has become the politically safe thing to do. But I digress again.

This is what Duy sees:

• Kevin Warsh of the board of governors: “If ‘whatever it takes’ was appropriate to arrest the panic, the refrain might turn out to be equally necessary at a stage during the recovery to ensure the Fed’s institutional credibility.”
• Richmond Fed president Jeffrey Lacker, from Bloomberg: “The Federal Reserve will need to raise interest rates when the economic recovery is ‘firmly’ in place, even if unemployment lingers near 10 percent, Federal Reserve Bank of Richmond President Jeffrey Lacker said.”
• Philadelphia Fed president Charles Plosser: “[J]ust as the Fed has taken aggressive steps in flooding the financial markets with liquidity during this crisis to reduce the possibility of a second Great Depression, it will also have to take the necessary steps to prevent a second Great Inflation. Our credibility depends on it. …  The Fed will need courage because I believe we will need to act well before unemployment rates and other measures of resource utilization have returned to acceptable levels.”

Can you feel the testosterone?

Duy argues that all this manliness is misplaced. The Fed hawks’ basic argument seems to be that, because it acted so aggressively to stimulate the economy last year, it will have to act equally aggressively to dampen growth at some point — just to send a message. And to send that message, they need to be willing to raise interest rates while unemployment is still 10% (Lacker) or “well before unemployment rates and other measures of resource utilization have returned to acceptable levels” (Plosser).

Now, there may be something to this. Duy points out that the hawks seem to be worried about recreating the debt bubble of the last decade through too much cheap money. If cheap money is going to flow straight into overvalued houses, then that’s a problem. But Duy says that that is a failure of regulation. Low rates are supposed to stimulate capital investment by businesses, which is what long-term economic growth depends on. But earlier this decade, despite low rates, capital investment never returned to 1990s levels, because all the cheap money was flowing into housing instead — for reasons we know.

“Are we really worried about a lending explosion by itself, or that the regulatory environment remains so weak that financial institutions will quickly repeat the experience of this decade’s debt bubble? …

“With the primary build out of the internet backbone complete, the US appeared to experience a dearth of traditional investment opportunities (I suspect that the need to expand production domestically was made moot by an international financial arrangement that favored the establishment of productive capacity overseas), and, like water flowing downhill, capital was thus allocated this decade to residential investment, which, we now know was more about consumption than investment, and the resulting economic activity was anemic by historical standards.”

The solution, then, is better regulation to protect against misallocation of credit to the next asset bubble. Simply raising rates will choke off an asset bubble, but it will also choke off real investment by businesses.

This goes back to what StatsGuy said in a post here:

“In order for the Fed to actually be able to fully use monetary policy to keep the economy humming at full throttle, we need financial regulation (to avoid new liquidity being channeled into bubbles instead of real investment), better capital asset ratios (to help moderate moral hazard and asymmetric risk), and limited expectations of future dollar devaluation (which currently result from our huge debts, and China’s continued mercantilist policies that keep the dollar propped up). …

“But what happens if we fail to fix the structural issues? Well, the answer is not good. Without the right scalpels and scaffolding, the Fed will use a sledgehammer – taking away the punchbowl during booms and giving it back during busts. Except that it will almost always get the timing wrong – taking away the punchbowl too fast and give it back too late, due to poor regulation and dollar instability, and its own anti-inflation intellectual bias and obsession with its credibility.”

In other words, if you’re going to throw in the towel on regulation, then there is no place for cheap money to go except the next asset bubble. You might as well try to prevent that, but then you are consigning the real economy to a long, slow decline since you have no way of getting monetary stimulus where you need it (factories, not new condo towers).

So there seem to be two possible futures. If we repeat the Greenspan policy of low rates during a boom, we’ll just create a bubble all over again, since none of the underlying factors (weak consumer protection, weak bank regulation, etc.) have changed. Or if the hawks win (both in the Fed and in Congress, which controls fiscal stimulus), we’ll have high unemployment for a long, long time, since no one will have the guts to risk higher inflation. Being a “hawk” has become the safe, comfortable choice — even in a week when monthly job losses were up and weekly new unemployment claims were up.

