Paul’s most recent knee-jerk reaction is to insist that Congress pass a law to “deter China’s currency manipulation”. He presses for this because the Administration–the Treasury Department in particular–did not name China as a currency manipulator in its semi-annual report to Congress (“Semi-Annual Report to Congress on International Economic and Exchange Rate Policies”) on the matter. Paul’s direct reaction was “We’re deeply disappointed by the Treasury Department’s decision not to name China as a currency manipulator.  America’s businesses and their workers depend on a level playing field to successfully compete, and they can’t halt unfair trade practices on their own.” Perhaps Paul thinks a trade war would solve the problem.

If China were to receive the “currency manipulator” tag, several things would happen immediately. Most of them are not good for America. China could stop its purchase of US sovereign debt. China is such a large buyer that the federal government would almost certainly have to raise rates to increase demand from other sources. Since many other rates used to charge consumers and businesses are pegged from federal rates, the American economy would be damaged by a rise in the cost of capital. Some economists believe that China would not hurt the value of its own currency reserves by taking this path, but this assumes that all political decisions are rational.

The “currency manipulation” tag would begin a series of sanctions between the US and China. The People’s Republic rarely takes aggressive actions towards its economy quietly. China could effectively put tariffs on US goods which might be so high that some American businesses would be severely damaged. The imports from China which America needs to keep the cost of living reasonable would in large numbers disappear. Wal-Mart’s “every day low prices” would be gone in a day. So would millions of goods built in China for export to the US. The by-products of Mr. Paul’s suggestion, if taken, would do incalculable damage to the American economy, and put a number of the workers at the companies that support the Alliance for American Manufacturing out of jobs. Perhaps those companies should pause to reconsider whether they benefit from what Paul has said.

The Administration knows full well that the China currency issue is a problem. In its report, Treasury said that China’s currency remains “significantly undervalued” and “further appreciation of the yuan against the dollar and other major currencies is warranted.” It is unfortunate that the US cannot immediately force China’s hand. But, China has a strong hand, too

Douglas A. McIntyre

For their part, the six countries representing the permanent members of the UN Security Council plus Germany are willing to provide some aid to Iran if the country will agree to end its 20% nuclear enrichment program. Iran is demanding an end to current and future sanctions, which the other side has refused to put on the table unless Iran agrees to a more significant pullback in its nuclear development.

The Financial Times cites one diplomat:

There is a mismatch of expectations between Iran and the six over the package that is being proposed. We need to drill down in discussions to see what aspects of the package Iran really is prepared to accept.

An apparent agreement between Iran and the International Atomic Energy Agency (IAEA) reached earlier this week was believed to hold out hope for an agreement that would reduce tensions between Iran and the six nations. But the agreement with the IAEA was related solely to inspections, not to changes in Iran’s development program.

A report at Bloomberg News claims the two sides are wrapping up negotiations, and that the likeliest outcome is an agreement to hold further discussions, perhaps as soon as in three weeks. An EU spokesman said, “If there wasn’t progress, we wouldn’t still be holding the talks. Progress has been made.”

When progress in negotiations is defined as only an agreement for further negotiations, that’s pretty small beer. Still, both sides continue to sound hopeful which is better than nothing.

Paul Ausick

The CBO’s new assessment of the effects of the budget and expected tax increases is this:

Under those fiscal conditions, which will occur under current law, growth in real (inflation-adjusted) GDP in calendar year 2013 will be just 0.5 percent, CBO expects — with the economy projected to contract at an annual rate of 1.3 percent in the first half of the year and expand at an annual rate of 2.3 percent in the second half. Given the pattern of past recessions as identified by the National Bureau of Economic Research, such a contraction in output in the first half of 2013 would probably be judged to be a recession.

This “scenario” could change, if only Congress and the Administration would revise their approaches and their plans to adjust the federal deficit to make it smaller:

CBO analyzed what would happen if lawmakers changed fiscal policy in late 2012 to remove or offset all of the policies that are scheduled to reduce the federal budget deficit by 5.1 percent of GDP between calendar years 2012 and 2013. In that case, CBO estimates, the growth of real GDP in calendar year 2013 would lie in a broad range around 4.4 percent, well above the 0.5 percent projected for 2013 under current law.

