2016-30. Dangers of Money Illusion

On Monday we talked about money illusion as one of the cost of inflation. If people have money illusion and there is inflation, they make suboptimal choices.

I have just come across a paper that provides evidence:

Money Illusion and Household Finance" 
CEPR Discussion Paper No. DP11643

THOMAS ALEXANDER STEPHENS, University of Vienna – Department of Economics
Email: thomas-alexander.stephens@univie.ac.at
JEAN-ROBERT TYRAN, University of Vienna, University of Copenhagen - Department of Economics, Centre for Economic Policy Research (CEPR)
Email: jean-robert.tyran@univie.ac.at

We elicit money illusion and match it with financial and sociodemographic data from official registers on a quasi-representative sample of the Danish population. We find that people who are more prone to money illusion hold more of their gross wealth in nominal assets, including bank deposits and bonds, and less in real assets, including real estate and stocks. This bias is robust to controls for education, income, cognitive ability and other relevant characteristics. We further find that money illusion is a costly bias: 10-year portfolio returns are about 10 percentage points lower for individuals with high money illusion.

2016-29 Monetary policy in Canada, US and EU

1. In Canada "Bank of Canada Governor Stephen Poloz suggested that continued uncertainties surrounding Canada’s economic outlook have set the bar high for an interest rate change, as the central bank approaches its deliberations for next week’s rate decision."

Next week the Governing Council will be making the policy decision, as we discussed on Monday. The statment by the governor, above, suggests they will not change the interest rate. If anything, they can lower it.

Note that the governor mentions current economic outlook. The actual decision is made on the basis of expectations of inflation (the goal of the Bank) 6-8 quarters into the future (since the monetary policy works with a lag). So the talk about " uncertainties  surrounding Canada's economic outlook" stands in for: given our expectations, in 6-8 quarters inflation will not be a problem.

Note also that: "The speech was the last word from the Bank of Canada Governor prior to the bank’s next interest rate announcement, on Dec. 7. The bank always observes a “blackout” period for one week prior to its rate decisions, when no senior officials at the bank speak publicly."

This means the Bank is careful not to affect the markets ahead of the policy decision

In Brussels "European Central Bank President Mario Draghi issued a blunt warning over the risks that low interest rates [...]

The warning underlines the dearth of policy choices central banks face as they seek to further stimulate their economies after years of aggressive easy-money policies.

Speaking at the European Parliament in Brussels on Monday, Mr. Draghi said a lengthy period of low rates had created “fertile terrain” for financial-market risks, including a buildup of debt and excessive risk-taking."

In Washington "Minutes from the Fed’s November meeting, released Wednesday after the usual three-week lag, indicated officials were looking for signs of an improving economy before increasing rates. Since then, the U.S. has seen a steady stream of robust economic news and a brighter consumer outlook in the wake of Donald Trump’s election.

​With the outcome of the presidential election settled and employment and inflation on the rise, economists and market participants almost overwhelmingly expect the Fed to raise rates in three weeks’ time."

US economy is in good shape and the central bank is expected to increase interest rates. Note that the FED releases the minutes of the meeting three weeks after it has taken place. This is transparency, but a delayed one.

2016-28 Deficits, deficits, as far as the eye can see

According to Finance Canada, in the first half of 2016 the Federal government had a deficit of $7.8 billion, compared with a surplus of $1.6 billion in the first half of 2015. This is a deterioration of $9.4 billion, almost equal to the increase in program spending of $8.9 billion. In addition, interest on Federal debt fell by $1.4 billion. This means government expenditures increased by $7.5 billion (8.9-1.4) and so government revenue fell by $1.9 billion (9.4-7.5).

Here is the recent history: 

"The federal government posted a $1.9-billion surplus in 2014-15 after six straight years of deficits. The final bottom line for 2015-16 was a small deficit of $987-million."

And here is the near future:

"Nov. 1 fiscal update projected a $25.1-billion deficit for the current 2016-17 fiscal year. The deficit has been forecast to reach $27.8-billion the next year before shrinking gradually to $14.6-billion by 2021-22. Mr. Morneau has not provided a timeline for when the federal government will return to a balanced budget."