By James Kwak

2. The real economy begins to bottom out, although unemployment will not peak for a while and could stay high for several years.  Longer term growth prospects remain uncertain – has consumer behavior really changed; if finance doesn’t drive growth, what will; is the budget deficit under control or not (note: most of the guarantees extended to banks and other financial institutions are not scored in the budget)?

3.  More broadly, there is sophisticated window dressing in the pipeline but no real reform on any issue central to (a) how the banking system operates, or (b) more broadly, how hubris in finance led us into this crisis.  The financial sector lobbies appear stronger than ever.  The administration ducked the early fights that set the tone (credit cards, bankruptcy, even cap and trade); it’s hard to see them making much progress on anything – with the possible exception of healthcare.

4. The consensus from conventional macroeconomics is that there can’t be significant inflation with unemployment so high, and the Fed will not tighten before late 2010.  The financial markets beg to differ – presumably worrying, in part, about easy credit leading to dollar depreciation, higher import prices, and potential commodity price inflation worldwide.  In all recent showdowns with standard macro models recently, the markets’ view of reality has prevailed.  My advice: pay close attention to oil prices. 

5. Emerging markets are increasingly viewed as having “decoupled” from the US/European malaise.  This idea was wrong in early 2008, when it gained consensus status; this time around, it is probably setting us up for a new bubble – based on a “carry trade” that now runs out of the US.  The ”appetite for risk” among investors is up sharply.  The G7/G8/G20 is back to being irrelevant or merely cheerleaders for the financial sector.

Comments welcome.

By Simon Johnson

In the New United States, life is much simpler and bank tunneling considerably more brazen.

I’m starting a bank blotter.  Here are some early entries, from the WSJ on Wednesday:

1. We’ll pay ourselves very high wages, rather than substantial bonuses (p.C3 in print edition).  This is brilliant.  These banks are supposed to be recapitalizing themselves, which means earning profit - and this is usually harder to do if you increase wages.  Lower wages would mean the exit of employees at some of the world’s least well run firms - entities consistently plagued also by the world’s most blatant agency problems – but the banks simply assert that would be a bad thing.
2. We’ll use the PPIP money to buy toxic assets from ourselves and thus “participate in the upside” (p.C1 in print edition; reviewed here yesterday).  In any decent society, this would set the red flags flying, but the banks have apparently lost all sense of moderation.  Look carefully at (perhaps) the most fantastic angle here – these assets will be moved “off balance sheet”, as if that does anyone any good; remember many such assets started off there and moved on balance sheet as the crisis developed.  Come to think of it, the complexity inherent in the implicit conflicts of interest in this scam scheme would go over well in Russia.

What does any of this have to do with inflation?  If you want to the Fed ever to be able to tighten, you need a healthy enough financial sector – i.e., given what we now know about policymakers’ preferences, banks in the “too big to fail” category better not be close to failing. 

Big banks that pay higher wages will have less capital for the next round of difficulties.  Banks that keep legacy assets close at hand will likely find out (again) why these loans and securities were called toxic.  A weaker set of big banks will encourage the Fed to allow the yield curve to steepen, so monetary tightening happens later and perhaps too late to prevent inflation from taking off.  Tunneling makes it harder for the Fed to tighten when inflationary pressures appear. 

And if you think that inflation is not possible in the US any time soon, please see my column on NYT’s Economix (usually appears at around 7am Thursday morning, New York time) – post comments there or here.

By Simon Johnson

My post about French sociology got a wide range of comments, ranging from “Without a doubt, your best post yet” to “Reading this post made me think, for the first time, of ignoring Baseline Scenario from now on,” which I guess indicates we have a wide range of readers. In any case, for today I’m returning to something much more mundane: GDP growth rates. Like many Beginners articles, this one starts out with some basics, and then gets (a little) more interesting, but its main goal is to help you decipher the news that you already read.

To a casual reader, yesterday’s GDP announcement was that Gross Domestic Product (an aggregate measure of economic activity) fell by 6.1% or, more precisely, at an annual rate of 6.1%. What does this mean?

