Sunday, January 30, 2011

US New Homes Sales Reveals Weakness

US New home sales data came out this week and it got a lot of people excited. In particular, the hike in the annualised sales to December seemed to suggest better days. For the record, the number went from 280k in November to 329k. An impressive increase.

Unfortunately, on deeper inspection, it is not that good. Much of the increase was due to a large jump in sales in California because purchasers were rushing to meet a tax credit deadline in the State. Looking closer at the numbers for annualised sales...

US 3 Month Av
US Ex-West 3 Month



source: US Census Bureau, Earnings View

....reveals that the data is not so impressive. Excluding the West region shows that the three month average actually fell. Moreover, even if the West is left in, the three month average is only marginally up.

Inventories are coming down but it looks like the housing recovery still hasn't taken place yet.


U.S. Census Bureau News

Tuesday, January 25, 2011

Amanda Knox and the Murder of Meredith Kercher at the Copacabana

Foxy Knoxy

The Meredith Kercher trial has, in my opinion, been approached from a flawed perspective. I think that, instead of focusing on integrating the forensic evidence and statements of the accused (Guede, Knox and Sollecito) into a theory of a premeditated crime, the correct approach would be that articulated in Barry Manilow’s ‘Copacabana’.

The Trials of Rudy Guede, Amanda Knox and Raffaele Sollecito

If you need reminding of the case, than I recommend a quick perusal of the Wikipedia entry. You will find all the key points regarding Amanda Knox’s erratic and contradictory testimony and behavior. The self styled ‘Foxy Knoxy’ Similarly, Sollecito gave contradictory. As for Rudy Guede, his testimony can’t be taken seriously. Guede is a liar, an alleged thief, a murderer and the forensic evidence is indisputable. His actions betray no remorse and I suspect he was lying through his teeth purely to get a more lenient sentence.

So what does all of this have to do with the 'Copacabana'?

How Lola Lost Her Love

Don’t get me wrong. I’d rather listen to an operatic duet from Janet Street-Porter and Forrest Gump, than listen to this song. However, it is always played at weddings in Lebanon so, I can hardly avoid hearing it. In case you don’t know it, Manilow depicts a crime which takes place after a considerable amount of situational events and environmental factors contribute to the inevitable denouement.

‘His name was Rico, he wore a diamond
He was escorted to his chair, he saw Lola dancin' there
And when she finished, he called her over
But Rico went a bit too far, Tony sailed across the bar
And then the punches flew and chairs were smashed in two
There was blood and a single gun shot
But just who shot who?’

According to Manilow, Lola spent the next thirty years wearing the same dress and drinking herself half blind whilst greaving over the death of Tony.

The serious point being that in ‘Copacabana’, the situational factors that govern the murder are given far more prominence than purely relying on a character assessment. Also, if you were to a posteriori piece together the sequence of events from a perspective of a premeditated crime, than it would hard to conceive of anyone turning up at the Copacabana and shooting someone in front numerous witnesses. This wasn’t premeditated.

The same argument applies to the murder of Meredith Kercher.

However, I digress. Turning back to the case, I want to put these understandings together and come up with a theory of what I think happened. The following is purely a fictional reconstruction of what might have happened, it is not intended to be an accurate depiction of events.

The Murder of Meredith Kercher?

Rudy Guede was an alleged thief and a drug dealer. Amanda Knox and Raffaele Sollecito both confessed to smoking hashish on the evening in question.  Knox goes to the house with Guede in order to either buy or pay for some hashish. Sollecito is supposed to meet her later after having been with her earlier that evening at his flat.  Testimony places them there at 8:40pm.

Guede wants money for the hashish and is threatening Knox, he needs the money to score his next hit for the class A drugs that he is known to take. Knox doesn’t have the money and decides to ask Meredith Kercher to give her the share of the rent in cash and she (Knox) will pay it all together in two days when it is due. Kercher refuses. Bank records show Kercher withdrew 250 Euros for her rent, due in two days time. Knox/Sollecito both said they smoked hashish on the evening.