And here is what the government promised a year ago:

"The party’s 2015 campaign platform promised “modest short-term deficits of less than $10-billion in each of the next two fiscal years” and that after that “the deficit will decline and our investment plan will return Canada to a balanced budget in 2019.” " 

Conclusions: 

1. You should vote, as you will be paying for today's deficits

2. Voting alone is not sufficient. You need to become politically active, and hold the government to its promises.

2016-27 President elect and our foreign trade

As you probably know by now, US president-elect is anti free trade. He campained on revising NAFTA , which he called the worst agreement ever.

His main concern is Mexico. A lot of US firms moved there to take advantage of  cheap labour. As a result, US trade deficit with Mexico is 60 billion dollars. The deficit with Canada is $15 billion.

So are we safe? No. Here is a list of the main problems: "Any talks with Canada, which had a trade agreement with the U.S. that predates Nafta, would likely bring up thorny issues that have long dogged relations, including softwood lumber imports from British Columbia, Canada’s support for its dairy farmers and the labeling of beef in the U.S. produced from cattle born or raised in Canada."

2016-26 Economic effects of Trump's victory so far

Bonds are falling (i.e. interest rates are increasing) and stock prices are rising

"More than $1-trillion was wiped off the value of bonds around the world this week as U.S. President-elect Donald Trump’s policies are seen boosting spending and quickening inflation."
"Global stocks gained $1.3-trillion in the same period"

So what is going on? Markets believe that Trump will deliver on the following promisses:
- tax cuts
- infrastructure spending
- reducing regulation

The first two imply that inflation will increase. Higher expected inflation implies higher nominal interest rates, i.e. lower bond prices.
The first two also imply that the economy will improve in the short to medium run. This means the FED will increase interest rates earlier than expected, and prices of bonds fall.
Reduction in regulation is likely to lead to higher profits and so stock prices rise.

What will happen long - term is difficult to say. US will have larger deficits and debt,which may lead to slower growth and still higher interest rates.

2016-25 Good economic news from the US

October sales numbers just became available and they are very good: retail sales were almost 1% higher than in September. As consumption in the US is about 70% of GDP, this means that the US economy is in good shape.

We can fit it into the IS-IC model we will be analyzing. Higher output in the US means that our exports are likely to significantly increase, as we will discuss today. This means that the IS curve will shift to the right, raising Canadian output (unless there are changes in the IC curve).

2016-24 Messing up with the monetary system

Last week,  the largest Indian notes were declared to no longer be "legal tender". The large notes, 500 and 1000 rupee notes, constituted 86% of cash in India. The goal of the operation was to reduce corruption.

What is happening now?

• people are running from one cash machine to another to get 100 rupee notes (largest available) with limited succes
• real estate transactions, which are often made in cash, are at a standstill
• low denomination notes are in short supply, with households hording small notes. This means lower spending
• potential hit to growth is large: "UBS economists wrote Tuesday that if cash supplies remain in disarray for another three weeks, as Finance Minister Arun Jaitley has suggested, 1.2 percentage points could be shaved off India’s economic growth, which at more than 7% is presently the fastest among major nations."[...]"“Everything is stopped right now,” said Sunny Narang, who helps run a steel factory near Delhi."
• What happens when cash in short supply? Barter: "In the village of Dalan Chapra, deep in India’s northern hinterland, the cash crunch is forcing residents to return to the original cashless transaction: barter. They are swapping corn and rice for lentils and vegetables, a practice once known only among the village’s poorest."
• Here are some doubts on whether the operation will be successful: "Whether forcing people to turn in their big bills once will deter them from concealing their earnings in the future is an open question. In India, wealth generated outside the taxman’s purview is also stored in property, business assets and precious metals and gems."

2016-23 meanwhile in Canada

As we have already discussed (post 2016-10) Canada is, similarly, planning a fiscal stimulus. This is "Mr. Trudeau’s plan to jump-start economic growth by running a budget deficit to fund sweeping spending on roads, schools, bridges, hospitals and other infrastructure."

So, as it turns out, our liberal government has some of the same plans as the Mr. Trump. In the Canadian case, it was called a bold move, observed by other countries. Perhaps this inspired the president - elect.