For those of you who have never visited the BEA website, this is what the raw numbers look like. (They give you  columns B and E, I calculated the rest.) Note that this is all in 2000 dollars, so inflation has been taken out.

The columns are as follows:

• B: Quarterly GDP, or economic activity in that quarter. However, these numbers are expressed as seasonally adjusted annual rates. That is, GDP in 2009Q1 was not $11.3 trillion, but closer to 1/4 of that number, or about $2.8 trillion. The BEA multiplies by four, and also applies seasonal adjustments, like correcting for the fact that different quarters have different numbers of days.
• C: The change from the last quarter. So GDP in 2009Q1 was 1.6% less than in 2008Q4.
• D: The change from the last quarter, annualized; put another way, the total change you would get if that rate held constant for a full year; or, roughly column C times 4. This is the headline number you see in the newspapers. But the economy has not actually contracted by 6.1%. Skip ahead to column . . .
• H: This is the total change in economic activity since the most recent peak. In our case, the last peak was 2008Q2, when annualized GDP reached $11.727 trillion. So far, the economy has contracted by 3.3% – which is already a large amount. Head back to column . . .
• E: This is GDP for the full calendar year. Since column B was already annualized, you don’t add up the four quarters for each year; instead, you average them. The confusing thing is that there are two different ways of measuring changes in GDP from year to year, shown in columns F and G.
• F: This is the simple percentage change in column E. So total economic activity in 2008 was 1.1% greater than in 2007.
• G: This is the change from Q4 of one year to Q4 of the next year. This shows you how much GDP grew or contracted during the second year. So the economy in Q42008 was 0.8% smaller than in Q42007, meaning it contracted in 2008 – even though overall there was 1.1% more economic activity in 2008 than in 2007.

GDP also, by definition, has four components: personal consumption expenditures; private domestic investment (investment by companies and households in big things, like factories or houses); net exports (exports minus imports); and government spending. You will also see growth rates (like above) for each of these components, and for their sub-components. You can see all the tables in the BEA’s nice news release. For example, in Q1 personal consumption grew at an annual rate of 2.2%, which was the “good” news, but private domestic investment fell at an annual rate of 51.8%, which was the “bad” news. (That 51.8% includes a preliminary wild guess at inventory changes – adding stuff to inventory counts as GDP, taking stuff out of inventory counts as negative GDP – but even excluding inventories, fixed investment fell at a 37.9% rate.) The aggregate GDP growth rates are just the weighted averages of the growth rates of the components.

Yesterday’s announcement was at the low (bad) end of most forecasts. The first thing to bear in mind, though, is that this is just the advance estimate. While advance estimates under ordinary circumstances are not that bad, the advance estimate for Q4 was way off. All of these numbers are estimates, and when the world changes, the estimating models become less accurate.

In some cases, a steep fall might mean that the recovery will just come that much sooner – if the floor is somehow independently determined. This could be the case with housing prices, for example, where there are reasons to believe that fundamentals will put a floor under prices, at least expressed as a percentage of average income. But the economy as a whole is a much more complex system, so I doubt you can take the level of the floor as given.

The principles above apply generally to the rates of change you see in the newspaper: you’ll see period-to-period changes, which may or may not be annualized, and year-to-year changes, which may compare entire years or a single period with the period one year before. But there are differences in presentation that can be confusing.

For example, the Consumer Price Index (technically, the CPI-U, which is the headline index) is reported on a monthly basis, and changes in the CPI are reported over three different periods:

1. Change from the previous month, seasonally adjusted (to take into account the fact that people’s consumption mix changes over the year) but not annualized. This is the current short-term monthly inflation rate.
2. Change from three months before, seasonally adjusted and annualized. This is the average annualized inflation rate over the last three months.
3. Change from the same month the previous year;  this figure is already annualized by construction.

If you look at the most recent CPI news release, you’ll see that these three numbers are -0.1% (change from February to March, not annualized), 2.2% (change from December to March, annualized), and -0.4% (change from March 2008 to March 2009). The 2.2% and -0.4% are comparable, because they are both annual rates, but they are not comparable to -0.1%, which is a monthly rate. And is inflation positive or negative? It depends on which number you look at.