Guede threatens Knox and decides to let them sort it out whilst he defecates in the toilet. Knox and Kercher argue loudly over the money issue. A tussle ensues. Guede then decides he wants to deal with it directly, and starts bullying Kercher. Sollecito arrives and Knox leaves the flat and talks with him outside telling him what is going on. Guede’s DNA was found all over the crime scene and on body of Kercher as was his feces in the toilet.

Guede loses control, pulls a knife and then rapes and slashes Kercher whilst she fights back. Knox and Sollecito return. Guede threatens to kill them both and implicate them if they inform on him. Kercher is slowly dying of asphyxiation (on her own blood) and it starts making her chest feel very tight as her lungs fill up. Sollecito rips off her bra clasp in order to help her. Guede frames the scene so it looks like a break in and murder. The murder scene was believed to have been framed to look like a murder and the only DNA evidence that places either Knox or Sollecito at the crime was that found on Kercher’s bra clasp (Sollecito’s).

Knox and Sollecito are scared of Guede’s revenge plus his threat to inform on them. Guede goes on the run. Sollecito takes the knife home and scrapes it clean in order to hide the evidence. A knife was found with Kercher’s DNA on the tip and Knox DNA on the handle at Sollecito’s flat.

Knox, Guede and Sollecito’s Conflicting Testimonies

 Knox initially said she went to the house with Patrick Lumumba (a different black man) and he did the murder. Clearly, she feared that she had been seen going to the house with a black man (Guede) and wanted to detract attention from Guede, whom she feared. She did not conceive that no witnesses would place her at the scene.

Sollecito initially said that he wasn’t sure whether he was with Knox on the evening or not. He said this because he wanted to ‘wait and see’ what came from witnesses. He knew that one witness could confirm he was with Knox at his flat, this would be damaging to him because it would establish that they were together for at least part of the evening. If no forensic or witness evidence had come forward, there would be nothing linking him with the crime.

In his appeal, Guede claimed that Knox and Kercher argued, loudly, over money. In my ‘version’ they do. I think he thought that a witness was coming forward that had heard them arguing and that that would substantiate his story.

The Official Verdict

I don’t buy the verdict that there was a premeditated orgy of sex and drugs that went wrong. Sollecito was reported to be sexually inexperienced and such an attack on Kercher is unlikely to have been planned with someone like Guede. No DNA evidence places Knox in the room of the crime and none-save for the bra clasp-places Sollecito there either. The knife evidence and contradictory testimony, is merely two scared kids (as much from Guede as from the police) trying to hide the evidence of a murder that they did not actually commit themselves.

The fixation on some sort of rational premeditation to this crime and subsequent testimony is flawed. I think it is more to do with situational factors causing Knox and Sollecito to act in the way that they do.

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Sunday, January 23, 2011

European Sovereign Debt Crisis: Spain to Recapitalise Banks?

Sometimes the most obvious things are the hardest to see. If anyone was in any doubt as to the nature of the problem concerning Spanish Sovereign Debt, than this weeks evidence should make things clear. For Spain, it is all about the banks.

I want to take a look at the latest developments in the European Sovereign Debt crisis. Starting with the sudden appetite for risk with their Government Debt. See here, Spain ten year yield premium over Germany...

One-Year Chart for SPAIN 10 YEAR - GERMAN 10 YEAR (.SPAGER10:IND)

Moreover, suddenly the market is happy to insure Spain Sovereign Debt. See five year CDS pricing...

One-Year Chart for SPAIN CDS USD SR 5Y (CSPA1U5:IND)
source: Bloomberg

What caused this turn around in sentiment? 

Spain to Recapitalise the Cajas?

According to reports, Spain is planning to recapitalise the Cajas. The plan seems to involve trying to raise private funding first, and if that fails, the state (via the Fondo de Reestructuracion Ordenada Bancaria) will probably end up buying equity via raising debt.

