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."