Shadow and Flame

"Moria! Moria! Wonder of the Northern world! Too deep we delved there, and woke the nameless fear."
— Glóin from The Lord of the Rings 2 II The Council of Elrond

"The dwarves delved too greedily and too deep. You know what they awoke in the darkness of Khazad-dum... shadow and flame."
— Saruman

Apologies to non-Tolkien fans, but this example of life imitating art/literature struck me when I first read about the Deepwater Horizon explosion and oil spill. Tolkien powerfully captures the clash of nature and industry as one of the recurring themes in his Lord of the Rings trilogy, and tragically this disaster has some uncanny parallels. For those not familiar with the story of the Lord of the Rings, when the dwarves delve "too greedily and too deep" they awaken a Balrog, a demon of shadow and flame, and it proves too powerful to overcome. After much loss of life, the magnificent underground city and mining operation is abandoned.

Of course, the evidence is that this incident was avoidable, whether or not the driver was "greed" or a dysfunctional and reckless corporate culture (BP had an astonishing 760 egregious willful citations at refineries versus 1 for other companies in the same period!) . Yves Smith has provided solid coverage over recent weeks, and yesterday excerpted a letter sent from the government to BP: "In effect, it appears that BP repeatedly chose risky procedures in order to reduce costs and save time and made minimal efforts to contain the added risk." (much more via the link).

A guest post by George Washington and a link highlighted by Yves Smith both get into the possibility of undisclosed damage to the system and the threat of an accelerated flow of oil with no credible way to contain it at the well site. A knowledgeable commenter on Yves' site concludes "the relief well has to work. They will have to keep trying until they intersect the well."

If you need a less alarmist perspective, think of the oil spill relative to the Gulf of Mexico as "ONE raindrop in 10 olympic sized swimming pools" (and better mandate all wildlife to cease swimming or landing in the vicinity of said raindrop until further notice!) I suppose this is a bit sarcastic but I actually find it a worthwhile data point as food for thought, despite believing it to be rather misleading.

What To Expect From This Blog

I realize I haven't posted in a couple months, so I thought that a short status post might be valuable. The brief summary is that you are likely to see continued sporadic posts here in the future, though probably less often than before (not that they were ever frequent!) I'm less likely to do updates every month/quarter of certain series of posts I've been covering, though I will make an effort to update them when the data changes in a noteworthy way. For example, the deflationary CPI trend is now becoming apparent to more and more observers and bears revisiting. Remember, Japan's deflation took years to arrive after its asset bubbles peaked. Other past topics likely to be revisited include Modern Monetary Theory, flow of funds data and borrowing trends, macroeconomic and market outlook, stock dividend trends, deflation outside the US, etc. New topics won't be frequent but I do have some some in mind.

I didn't exactly plan to have an economics blog (I'm an engineer, for one thing). I initially set it up as an easy platform to share my macroeconomic and market outlook, distilled from much reading in the econoblogosphere, with a select set of real life acquaintances. However, I subsequently found myself becoming dissatisfied with some gaps in my knowledge and with some of the third party commentary I'd been reading, so I decided to do more digging in raw data myself, wherever possible, rather than only relying on the commentary and analysis of others. And at times the data has seemed worth sharing. I hope some have found it useful — this site has 60+ RSS subscribers via Google Reader (and I don't know how many in other readers) — a small number, especially given that many probably don't read all their feeds, but not zero!

Other than general time constraints, the other reason for the shortage of posts lately is I've been putting a little time into attempting a second macroeconomic visualization that I hope could have broader value, if successful, than the last one (which I know still needs further updates). So if I make progress on it, look for a future post introducing it.

As a bonus for reading this far, and so as to include some actual economic content, here is a chart from an April presentation by Richard Koo that I think is useful and have not seen posted elsewhere:

It's the first actual "picture" of the so-called reverse-square-root-sign recovery that I recall seeing, and nicely shows two things. First, that the "Lehman Shock" probably did contribute to a collapse in confidence and GDP beyond that attributable to the Minsky-style private debt dynamics alone (though contagion and adverse feedback loops were certainly a real risk that could have kept GDP on its downward path, even so). Japan's GDP never fell this dramatically, even after its own giant asset bubbles popped. Second, it shows the uncertain future with respect to the degree of ongoing private sector deleveraging versus government fiscal stimulus.