The swing of nearly 5% in GDP between the better case and the worse one may be too large to be credible. The debate in Europe between the International Monetary Fund and France on the one side and Germany on the other has brought similar claims of the difference between calamity and growth.

Tax increases may hamper economic activity, but the extent to which that is true is debatable. Some economists believe that most high taxes on businesses and individuals are regressive. The Bush tax cuts are assumed to have kept economic growth moderately strong because taxes rob consumers of their ability to consume. But other, negative factors, particularly the drop in home prices, have only held the consumer back so far. He has, in general, been relatively active, despite the housing crisis and unemployment. The latter has remained above 8% since 2008. Consumer confidence has improved by most measures over the past year. The consumer’s appetite for credit has moved higher recently.

While the effects of higher taxes and more stimulus cannot be known, the CBO has a theory:

[I]f policymakers wanted to minimize the short-run costs of narrowing the deficit very quickly while also minimizing the longer-run costs of allowing large deficits to persist, they could enact a combination of policies: changes in taxes and spending that would widen the deficit in 2013 relative to what would occur under current law but that would reduce deficits later in the decade relative to what would occur if current policies were extended for a prolonged period.

In other words, help the economy now and take the fruits of that later as rapid expansion improves the tax base, which lowers the deficit eventually.

The same debate about stimulus and government cost cuts is going on more urgently in Europe now. The EU summit is about to begin. Germany has warned Greece that if its steps back from austerity measures, its economy will be ruined and its future as a member of the eurozone club will be compromised. Germany also refuses to participate in a grand scheme to save the region economically that would involve, at least, a common bond to raise money for all countries, the weak and strong alike. Even less palatable for Germany, France and the IMF want aid to be given to Spain and Portugal as a means to take them out of recession and improve unemployment. Germany believes this will encourage these governments to waste money as they have in the past. These long-time bad habits make stimulus a risk. One the other hand, cost cuts are easy to measure and easy to enforce.

Enforcement is at the center of the debate because it can be measured. That is true whether the judge is Germany or Congress. Many leaders in America and Europe are willing to trade the tangible for a gamble, even if the gamble is the more likely route to a recovery.

Douglas A. McIntyre

Now that Iran has agreed to inspections by the IAEA, an agreement at the Baghdad meeting is far more likely. If the Baghdad meeting results in a further agreement between Iran and the P5+1, crude prices could fall another $5/barrel, perhaps even more. And Iran has plenty of incentive to negotiate this time.

Iran crude shipments are stalled, with an estimated 40 million barrels or so floating around in the Persian Gulf with nowhere to go. Tankers cannot buy insurance, and without insurance the crude stays put. Iran cannot cut production significantly because that could damage the country’s wells, so it continues to produce millions of barrels a day that it cannot sell.

The oil Iran does sell to India and China is paid for in rupees and yuan, neither of which can be spent outside the country of origin. Iran’s estimated unemployment rate approaches 35% and food prices have risen anywhere from 25%-125% in the last year. Brave words aside, Iran is suffering, the suffering is getting worse, and the sanctions due in July will make the country even more miserable.

Sanctions against Iran won’t miraculously disappear even if the Baghdad conferees reach an agreement. But a delay in imposing part or all of the tougher sanctions due in July is possible. Any movement toward freeing up some of Iran’s production will instantly cause the price of crude to fall, no matter how small the movement. That’s just the way the oil market works these days.

Both Iran and the P5+1 want to be able to claim victory from the coming meeting, and no one wants that victory more than President Obama who is just five months away from an election. Easing tensions with Iran will do more than anything else to lower pump prices, which in turn will be good for the US economy.

The next few days will figure heavily in the US elections, and those of us with long memories may see some parallels with the 1980 presidential election. Predicting what Iran will do is a fool’s game, but politicians in Iran, the US, and Western Europe have too much to lose to let an agreement slip away.

Brent crude prices are down about -0.5% in electronic trading this morning, at $109.77/barrel, while WTI is up about 1.2% at $92.57/barrel.

Paul Ausick

The arguments for a sale are well laid out in this article from the Center for American Progress. Price volatility due to hurricanes in the Gulf of Mexico, political turmoil in Africa or the Middle East, or a more serious confrontation with Iran over its nuclear program could send crude prices soaring again. The main issue that the Center for American Progress focuses on is speculation, and how curbing speculation will keep crude prices lower.