Of course, raising debt to support the Cajas would not get rid of the risk. It would merely shift it onto the Sovereign Debt. However, the markets reaction suggests that the risk was in the worry that Spain was not dealing with the Cajas problems in favour of pretending the issues didn't exist.  Ever since five of the Cajas failed the European banking stress tests last year-seen as 'soft' by many- the spotlight has been on them. Moreover, according to the BIS, Spanish banks are exposed to $108bn worth of Portuguese Sovereign Debt. A very weak growth outlook and a -still faltering-housing market did nothing to allay fears. However, Spain were not without friends.

Support for Spanish Sovereign Debt

China came on a trade mission and said they would buy European sovereign debt. Japan said it would buy peripheral sovereign debt. The ECB talked about raising the European Financial Stability Facility (EFSF) in order to help with future problems. Nothing worked.

That is, until the Government tried to grasp at the nature of the problem by, at least, talking, about recapitalising them. This is critical because, whilst Portugal can be bailed out with the EFSF, Spain can't. Here is some analysis from RBS on the situation


Spain to Avoid a European Sovereign Debt Crisis?
Based on previous calculations by Markets and Culture found in this link here, Spain appears to have some significant austerity measures still to make which will hamper growth. In order to stay on a sustainable debt path they will need a continuation of moderation in sovereign debt yields and strong growth in Europe.

The good news is that the authorities learnt their lesson from the mini liquidity crises we saw last year when Greece hit the headlines. See the TED spread...

One-Year Chart for Ted Spread (.TEDSP:IND)
source: Bloomberg

So, I would expect growth to be less impeded from Portugal/Spain's problems. Frankly, I don't think Portugal can avoid a bail out, but if Spain acts swiftly it appears that the market believes that the Caja recapitalisation plans give them a chance.

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Friday, January 21, 2011

US Housing Market Set for Subdued Recovery

The US housing market was at the epicentre of the financial crises so it is reasonable to assume that it needs to recover in order to confirm a full recovery. This is especially important as the 'wealth effect' of rising house price values has a direct correlation with US consumption demand. Ultimately, housing will recover as new household generation catches up with reducing inventory, but is 2011 the year when the housing market will definitively recover? Ultimately, the answer to this question will lie in a combination of inventory, affordability and employment.

Existing Home Sales Data

The latest existing homes data from the National Association of Realtors is out and I've incorporated them into this table

Mar 2010
Jun 2010
Sep 2010
Dec 2010
Inventory (m)
Sales (yearly rate)
Months Supply
Av Price (k)
source: National Association of Realtors, Markets and Culture

As a rough guide, a 'normal' months supply data is 6 months, but this number can reduce dramatically given a pick up in sales.  I think a normal inventory could be around 3m. Transactions should improve given ongoing employment gains. However, prices appear to be weakening, even though, Robert Shiller doesn't believe they have gone far enough...


Frankly, I'm not convinced by the Case-Shiller 'Long-Term Trend', as the US economy has seen a marginal shift increase in home ownership.

Shadow Housing Inventory

Unfortunately, the inventory data is not the whole story. Their is a whole load of shadow inventory in the pipeline from banks and repossessions. Corelogic gave some estimates for how much this could be to August...
CoreLogic Visible and Pending Inventory 
   and the future inventory looks like it will hold back housing...

CoreLogic Shadow Inventory

The real key to understanding how much future shadow inventory will be to look at serious delinquency rates are faring. I've compared October 2010 delinquency rates with 2005, on single and multiple family serious delinquency rates.

  • Single family rates at 4.52% vs. .77% in 2005
  • Multiple family rates at .71% vs. .27% in 2005
Clearly there are more foreclosures in the pipeline. So for 2011, it looks like a subdued recovery in housing.


Corelogic Report

Fannie Mae Monthly Report

National Association of Realtors

Saturday, January 15, 2011

Free to Choose? Why Free Market Economies Create Happier Populations

Adam Smith

In a previous article I discussed the moral foundations of market institutions and touched upon a subject which will be the focus of this piece. Specifically, whether the concept of the ‘satiability of needs’ is valid? 
If needs are satiable then it could be argued that they could be defined and, there is a valid argument for centralized provision.  If they cannot, then the best solution appears to be to allow market provision. Note that, the former argument does not imply a loss of autonomy, since autonomy is only seen as having a value if it leads to needs being satiated and-according to the theory-these needs can be satiated. 