Total Borrowing Still Contracting at a Stable Rate in Q4 2009 ($577 billion annualized)

The Z.1 Federal Reserve Flow of Funds report is out for Q4 2009. Here are some updated graphs:

Total US Government and Private Sector Borrowing Relative to GDP (Quarterly 2003 - 2009/Q4)

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US Borrowing by Sector (Quarterly 2003 - 2009/Q4)

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The trend has been somewhat consistent over the last three quarters, with the size of government borrowing almost offsetting the contraction in private sector borrowing, which has been largest (as a percentage of GDP) in the financial sector. However, it seems the financial sector's rate of negative borrowing is shrinking, a trend which bears watching. Home mortgages, consumer credit, and business debt all show continued contraction, but there is no way to know which way their trends will go from here. A lot may depend on the future path of housing prices, which most likely aren't completely done falling. But it's possible there could be some surprises, for example Felix Salmon observes (and EconomPic charts) that consumers haven't actually been paying down credit card debt since Q1 2009 — they've actually continued to add to debt, whether out of necessity or choice — so the overall contraction since then has been all due to charge-offs.

In rough terms, I think these graphs show:

1. Fears of "massive" government debt supply driving up interest rates to any dangerous degree are misplaced. Government bonds (plus shorter duration instruments) are replacing disappearing private sector assets. (See further discussion of outlook for treasuries here).
   
2. Government deficit spending (a lot of it via the automatic stabilizers) has helped sustain incomes in the face of defaults and attempted private sector deleveraging, thus preventing a worse outcome to date. Of course, there is a lot that can still go wrong.
   

Some past posts discuss these graphs in more detail:

• Deadlock! Total Borrowing Has Stabilized at a Mild Contraction Rate as Private Debt Reduction Stops Increasing and Government Borrowing Stays Steady
• Total Borrowing Continues Contracting in Q2
• Why Treasuries Find Buyers and Interest Rates Will Not Rise (Much)

Balance Sheet Wealth in the US and Japan; Historical Data in the Context of Modern Monetary Theory

While gradually learning more about Modern Monetary Theory (aka Chartalism) I've started looking at the balance sheet tables in the official national accounts data of the US and Japan. MMT emphasizes stock-flow consistent modeling of the economy when analyzing the impact of various private sector and government actions. Separately, I've started creating a macroeconomic balance sheet visualization tool to illustrate this approach. But in this post I'll share some charts of the real world "stock" data (i.e., accumulated aggregate wealth). I'll likely share some related "flow" data (i.e., components of Gross Domestic Product as a measure of national income) in a subsequent post.

One of the principles of MMT is that the non-government sector (which includes the domestic private sector as well as the foreign sector) cannot change its own net financial assets. Only the government can, by running a deficit or a surplus. One of the key roles of a government deficit is to allow the private sector as a whole to net save (i.e., spend less than it earns). This results in an accumulation within the non-government sector of "wealth" (also referred to as balance sheet equity or net worth) in the form of government liabilities, which are a mix of treasury bonds (and notes and bills), physical currency (notes and coins), and bank deposits (matched by corresponding bank reserves). These are all just liabilities of the government with different durations and interest rates, and they never have to be paid back (though with a healthy growing economy they often shrink as a percentage of GDP). The emphasis that government liabilities are also assets is one of the most important insights of MMT, in my opinion. The primary limitation to running government deficits is inflation.

These aggregate "stocks" are illustrated in this simplified balance sheet diagram that excludes tangible assets — the government sector (combined treasury and central bank) has (as an indisputable accounting identity) negative financial net worth (i.e., when you exclude tangible assets like buildings and equipment) exactly equal to the positive financial net worth of the private sector. In this case $160 (just toy numbers for illustration) — the blue boxes labeled "equity" and "negative equity". Balance sheet equity or net worth equals assets minus liabilities. Note, this graphic leaves out the foreign sector for simplicity.

However, there are a few areas I still find myself disagreeing with MMT on (subject to change as I learn more!) and one is the treatment of equities/shares (in the stock market sense). In short, when the market bids up stock prices, owners of those stocks feel wealthier, but the corporations to which those shares are a liability do not act correspondingly poorer or reduce their propensity to invest or generate revenue in any way. I could elaborate but will leave it at that for now as that is not the focus of this post.