Well, maybe, but not likely, at least not lower for very long. The President and other foreign leaders first broached the subject in March and prices have been falling pretty much ever since. The threat of a release from strategic reserves is often, as in this case, just as good as actually releasing the crude.

Trying to drive speculation out of the oil markets by selling crude from strategic reserves is a blunt instrument that is hard to control. Everyone knows the taps have to be turned off at some point or the strategic reserves no longer serve any strategic purpose. Their availability will just be priced in.

And there’s probably no good reason to drive speculators (that is, non-commercial traders who have no interest in taking delivery of the physical oil) completely out of the market anyway. If that were to happen, the oil markets would once more be controlled by the big oil companies and OPEC. We’ve been down that road before.

A recent article by economist Lutz Kilian of the University of Michigan points out that speculation is not only not bad, it is necessary. The entire article is worth reading, but here are some highlights:

• [T]here is evidence that price increases were somewhat higher for non-exchange traded commodities than for exchange-traded commodities, consistent with the view that financialisation actually dampened price increases.
• There is no compelling evidence that changes in financial traders’ positions predict changes in the price of oil futures.
• Contrary to widely held beliefs that increases in oil futures prices precede increases in the spot price of oil, there is no evidence that oil futures prices significantly improve the out-of-sample accuracy of forecasts of the spot price of oil.
• The oil price–inventory relationship tells us nothing about the quantitative importance of speculation in oil markets. In particular, the absence or presence of speculative pressures in the oil market cannot be inferred from studying oil inventory data without a fully specified structural model.
• There is no empirical evidence that the short-run price elasticity of gasoline demand is literally zero, as required by theoretical models that explain increases in the spot price based on speculation in oil futures markets without an accumulation of oil inventories.

While releasing crude from national strategic reserves is popular among policy makers, its use is usually no better than the threat of its use, and it is only a short-term, temporary solution. The long-term solution is to figure out a way to break the world’s addiction to oil.

Paul Ausick

[T]he main risk lies in potentially overcommitting to the ultra-easy monetary policy, reigniting the global inflation debacle of the 1970s.

Bullard includes a chart in his presentation that shows personal consumption expenditures running slightly above an annual inflation rate of 2%, the Fed’s sort-of target.

Harking back to the bad, old days of the 1970s, Bullard notes that the era suffered 4 recessions in 13 years, double-digit inflation, and double-digit unemployment. Calling monetary policy a “blunt instrument,” Bullard argues that labor policy should replace monetary policy in grappling with unemployment.

That’s probably a wise suggestion, except that labor policy depends on getting legislation through the Congress, and if that had been easy, it would already have been done. Even though Fed monetary policy may be a club and not a scalpel, it may be all that’s left in the policy arsenal.

Bullard’s slide presentation is available here.

Paul Ausick

InterOil’s Gulf project has been scheduled for completion in 2014 or 2015, but the company has had trouble finding another partner to help with the estimated $6 billion construction costs. A plan to use a floating LNG plant was scrapped in March and InterOil’s discussions with the government have become increasingly strained. An energy industry publication, Upstream Online, cites the country’s oil minister:

Minister for Petroleum and Energy William Duma had said that “far from being a world class project of international scale and quality”, InterOil’s new plan was a “small scale, fragmented LNG project using a combination of different production methods.”

The company denies the charge and says it continues to plan a “world class” facility.

A January landslide at a quarry once operated by a subsidiary of Exxon killed at least 25 people, forcing the closure of Exxon’s own $15.7 billion PNG project for two weeks in March following a protest by local landowners. The project is scheduled to begin operation in 2014.

InterOil’s may be able to solve its problems with the PNG government, but delays in contracted deliveries are another problem the company could face. The company signed a long-term deal with trading firm Gunvor late last year for 1 million metric tons of LNG per year beginning in 2015. The deal is non-binding, but InterOil’s ability to fund construction and have a chance of completing the project depend on its ability to convince Gunvor that InterOil will deliver. Any threat to that agreement, or to others that the company has made, jeopardizes InterOil’s very existence.