(Of course, the figure that the Fed and many economists focus on is CPI with food and energy stripped out. For that measure, the three numbers are 0.2%, 2.2%, and 1.8%, which are much more in line with each other; remember, the first one is monthly and the others are annual.)

When you see housing price changes, like changes in the Case-Shiller index, you usually see changes from the previous month or changes from the same month a year before; which one you focus on can have a major impact on how you interpret the numbers.

You need to be especially careful when interpreting economic indicator indexes. These do not show the absolute level of some economic phenomenon, but they are constructed to reflect the degree of change in some economic phenomenon. As a result, the index is already the “first derivative” of the economic phenomenon, so changes in the index are the “second derivative.”

For example, Calculated Risk today reported that the Restaurant Performance Index increased by 0.2% to 97.7 from February to March. However, as CR points out, “Any reading below 100 shows contraction. So the improvement in the index to 97.7 means the business is still contracting, but contracting at a slower pace.” In other words, activity was lower in March than in February. Is the increase in the index good news? Well, it’s better than a decline, and it’s better than staying the same. But indexes like this should have some degree of built-in reversion to the mean (around 100); things just can’t keep falling at a linear rate forever.

Finally, the Consumer Confidence Index of the Conference Board can be especially confusing. The index as a whole increased from 26.9 to 39.2 in April (the median over the last 20 years has been around 100, or a little below), driven largely by a jump in the Expectations Index (expectations about how the economy will be in six months) from 30.2 to 49.5. But the reading of 49.5, and the poll questions behind it, still indicate that many more people think the economy will get worse than think it will get better. So what we have is the economy getting worse, and even as it gets worse, most people think it will continue getting worse – but as time passes, a growing minority think that we are within six months of the bottom.

Hopefully that will help people interpret the numbers that make up so much of the economic news these days. As always, if you find mistakes, please let me know.

By James Kwak

Only a few years ago, the accepted remedy for a recession was for the Federal Reserve to lower interest rates – namely, the Federal funds rate. Now, however, the economy has been stuck in recession for over fifteen months and the Federal funds rate has spent the last several months at zero. (The Fed funds rate cannot ordinarily be negative, because one bank won’t lend $100 to another bank and accept less than $100 in return; it always has the option of just holding onto its $100.) As a result, the Fed has resorted to other policy tools, most notably large-scale purchases of agency and Treasury securities, funded by creating money. (Here’s James Hamilton’s analysis.)

As the Fed’s monetary policy plays a more prominent role in the response to the economic crisis, there will be more talk of inflation or, more accurately, inflation expectations. While inflation is what affects the purchasing power of the money in your wallet, inflation expectations are what affect people’s behavior in ways that have a long-term economic impact. Take the case of wage negotiations, for example: a union that believes inflation will average 5% over the life of a contract will demand higher wage increases than a union that believes inflation will average only 1%. Once those higher wages are built into the contract, the employer is forced to raise prices in order to cover those wage increases, and inflation begins to ripple through the economy.

One of the major objectives of modern monetary policy is to control inflation expectations, because controlling inflation expectations is the first step to controlling inflation. If there is a short-term burst of inflation – as we had a year ago, if you look at headline inflation numbers that include the prices of food and energy – the macroeconomic consequences can be limited if people believe that the Fed can and will bring inflation under control.

Unfortunately, it is impossible to know exactly what people’s inflation expectations are; in fact, it may not even be a sensible question, since different people have different understandings of what inflation is. However, there are three main approaches to estimating inflation expectations.

1. Inflation-indexed government bonds. (If you need a refresher on how a bond works, read the first part of this article.) A traditional bond is a stream of payments that is fixed in nominal terms: for example, $100 in 10 years, and 6% interest, paid semi-annually ($3 every 6 months). Such a bond is not inflation-indexed; if inflation goes up, the purchasing power of that $100 goes down, and it’s too bad for the bondholder.

