August Hangover

Don’t begin to worry, just yet, about the continued low volumes. It isn’t unusual, following a long weekend, for the first day back to still be sluggish. People are catching up with e-mail, greeting friends (friends which, in Europe at least, they may not have seen for a month or more), and so on.

And anyway, we should put today’s light volume – 599 million shares on the NYSE – in context. The average for all of last month was only 581 million shares, and only 544 million for the last half of the month. Only eight days in August were busier than today’s total, and three of those were the FOMC meeting day, the last day of the month, and Employment day. That’s slim solace if you’re a broker, I am sure, but brighter and busier days are ahead. In fact, proximately ahead.

European bonds rallied strongly as details of the ECB’s plan to buy Eurozone bonds were leaked; ECB President Draghi told the European Parliament in a “closed door” (but apparently open-mic) session that the ECB simply must buy bonds because the traditional instruments of monetary policy are ineffective. “We cannot pursue price stability now with a fragmented euro area because changes in interest rates affect only one country, or two countries at most. They have no importance whatsoever in the rest of the euro area.” It is true that to a man with a hammer, everything looks like a nail, but Draghi was essentially arguing that in want of a hammer, anything that will pound a nail will do. In short, because the traditional tools don’t work, Draghi claims that anything else which accomplishes the same ends is allowed.

The Bundesbank will not agree.

But Draghi claims the Euro’s survival depends on his being allowed to buy bonds under 3 years to maturity (why there is a limit at 3 years is unclear to me; if it was necessary to extend the program to 5 years because buying everything less than 3 years wasn’t working, why won’t the same argument work?), and it seems unlikely that there will be enough opposition to dissuade him from this action. It is one thing to ask legislatures to write a check, but the costs of profligate monetary policy (as we have seen) are not as apparent and not as immediate; and anyway, the politicians can campaign later on the need to have them around to fix whatever new problem that is created as a result.

The continuing question should be – if there is no cost to buying huge numbers of bonds, then why should the central banks ever have eschewed that action? Of course, there is no such free lunch, as William White wrote last week.  But from the standpoint of a politician, it’s almost a free lunch. “I’ll glad you pay you next election cycle for a hamburger today,” as Popeye’s pal Wimpy might have said.

Or, better yet, chastise the monetary policymakers for not foreseeing the true cost of that hamburger today!

One more comment on that William White piece. In it, he discusses among other things the many ways in which overcapacity has developed last couple of decades in many countries and many industries. He does this to illustrate the concept of “malinvestment,” which mainstream economists these days pooh-pooh but which many Nobel Laureate economists (such as Hayek) did not.

However, like many of those earlier authors, White seems to take the existence of overcapacity as implying that deflation is a serious risk. I think this is based on a misunderstanding and misapplication of the original concept of malinvestment. Overcapacity implies that resources have been mis-allocated in the past, and this creates a cost in the future – but it only implies deflation in the presence of traditional monetary response (which, let’s remember, we haven’t had in a decade or more). Overcapacity implies declining real prices, and declining real returns to property, plant, and equipment relative to labor – and that is good news for consumers. But, if this overcapacity is coupled with ample money printing, this is not inconsistent with rising, rather than falling, price levels.

Remember that the original Keynesians and Austrians were writing in a period during which most of the historical record involved a money supply effectively, if not explicitly, limited by linkage to gold. In the presence of a fixed money supply, overcapacity most assuredly leads to deflation. But in the presence of a rising money supply, these are no longer automatically connected concepts: overcapacity is a statement of investments and returns in real space, while inflation measures a change in nominal prices.

And that’s why the malinvestment of the 1990s and 2000s need not lead to the same end result as the malinvestment of the 1920s. Indeed, unless something very odd happens – and I gave the parameters I would consider odd last week  – deflation, with or without the hangover effects of prior malinvestment, isn’t going to happen.

The next few weeks will be more increasingly more active, to a degree that we may long for the quiet days of August. Keep in mind that it is a very strong time of the year for bonds, seasonally speaking, and a weak one (although not as consistently so) for stocks. But I wouldn’t try to play those zig-zags. The DJ-UBS index reached a 6-month high this morning, before backing off; that’s where I would have (and do have) my money.

    September 4, 2012 at 4:57 pm


  2. September 5, 2012 at 3:43 am

    You wrote: “Overcapacity implies declining real prices, and declining real returns to property, plant, and equipment relative to labor – and that is good news for consumers.”

    Isn’t that BAD news for employement?

    • September 5, 2012 at 6:05 am

      It MAY be bad news for employment in a particular industry, but by definition if real returns to PP&E are declining, they have to be declining relative to other factors of production. If some people lose their jobs, but as a whole the workforce can purchase more of the product of industry (because their wages went up by more than the prices of the stuff they produce), then the real wages of the AGGREGATE workforce rose.

      But also, think of what this means…if you have a huge plant, with huge overcapacity, it doesn’t mean you’ll fire workers necessarily. It may just mean the returns to capital are weak while your workforce is smaller than it needs to be to utilize your plant. But over time, as demand increases, you’ll hire more workers – but not build more plant. That’s probably the mechanism for equilibrium in this case. If GM goes out of business because of insufficient demand for its cars, they’re not going to tear down the buildings…they’ll still be used, when some other auto company buys them and runs them at 2/3 capacity. Some employees lose their jobs, but the overcapacity also means that car prices shouldn’t outpace wages for a while (and over the whole workforce, that’s a much larger effect than 50,000 people losing their jobs).

      Good question!

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