2016-22 Trump's economic policy

This article discusses what policies the president - elect may pursue. Here are some quotations

"He wants tax cuts and increased spending on infrastructure. In other words more stimulus to the economy from the government budget."

"The aftermath of the financial crisis was an important part of the background to Mr Trump's election success. The subsequent recovery has not been particularly strong. Many Americans, especially in former industrial areas, have felt that it has passed them by.

Most of the work in terms of economic policy to support that recovery has been done by the US Federal Reserve, the country's central bank."[...]"The Fed has maintained a policy of ultra-low interest rates, keeping a key rate for lending between banks rates practically zero until a year ago. That tends to keep rates low across the economy. Even now that interest rate which the Fed targets has been raised only once since the crisis and is just a little above zero.[...]The Fed also ran a programme of "quantitative easing", buying financial assets with newly-created money. That may have helped add to the downward pressure on interest rates paid by businesses and households."

"But what about support from the government budget, or fiscal policy? Tax cuts and spending can be used to provide economic stimulus. It has often been done in the past in the US and many other countries. President Obama did do that in his first term, with the American Recovery and Reinvestment Act in 2009, a programme worth $800 billion."

"[...]more recently, Fed officials are thought to have believed that more stimulus from fiscal policy (taxes and government spending) would have been useful."

"Mr Trump's plans so far suggest a stimulus to the US economy from the Federal government budget. That means the Federal Reserve is likely to feel less need to continue providing its own stimulus in the form of its exceptionally low interest rates."

"Apart from anything else, higher Fed rates would give the central bank more ammunition - more scope to cut rates later - when the US economy has another downturn, as it surely will sooner or later."

A summary

• The recovery form the Great Recession was weak. The main economic policy was the low interest rates maintained by the Federal Reserve.
• Trump's plans include tax cuts and spending on infrastructure. 
• That is a traditional fiscal policy to stimulate the economy. For example, in 2009 in the US there was a fiscal program with extra spending of $800 billion, or around 5% of GDP.
• The fiscal stimulus will reduce the need for low interest rates and will allow the FED to start raising interest rates, perhaps as early as the next policy meeting, 13-14 December.
• Higher interest rates now will allow the use of monetary policy in the future, when a new recession comes.

2016-21 Trump's win and financial markets

All predictions were that Clinton would win. As I am writing this (11pm Tuesday) it seems that the result is a surprise: it looks like Trump will win the election. Florida has just been called for Trump.

How do markets react to surprise? We have seen before that markets view Trump's win negatively. And indeed:

• Asian markets fell (except for China)
• Dow Jones futures fell 4% (700 points)
• Which country is expected to lose the most if Trump wins? Mexico. And, indeed: "The Mexican peso has plunged more than 10% to an all-time low"

What is the problem? Uncertainty. Here is a comment from the CNN:

"Investors turned to assets that are seen as safer bets in times of uncertainty. Gold jumped more than 2% and the Japanese yen surged more than 2% against the dollar."

What about the Canadian dollar? It should appreciate, especially if Americans will now move to Canada. You know: they will be selling assets in the US and buying assets in Canada.

We will see tomorrow

2016-20 A successful money manager

David Swensen has been running Yale endowment fund for a long time. This article tells his story and describes his approach. It is worth reading, especially if you aspire to have a career in finance.

2016-19 It is not over until it is over

No, it is not about game 7 of the World Series
It is about the Comprehensive Economic and Trade Agreement (CETA).
Now in the Netherlands they are demanding a referendum 
And they may get their wish. And kill the agreement
Here is one objection:
“TTIP and CETA are old-school trade agreements where the interests of companies are more important than the people who live in those countries,” 

2016-18 Canada's housing bubble

House prices in Canada have been increasing rapidly, in particular in Vancouver and Toronto.
This article from McLean's shows that, in comparison with the house bubble in the US which preceded the Great Recession, it looks pretty bad.

NOTE: THE ARTICLE IS AVAILABLE AND YOU SHOULD READ THE ARTICLE, NOT JUST MY BRIEF COMMENT