An inflation-indexed bond, by contrast, pays an amount that is indexed to some measure of inflation. In the U.S., where these bonds are called Treasury Inflation Protected Securities (TIPS),  we use the Consumer Price Index. A TIPS bond may have a $100 face value and pay a 2% interest rate. However, every 6 months, that $100 face value is adjusted to reflect the change in the CPI, and the interest payment is calculated as a percentage of the adjusted value of the bond. Then, after 10 years, the bondholder gets back not $100, but $100 times the ratio between the CPI at the end of the period and the CPI at the beginning of the period. This way the bondholder is guaranteed a 2% real return (assuming he paid $100 for the bond), no matter what the rate of inflation is in the interim.

The implied inflation expectation, then, is the difference between the yield on an ordinary bond and the yield on an inflation-indexed bond with the same maturity. If the 5-year Treasury has a yield of 4% and the 5-year TIPS has a yield of 2%, then inflation expectations for the next five years are (about) 2% per year. The reasoning is that in order to buy the regular bond as opposed to the inflation-indexed bond, an investor has to be paid a higher yield to compensate him for the level of inflation that he expects.

Actually, in addition to expected inflation, the Treasury investor also has to be paid an inflation risk premium because, all things being equal, it is better not to have inflation risk than to have it. So the implied inflation expectation is actually slightly less than the spread between the regular and the inflation-indexed bonds. If you didn’t follow that, don’t worry, just remember that, roughly speaking, Treasury yield = TIPS yield + expected inflation.

2. Inflation swaps. These are a type of derivative contract, where the payments under the contract depend on the value of an inflation index, such as the CPI. The swap has a nominal value of, say, $100, but $100 never changes hands. Instead, at the end of some period of time, party A pays party B a fixed rate of interest on $100 – say 2.5% per year. At the end of the period, B pays A the cumulative percentage change in the inflation index over the period. Assuming A has $100 in his pocket, he has now hedged the inflation risk on that $100, because no matter what happens, at the end of the period he will get an amount that compensates him for the impact of inflation on his $100. The price of this hedge is $2.50 per year. (Because these are over-the-counter contracts, there many variations on this, including swaps with periodic coupon payments.)

For the same reasons described above, the implied inflation expectation is roughly 2.5% per year: party B thinks inflation will be less than 2.5% per year, and therefore is willing to take 2.5% and pay the amount of inflation; party A thinks inflation will be more than 2.5% per year, and therefore is willing to pay 2.5% per year to get the amount of inflation back. So the market clears at 2.5%. (Actually, for the exact same reasons as with bonds – party B has to be paid an inflation risk premium for absorbing the risk in this trade – the inflation expectation is slightly less than 2.5% per year. There are also some complications having to do with the lag in the publication of inflation indices, but let’s ignore that for now.)

One curiosity is that the inflation-indexed bond method and the inflation swap method can produce different estimates. Theoretically this should not happen, because if two products that will have the same price in the long term (since they are based on the same index) have different prices today, there should be an arbitrage opportunity. Why this happens in practice is discussed on pp. 5-6 of this Bank of England paper. (Thanks to Bond Girl for pointing out the paper.)

3. Surveys. You can also just ask people what they think inflation will be. Economists ordinarily prefer markets, under the principle that when people are paying money they are signaling what they really believe. But if you think there are sufficient problems with the markets you may want to go with surveys. Tim Duy has a post with a number of charts, including one of an inflation expectations survey.

So what do things look like today?

This is the historical graph for implied U.S. inflation over the next 5 years, based on TIPS. Remember, you are looking at 5-year inflation expectations as they changed over the last year.

In the dark days of October-December, inflation expectations were clearly negative: that is, the market was expecting deflation over a 5-year period. Things have picked up, but inflation expectations are still around 0.6% – far less than the 1.7-2.0% targeted by the Fed. And that 0.6% is before adjusting for the inflation risk premium, so inflation expectations are actually lower than the chart shows.

And these are current inflation expectations over various time horizons, again derived from inflation-indexed bonds. Note that they are sorted by value, not by time.