The charts of wealth below combine:

• Tangible assets (real estate, equipment, software, etc).
• Net government liabilities (since these are assets to the private sector and typically never have to be paid back on aggregate).
• Total valuation of publicly traded stock market (market prices of bonds and other securities may also have impacts on net perceived wealth but I have skipped those for now). [Note: Admittedly if we are only looking at net financial assets (assets minus liabilities) then perhaps we should subtract from this the total "paid in capital" liability entries across all corporate balance sheets, but aside from that data not being available in this source, from a behavioral standpoint I don't think those liabilities impact economic activity in the same way that debt liabilities do, so I'm not convinced they should be subtracted anyway.]
  

There are two totals in each graph, one including stock market valuation and one without, because as mentioned above the appropriate treatment of this seems debatable to me. You the reader can choose which total you prefer.

I don't know how directly comparable the Japanese and US data are. It is possible that the underlying accounting (for example what is included in tangible assets, how values are determined, etc) could differ substantially. But in a broad trend sense the comparisons are still interesting. One significant difference I know of is that the tangible assets data for the US only includes households, corporate non-financial business, and non-corporate business, whereas the Japanese tangible assets data includes all sectors (government and financial corporate being two large sectors that are not in the US data).

Balance Sheet Wealth in Japan (1980-2007)

(click on chart for a larger version in a new window)

Observations:

• Japan's stock market peaked (on an annual basis) in 1989 (yellow line). Its real estate bubble peaked in 1990 (red line, to which real estate and land are the largest contributors).
• Aggregate balance sheet valuation of tangible assets declined from 1990 until 2004. While this is probably due primarily to declining market prices (revaluation and/or depreciation), it's possible that quantity also changed.
• Government deficits have clearly helped stabilize nominal private sector wealth relative to what would have occurred otherwise (see the dark blue and light blue lines for totals with and without stock prices).
• Government liabilities are not particularly large as a percentage of total wealth. Of course the annual deficits that created the net liabilities would have contributed significantly to incomes, and that effect is not shown here.
  

Balance Sheet Wealth in United States (1980-2009/Q3)

(click on chart for a larger version in a new window)

Observations:

• NOTE: US tangible assets shown here does not include all sectors (see note above).
• The US had two stock market peaks (note that this is the entire public share market as captured in Flow of Funds data, not a particular index such as S&P500), first in 1999 (on an end of year basis), and second in 2007 (see yellow line).
• Tangible asset prices (red line, dominated by real estate) peaked in 2006 (on an end of year basis).
  

Balance Sheet Wealth in Japan (1980-2007) as Percent of GDP

(click on chart for a larger version in a new window)

Observations:

• Wealth relative to nominal GDP adjusts in rough terms for changes in price level (inflation), demographics, and productivity.
  
• Because Japan's GDP has partially stagnated, wealth relative to GDP does not look dramatically different to wealth in nominal terms (prior graph).

Balance Sheet Wealth in United States (1980-2009/Q3) as Percent of GDP

(click on chart for a larger version in a new window)

Observations:

• NOTE: US tangible assets shown here does not include all sectors (see note above).
• Wealth relative to GDP has slowed its fall and is in the rough vicinity of the level from before stock market and housing bubbles accelerated in the mid 1990s.
  
• I don't know whether wealth-to-GDP is mean-reverting or even meaningful over long periods of time, but if it is, perhaps this reversion is a positive sign of stabilization suggesting nominal wealth need not fall much further. Though given the likelihood of further falls in residential and commercial real estate prices (the opinion of many credible commentators), a not-so-positive alternative is that both nominal wealth and GDP could fall at the same time, still leaving their ratio semi-stable.
• Interestingly the Japanese and US stock markets both peaked at just over 200% of GDP! (Some have called the Japanese stock bubble larger, but perhaps it just rose more quickly from more undervalued levels). Yet at the end of 2007 (the latest Japanese data), Japan's stock market valuation was at 108% of GDP, and the US at 182% of GDP, and Japan's market has had the bigger fall since 2007. This suggests some potential combination of (please comment if you have insights!):
• Japanese stocks undervalued.
• US stocks overvalued.
• Japanese public companies inherently less profitable.
• Japan's market pricing in lower growth prospects.
• Japan's publicly traded companies commanding a smaller share of the economy (relative to private enterprise) than US publicly traded companies.
• US stocks still look overpriced relative to GDP, though a longer time line is needed to confirm this, and a valid justification for the higher level could be if public companies control a larger share of economic activity than in the past.
  