I want to explore this problem of choices and needs from the perspective of the work of behavioral psychology in consumer choice.

Too Much Choice: People Only Want Jam Tomorrow?

One of the most cited pieces of research on consumer choice is Sheen Iyengar’s ‘When Choice is Demotivating: Can One Desire Too Much of a Good Thing?’ which is most famous for its study of jam selection. The lessons of this study (which is just one part of the work) are oft referred to in the ‘Apprentice’ television series, whereby contestants have actually received challenges which replicate the decision making in this research.

When faced with a large number of jars of jam, consumers appear bewildered by the options and bought less jam. Moreover, they were less satisfied with their purchases. On the contrary, faced with a smaller selection, consumers bought more and were happier with their selections.

Overall, in this work, Iyengar argues…

‘psychological theory and research affirm the positive affective and motivational consequences of having personal choice. These findings have led to the popular notion that more choice is better, that the human ability to desire and manage choice is unlimited. Findings from three studies starkly challenge the implicit assumption that having more choice is necessarily more intrinsically motivating than having fewer options.’

So it seems that consumers do not actually value having unlimited choice over limited choice. So long as that limited choice fulfills their needs. This argument appears to strengthen the idea that needs can be satiated, or at least, that a market with a few suppliers could in fact be better than one with many. An idea, that opens up the possibility of centralized creation of oligopolies, as opposed to completely free markets.

Heuristics in Consumer Choice

Iyengar’s work seems to conform to the principles of the work of Kahneman & Tversky. These two cognitive behavioral psychologists built up a body of research that affirmed the usage of heuristics or ‘short cuts’ in decision making under uncertainty. When faced with many options, humans go through a process of cognitively narrowing the options via using learnt rules or heuristics. If the effort expended in applying this process out cedes the marginal utility in making it, then the process tends to be discarded. In other words, no one can be bothered to decide over what jam to buy.

Free to Choose?

If you put the arguments- in the sections above- together than the case for needs being satiable, appears to be a strong one. However, they appear to go against common preconceptions over the benefit of more choice. Moreover, they also appear to go against the common experience of consumers being offered multiple choices in the marketplace. Supermarkets are full of multiple choices of goods and the internet is booming with long tailed retail. In Chris Anderson's 'The Long Tail' this growing aspect of consumer preferences is discussed in length.

So is this just academic research that falls apart in real world? In addition, is there something intrinsically valuable in having choices that consumers do not necessarily want to use? I suspect so.

Consumers Need Choices That They Don’t Use

It appears that the consumer values having a wide range of options even if it doesn’t appear to be the optimal way for them to make decisions. This perplexing conclusion is only elucidated if one accepts that the value lies in consumers feeling that they are free to make purchasing decisions of their own volition. In a later work, Iyengar expresses this view succinctly in “Knowing What You Like versus Discovering What You Want: The Influence of Choice Making Goals on Decision Satisfaction

‘Despite the detriments associated with choice overload, consumers want choice and they want a lot of it. The benefits that stem from choice, however, come not from the options themselves, but rather from the process of choosing. By allowing choosers to perceive themselves as volitional agents having successfully constructed their preference and ultimate selection outcomes during the choosing task, the importance of choice is reinstated.’

I am sympathetic to this argument. However, this should not be taken as a validation of the argument that all that need be done is make sure that consumers feel they are making autonomous choices, when in fact they are being manipulated.

The value not only lies in feeling autonomous but also in being part of the epistemic process of the market, whereby tacit knowledge of wants and purchasing desires is expressed through market pricing mechanisms. Consumers want to feel they are part of this process, not only because it is the best way to utilize resources, but people value being free to choose.

Satiability of Needs?