TIPS are not very liquid compared to regular Treasury bonds, and the implied inflation expectation numbers are sensitive to aberrations in both the Treasury and the TIPS markets (which have both been pretty aberrant recently). For example, if there is a shortage of TIPS of a given maturity, then the TIPS yields will be artificially low and the implied inflation expectation will be artificially high. Still, it seems like inflation expectations are on the low side, even when it comes to the 10- and 20-year time horizons. (I don’t know what’s going on with the 2-year number: when I look at the underlying bonds, it seems like it should be about -0.1%.)

For more on measuring inflation expectations, there is a short primer from the San Francisco Fed, as well as the Bank of England paper mentioned above.

By James Kwak

1. The financial sector is busy setting up arrangements in which employees are guaranteed high levels of compensation if they stay on through the difficult days ahead.  These retention-type payments allow firms to survive in their existing form, pursue business-as-usual, and gamble for resurrection, i.e., make further risky investments.

2. But these same payment schemes, e.g., Goldman Sachs’ loans-for-employees deal, are a form of poison pill with regard to further bailouts – the Administration may want to help these firms down the road, but this kind of tunneling means Congress will put its foot down.  Do you think that President Obama’s $750bn for bailouts (scored as $250bn) will survive the budget process?  No New Bailout Money is a slogan reaching from here to the midterm congressional elections. 

3. And the financial system is in big trouble.  Unless the economy turns around, somewhat miraculously, we are in for a big slump.  Or even for a Great Depression – watch closely the words and body language in Bernanke’s interview on 60 Minutes. 

The big banks are essentially making themselves Too Politically Toxic To Rescue, and this has potentially bad macroeconomic consequences.  So what will Bernanke do?

As he sees the world, there is only one course of action remaining: print money and hope for a moderate degree of inflation.  The money part was, of course, the announcement yesterday from the Fed.

The inflation part is a leap of faith.  If inflation is driven by the so-called “output gap,” i.e., how far the US economy is below potential output, then prices will not increase much, the yield curve steepens moderately, and banks make out like bandits (it’s just an expression). 

But if the whole world is moving more into an emerging market-type situation then (a) inflation expectations become deanchored (central bank jargon for “really scary”), (b) potential output falls as we massively deleverage, and (b) people move increasingly into alternative assets – storable commodities spring to mind – and we get some serious inflation. 

If oil prices jump, then we have an even bigger inflation problem.  Oil is not storable, supposedly.  But if you can explain to me exactly why oil prices rose as they did during the first part of 2008, despite the slowing global economy, I might be greatly reassured that we are not heading immediately into a runaway inflation spiral.

By Simon Johnson

We also know East-Central Europe (including Turkey) has major debt rollover problems and most of that region is in transit to the IMF, with exact arrival times determined by precise funding needs relative to the usual political desire to keep the party going through at least one more local election.  Put the IMF down for another $100bn in loans over the next six months, and keep the G20 talking about providing the Fund with more resources.

But the big news of the week, with first-order implications for the US and the world, was from the UK where the prospect of further bank nationalization now looms. 

This is a AAA-rated sovereign with its housing market in a nose dive, overextended (and apparently mismanaged) major banks, and a government on its way to guaranteeing all financial liabilities and directing the flow of credit moving forward.  A strategy emerges, but it’s based more on depreciating the pound and surprising people with inflation than on fully-funded bank recapitalization.  Additional fiscal stimulus, increasingly, looks at best irrelevant and – worryingly – perhaps even destabilizing.  The yield on 10-year government bonds is, of course rising – now over 3.5%.

In this context and recognizing that credit ratings are a lagging but not meaningless indicator, Spain’s downgrade from AAA is a significant milestone.  Further European downgrades are in the air.

What do all these situations have in common?  We are repricing the risk (or coming to our senses) on the dangers of lending to a wide range of governments.  And this is not just about emerging markets (East-Central Europe) or industrialized countries that sustained a boom based on euro convergence (the PIIGS), it is potentially about rethinking any government’s obligations.  