Year-on-Year Change in Balance Sheet Wealth in Japan (1980-2007)

(click on chart for a larger version in a new window)

Observations:

• The year on year change makes it easier to see the magnitude of the changes in the previous graphs.

Year-on-Year Change in Balance Sheet Wealth in United States (1980-2009/Q3)

(click on chart for a larger version in a new window)

Observations:

• From a wealth perspective alone, increases in US government debt (green line) have been small relative to tangible asset and stock market losses, however from an income perspective (money that actually contributes to GDP), it is very clear that government deficits have prevented (so far) a far worse outcome. (I'll include flow/income charts in a separate post).

Deflation Watch (January 2010): Core CPI Negative while PPI Accelerates

I need to keep this one short, but decided it was worth putting up at least some basic graphs given the interesting juxtaposition of an accelerating rate of PPI increases alongside the first decline in core CPI since 1982.

Some Relevant Current Articles

• Graph of Core CPI, and Cleveland Fed Measures of Inflation - Calculated Risk
  

Consumer Price Index Trends: Great Depression versus Today through January 2010 (US)

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Our avoidance so far of a sustained price deflation remains a big differentiator between then and now, though inflation has slowed more quickly than in Japan's post-1990 experience.

Annualized 3-Month Rate of Change for Components of US Consumer Price Index (April 2006 - January 2010)

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Apologies for the crowded chart, but note in particular the continuous downward trajectory of the magenta line for shelter, which is a subset of the larger housing category. This represents a heavily weighted portion (32%) of the overall index. Most other measures are more volatile (in three month terms) and in positive territory, though recreation prices have been deflating for months. Also food prices (15% of CPI) seem to have recovered and been growing a little more quickly again.

Price Index Changes: Great Depression CPI versus Current PPI through January 2010 (US)

(click on chart for a larger version in a new window)

Look at the PPI measures for crude, intermediate, and finished goods. The accelerating price levels bear an uncanny similarity to the trajectory of the 2007-2008 price spike, which begs the question of whether they might crash in a similar way again as well. The answer likely depends on how much commodity prices are being affected by financial market speculation (controversial!) and how sustainable the resurgence in developing market growth is, especially China (the concerns regarding unsustainable private credit growth in China seem very valid).

16% Trimmed CPI

The 16% trimmed mean CPI (generated from the Cleveland Fed site) removes the most extreme monthly price changes:

(click on chart for a larger version in a new window)

CPI in Japan (Jan 1980 - Jul 2009)

From previous posts, for reference: "The peak of Japan's CPI occurred in October 1998, almost eight years after the stock market peaked, and Japan's notorious mild deflation has been in effect since then. A multi-year disinflation (of core CPI) leading to sustained mild deflation is one possible outcome for the US.

(click on chart for a larger version in a new window)

A Note on Seasonal Adjustments

I had previously been using seasonally adjusted figures for all the measures except headline and core CPI, as I assumed as aggregates that those would be smoothed out pretty well, and didn't know how effective the seasonal adjustment process is. Also the Great Depression data is not seasonally adjusted, nor are many other countries' data (such as within Europe). But there does appear to be an overall drop in prices through every December, and increase through every June, as the graph below shows, so I've switched to seasonally adjusted figures for everything.

Macroeconomic Balance Sheet Visualizer — Draft

I've been loosely following discussion of Circuitism and Chartalism (Modern Monetary Theory) since late summer or early fall, though I have not yet had time to work through some of the details to my satisfaction. But it's clear to me that the core accounting principles emphasized by Modern Monetary Theory are accurate, and that the MMT perspective is highly relevant to the global economy right now. At some point I hope to address some of my current issues with it, but they take secondary priority.

On some of the blogs I visit I've seen a lot of time spent discussing the mechanics of various macroeconomic operations (though I haven't had time to read or comment in much depth), and it always strikes me that a lot of time could be saved with better reference material on this stuff, whether wiki-based or otherwise. Discussion threads seem to lead to a lot of repetition of the same topics, ambiguity in descriptions, people talking past each other due to having different understandings of what concepts mean, etc.

It occurred to me to go ahead and try to put together a visual tool myself to help visualize and document some of these macroeconomic concepts. It was also an excuse to play with SVG (browser technology) for the first time.