InterOil’s shares lost about -6.7% yesterday to close at $53.73 in a 52-week range of $31.18-$75.87. Shares lost another -4.1% in after-hours trading, down to $51.56.

Paul Ausick

The Wall Street Journal reports that Fisher responded by repeating his call for smaller banks:

We don’t feel that we should have institutions that are ‘too big to fail. We don’t think we should allow a system that gives big institutions a subsidy over you of 20 to 100 basis points on their cost of borrowing. …

What I’m very worried about is that you can reach a size of complexity that risk management becomes a mathematical modeling exercise and you lose touch with your customer. What concerns me here, without referencing that bank, is … at what size do you not realize what’s going on underneath you? If you’ve gotten to that point, you’re too big. Period.

Fisher seems to be saying that ‘too big to fail’ is also ‘too big to manage’. His implication is clearly that Jamie Dimon could not possibly know what JPM’s traders were doing all the time and that when that’s the case, the bank is too big to manage.

Yet the Federal Reserve has done little to call the country’s largest banks to account. Capital requirements have been raised, but many critics argue that the requirements haven’t been raised enough.

In the recent round of bank stress tests, JPMorgan was recognized as one of the better capitalized and better run banks. If JPMorgan’s $2 billion loss is only the tip of a much larger iceberg, we’ll soon find out if the stress tests measured anything worth knowing.

One final point: JPMorgan was given approval to pay dividends and re-purchase stock following the stress tests. Dimon said yesterday that he wants to continue both practices. The Fed should stop that immediately, at least until the extent of the damage to JPMorgan’s balance sheet is determined. The added advantage is that by hitting the bank’s shareholders in the wallet, perhaps shareholders will get more interested in how their bank is run and whether Dimon is the crackerjack CEO and risk manager he is purported to be.

Paul Ausick

Kocherlakota supports the bank’s increased transparency initiatives:

A transparent central bank is more accountable to the public because it is forced to be more disciplined in ensuring that its policy actions are in fact consistent with its policy objectives. When performance matches words, the public will have an even stronger belief in the central bank, which serves to anchor inflation expectations more solidly.

After presenting several charts and a discussion of Sweden’s experience in the early 1990s, Kocherlakota concludes:

For myself, I continue to pay close attention to the behavior of inflation. The term “maximum employment” in the statutory dual mandate is often interpreted as referring to the level of employment that is sustainable over the longer run without acceleration in inflation. Inflation was distinctly higher in 2011 than in 2010 and continues to run above the FOMC’s target of 2 percent.

Even core measures of inflation, which strip out energy goods and services, and food, went up notably. I see these changes as a signal that our country’s current labor market performance is much closer to “maximum employment” than the post-World War II U.S. data alone would suggest. As I’ve argued in the past, appropriate policy should be responsive to such signals.

Because the Fed mandate does not define “maximum employment”, Kocherlakota’s own definition appears to be 8% unemployment is pretty close. He may be willing to ratchet that down to 7%, but by then inflation might have rocketed up to 3% or even a little more. At that point the Republic will collapse.

Paul Ausick

Some IMF officials see this as a ploy to force Greece to form a coalition government that backs the agreed bailout. There are also questions related to the legality of withholding the payment. The Wall Street Journal reports that Germany and Finland, among others, are “wary” of making the payment because some Greek politicians want to renegotiate the deal.

The WSJ also notes that €3.3 billion of the total due to Greece would be used to repay bonds maturing on May 18. The largest holders of those bonds are the European Central Bank and the central banks of other EU countries, with both German and French central banks likely to be at the top list.

If there’s any remaining question that Greece might be better off cancelling its debt and leaving the Eurozone, a late payment of its bailout money could well put the issue beyond doubt. The country has little to lose by telling the ECB and other Eurozone central banks to take a hike because the funds it receives are in large part simply being used to pay down debt to the countries that Greece thought were its friends.

Germany’s, and the ECB’s, insistence on maintaining inflation at 2% or less means that austerity for the entire Eurozone is the only acceptable course. That can only lead to deflation in the peripheral countries that will bear the brunt of the austerity measures, and which now face a seemingly never-ending string of spending cuts and unemployment. Greece is essentially already out of the Eurozone, but it’s well to remember that it was driven out and did not leave of its own choice.

Paul Ausick