What about German debt?  There is no question that Germany will do whatever it takes to maintain a reputation for fiscal prudence.  But problems in the eurozone put pressure on the European Central Bank to loosen its policies (and there are murmurs already about easing repo-rules as credit ratings fall; basically, supporting euro sovereigns during their downward spiral), and this has implications for currency risk. Also, German exports are under severe pressure – their cars, machinery, and similar durables, of course, have a great reputation, but how many of them do you really need to buy this quarter? 

And what about the US?  One view is that US government debt remains the ultimate safe haven, and this is surely true in general terms – particularly in moments of high stress.  But I was struck recently by an excellent presentation by John Campbell (technical paper here).  His point is that while US long bonds go through episodes when they are good hedges against prevalent risks (e.g., now and in the recent past), this is not always true. In particular, if inflation becomes an issue – think 1970s – then long bonds are really quite risky, in both popular and technical meanings of risk.  You may think your bond holdings are a great hedge, but in fact they are a fairly substantial gamble that inflation will not jump upwards.

I also hear people increasingly talking about the limits on sustainable debt in the US (and we will shortly publish a Beginners’ Guide on this).  I’m supportive of the fiscal stimulus, at around the currently proposed level, and I also strongly support the view that cleaning up the banking system properly will add further to our national debt (probably in the region of 10-20% of GDP, when all is said and done).  And I further agree that some form of housing refinance program will help slow foreclosures, and this should further increase the chances that the financial system stabilizes. 

But all of this adds up.  US government debt held by the private sector will probably rise, as a percent of GDP, from around 41% to somewhere above 70%.  This is still manageable, but it should concentrate our minds.  The net effect of our financial fiasco is to push us towards European-style government debt levels, and this obviously presses us further to reform (i.e., spend less on) Social Security and Medicare.  And we really need to make sure we don’t have another fiasco (of any kind) of similar magnitude any time in the near future.

“The added clarity in that regard might help forestall the development of expectations that inflation would decline below desired levels, and hence keep real interest rates low and support aggregate demand,” according to the minutes.

In other words, a commitment to an inflation target, say annual growth of 1.5% to 2%, would help keep prices from falling outright and prevent the kind of economic chaos that plagued Japan in the 1990s and the U.S. during the Great Depression.

The Congressional Budget Office thinks there is still time to prevent deflation (or perhaps it is the new measures already in the works that will keep inflation positive).  Their forecast for 2009 (see Table 1 in today’s testimony) predicts low inflation, e.g., the PCE price index is expected to be 0.6 percent for 2009 – but note that the CPI is seen as barely positive, at 0.1 percent, over the same period.

Meanwhile, the financial markets (e.g., inflation swaps) predict minus 4 percent inflation in 2009 (part of which is likely due to lower commodity prices) and then a small degree of deflation over the next few years.  According to this view, we should next see today’s price level again in about 5 or 6 years.

Of course, the financial markets could well be wrong.  It may be that the markets haven’t fully digested or understood the size of the fiscal stimulus, and it may be that further news about other parts of the Obama approach (including the directly on housing and banking) will significantly change inflation expectations.

But it is striking that financial market inflation expectations – e.g., over a five year horizon – have barely moved from their low/near deflation level since it became clear that Mr Obama would win the election or since we first realized that a massive fiscal stimulus would soon arrive (see slide 2 in my presentation from Sunday; the scale is hard to read, but the decline is from around 2% through the summer to around 0% currently).  At least for now, whether or not we are heading for deflation remains the key open question.

There is at least one key question currently missing from this debate.  Is this Plan too much about a fiscal stimulus and too little about the other pieces that would help – and might even be essential – for a sustained recovery?  The fiscal stimulus may be roughly the right size (and $100bn more or less is unlikely to make a critical difference), but perhaps we should also be looking for more detail on the following:

1. Recapitalizing banks.  Their losses to date have not been replaced by new capital and it is currently not possible to issue new equity in the private markets.  If you think we can get back to growth without fixing banks, check Japan’s record in the 1990s.