NOTE: This is a preliminary DRAFT copy of a tool to help visualize the balance sheet effects of these concepts. I am hoping for feedback from folks who are already knowledgeable on these topics and can correct my mistakes. If you are learning this like me, I recommend you skip this until an updated version is ready, otherwise you could be unnecessarily misled or confused. I will post another blog entry when a more polished version is ready — both more accurate, and with added features, usability, more accessible step-by-step walkthrough, etc.

Here's the tool: Macroeconomic Balance Sheet Visualizer (DRAFT)

I welcome anyone (but especially those with a better understanding than me) to offer corrections and constructive feedback in the comments section below or via email (the address is on my profile). Thanks!

P.S., I'll hopefully be adding additional operations (equity/stock offerings, more central bank operations, markets repricing tradeable securities, etc) as well as adding better visualization of flows rather than just stocks (quantities). Plus depicting asset bubbles, the balance sheet outcomes of Japanese vs Great Depression vs "ideal" resolutions, balance sheet breakdowns within each sector, etc.

List of Updates to Balance Sheet Visualizer:

UPDATE1 2/22/2010: Renamed assets held by Treasury from 'Reserves' to 'Treasury Deposits' (abbreviated for now until able to show more detail).

UPDATE2 2/25/2010: New feature: Mouse over a balance sheet name to compare the balance sheet side by side with a copy from before the last operation.

Consumer Price Level Trends Still Vary Widely Across Debt Bubble Countries

Here is a quick update to the graphs from a prior post on international consumer price levels titled "Global Price Level Trends Show Varied Inflation/Deflation Across Housing Bubble Countries":

(click on chart for a larger version in a new window)

Given how much it has been in the news lately, I have added Greece to the price level graph. However, I excluded Greece from the three month trend graphs below because it is so seasonally volatile (and the European Harmonized Indexes of Consumer Prices don't seem to offer seasonally adjusted series). Nevertheless, as you can see in the absolute price level graph above, overall prices are roughly 3% higher than in July 2008 when global commodity prices peaked. This is near the high end of the countries I've included (excluding Iceland which is a dramatic outlier). A quick look at one summary of Greece's CPI suggests fuel prices for transportation and heating have been a big part of the increase in 2009, but it appears that other prices have been rising too.

Here is the three month trailing rate of change of consumer prices:

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And here is the exact same chart zoomed out to show all the Iceland data:

(click on chart for a larger version in a new window)

Japan and Ireland are the only countries showing significant deflation at present.

I think my concluding thoughts from the last post are still relevant:

This was a very rough high-level look at relative price level trends and short term inflation rates over a sampling of housing bubble countries and other countries of interest (Japan, Iceland). More insights would be likely with additional analysis such as adjusting for exchange rate trends, comparing rates of government deficit spending, comparing changes in private debt levels, etc.

The price level trends across countries show some correlation at times (e.g., late 2008), suggesting global macroeconomic factors matter to some degree, but also diverge significantly at other times (e.g., the current -4% to 8% range of 3-month annualized inflation across countries), suggesting domestic country-specific dynamics are the dominant factors in price level trends, even at times of global recession/crisis.

There are at least three key domestic dynamics that could be most heavily influencing price levels. One is the degree of government stimulus relative to the contraction in private spending. A second is whether private debt bubbles have actually popped or are still growing. A third would be the relative size of these debt bubbles (total debt-to-GDP) and their recent rate of growth (since added debt contributes to annual aggregate demand).

I have not included enough data in this post to evaluate these factors for each country. But at the risk of being wrong, my current assumption is that size of government response is the number one differentiating factor, and some countries are maintaining a stronger private-sector bubble mentality than others (e.g., with respect to Australia's housing prices). If government stimulus proves politically unsustainable, or private sector debt bubbles collapse and prove to be overpowering, it could be that countries like Australia will simply lag countries like Ireland with respect to consumer price deflation. Ireland may be the country to watch — I've seen suggested that it may have begun a full scale debt deflation.

Endnotes

Note that different countries construct their CPI measures differently, so some trend differences likely reflect what each country considers a representative "basket" of goods and services, though the European data is all drawn from Harmonized Indexes of Consumer Prices. Also the US, UK, Ireland, Spain, Iceland, and Euro 27 price levels are not seasonally adjusted. I think Japan's and Australia's are seasonally adjusted, but am not certain.

Looking at absolute price level charts rather than just rate of change (typically year-over-year) seems especially valuable when price levels are not moving in a single direction (until the recent deflationary trends, the direction of CPI indexes was primarily up).