2. Directly addressing housing problems, including moving to limit foreclosures and reduce the forced sales that follow foreclosures.  There is apparently some form of the Hubbard-Mayer proposal waiting in the wings, but we don’t know exactly what – and this matters, among other things, for thinking about the debt sustainability implications of the overall Plan.

3.  Finding ways to push up inflation, presumably by being more aggressive with monetary policy.  Deflation is looming – according to the financial markets, despite all of the Fed’s moves and recent statements, prices will fall or be flat over the next 3 to 5 years.  This fall in inflation, from its previous expected level around 2 percent per year, constitutes a big transfer from borrowers/spenders to net lenders/savers.  The contractionary effect is likely to outweigh any fiscal stimulus that is politically feasible or economically sound.  (We have more detail on this point on WSJ.com today, linked here.)

So perhaps the issue is not the absolute size or composition of the fiscal stimulus, but rather the role of the fiscal stimulus relative to other parts of the Plan.  Hopefully, it’s a more evenly weighted package, and just we haven’t yet seen the details.  Still, it’s odd that the presence and general contours of these other important elements have not yet been clearly flagged.

The precise outcomes for 2009 are, of course, hard to know yet – this depends primarily on the resilience of US consumer spending and whether large international shocks materialize.  But we can have a sense of what happens after the fiscal stimulus has played out (or its precise consequences become clear).   There are two main potential scenarios.

First, the fiscal strategy works.  In this case, the US pulls out of recession reasonably quickly (perhaps by the second half of 2009).  Once this seems likely, the Federal Reserve will want to cut back on its quantitative easing and perhaps even think about raising interest rates.  But this will be hard to do for political reasons – the Fed will feel pressed not to quash an incipient recovery, so it will err on the side of keeping interest rates low and credit available on generous terms.  At the same time, a great deal of the fiscal stimulus will be working its way through the pipeline for at least two years.  The net effect is inflation and presumably a weakening of the dollar (although the latter of course depends on what others are doing around the world.)

Second, the fiscal strategy does not work.  In this case, the US recession deepens and we head into a serious global slump.  Some more fiscal stimulus might be offered, but faith in its effectiveness will decline sharply.  The next policy move in this case is even more quantitative easing (i.e., essentially issuing even more money).  This would not usually be appealing, but the global depression would be fed by and feed into serious deflation, and the consensus will shift from “avoid inflation over 2%” to “any inflation is preferable to deflation”.  The net effect is again inflation, at least in the US and probably more broadly.

Of course, there are other possibilities.  The fiscal stimulus could reflate the economy just enough, i.e., so that growth returns to potential (whatever that is after a crisis of this nature), but not “too much” – so that prices increase but annual inflation never rises significantly above 2%.  This scenario seems rather too ideal, and to require too many things to go right, to be high probability.

It is also possible that in a global depression/deflation scenario even the Fed could not make inflation positive.  But this also seems to be quite a remote possibility.

So inflation seems hard to avoid, irrespective of how the upcoming fiscal moves play out.

What effect does this have on the rest of the world?  Well, if your central bank now sits idly by, most likely you will experience an appreciation of your currency relative to the US dollar.  (The caveat, of course, is that if you have a new major domestic disruption in your banks, or another member of your currency union runs into refinancing trouble, you could still experience a depreciation.)

Who is willing to experience a significant appreciation in a slowing global economy, with exporters everywhere already clamoring for assistance?  Most central banks will be pressed hard to ease further, either with interest rate cuts or their own version of “quantitative easing” (known as printing money to you and me). What happens within the eurozone will, in this context, be fascinating – who will support the Germans in arguing that monetary policy should remain relatively tight?  What happens if the Germans lose this argument at the level of the European Central Bank’s Governing Council?

In any case, the Fed’s move pushes us in the definite direction of higher global inflation.  This is better than the alternative of falling wages and prices, but it comes with risks.  Will we be able to control this inflation now or in the near future?  What are the consequences of inflation during a severe global recession – which seems unavoidable, even if the Obama Administration has all possible dimensions of expansionary policy firing on all cyclinders right away (this was the point in our latest baseline scenario).

(Thanks to Mark Thoma for flagging this.)