So what does this mean for the satiability of needs? I think that it should be recognized that market mechanisms and freedom to choose should be seen as an end, rather than a means to achieve wants. Whilst needs are not necessarily satiable, consumers are happier when they are presented with choice and the feeling that they are part of the iterative process of defining consumer choice.

In conclusion, being part of the market process appears to be as important as having needs satiated. The implications for social cohesion are clear. Consider two economies which happen to have equal provision of the same type of goods. One has them provided by the market, the latter via centralized control. The one that has it provided via the market mechanism is likely to have a happier population than the latter.  Moreover, it could be the case that the poorer segments of free market economies are happier than those equally poor in a command economy, even though they share the same amount of ‘autonomy’ in terms of being able to enjoy goods.


Anderson, Chris 'The Long Tail'  Random House Books, 2007

Iyengar, Sheena ‘Knowing What You Like versus Discovering What You Want: The Influence of Choice Making Goals on Decision Satisfaction’

Iyengar, Sheena ‘When Choice is Demotivating: Can One Desire Too Much of a Good Thing?’ Columbia University

Wednesday, January 12, 2011

More Good News for the UK Housing Market?

If ever you needed conclusive proof that the UK housing market is rigged in order to transfer wealth from the young to the old, then please read this from Barratt Developments statement this morning...

Today we are also announcing a tie-up with Hitachi Capital (UK) PLC that will allow parents to borrow money to help their children onto the property ladder.  The product is unique in the market and is specifically designed to address current mortgage restrictions on loan to value.
In other words, we've given up focusing on getting young people into debt in order to prop up UK house prices. Instead, let's cut out the middle man and just get the parents directly into debt instead.

Meanwhile, in the six months to December, their completions were down to 4,832 from 5,053 last year. However, the average selling price was up 6% to £176k. As for the growth outlook...

Mortgage lending remains at unusually low levels and we view this restricted availability of mortgage finance as continuing to be the key constraint on market growth in the near term.
So much for the restructuring in the banking sector.

Although, one thing that has gone back to normal is that Lloyds CEO Eric Daniels looks set for a £1m bonus, whilst Stephen Hester has £2.5m lined up. Meanwhile, Bob Diamond thinks its time for the banks to stop apologising for the credit crunch.

Aside from the moral issues, the banking sector underperformed benchmark indices in 2010.


Prices up, supply growth slowing, the banking sector not lending money and now, parents are having to borrow money to pay for their parents houses. Meanwhile, the banking sector looks set to award itself £7bn in bonuses-of which Savile's estimates 1.6bn will go into the London housing market- after having seen increases in their salary in 2010 to counter weight the tax last year.

When will this madness end?

Monday, January 10, 2011

The MMR Vaccine, Autism, Andrew Wakefield and Lawyers Too

Andrew Wakefield

According to a recent report in the British Medical Journal the study published in the Lancet in 1998 (led by Dr Andrew Wakefield) was declared as being a fraud. The press will be full of stories relating to the MMR/Autism scandal. I wanted to highlight the facts behind the case and talk about the critical role that Lawyers greed played in the whole scandal. Their disgraceful role in the affair has not received enough attention.

There has not been a single scientific study that links the measles, mumps and rubella (MMR) vaccine with autism. In addition, there has not even been any scientific evidence to link thiomersal with autism. Thiomersal is referenced because it contains trace elements of mercury and was formerly posited as being responsible for the rise in autism. These suppositions have, thus far, proved to be without foundation.

So why do people persist in believing that there is a link? Whatever the reason, it does not lay in science.

The Scientific Evidence for Link between MMR and Autism?

Here is a list of medical bodies that have found no casual link between MMR and autism/thiomersal
  • Centers for Disease Control and Prevention (CDC)
  • The National Health Service in the UK (NHS)
  • Institute of Medicine (IOM)
  • World Health Organisation (WHO)
  • Food and Drug Administration (FDA)
  • New Scientist Magazine
According to the FDA’s "Thiomersal in Vaccines,” the IOM's Immunization Safety Review Committee concluded in 2004 that the:
... evidence favors rejection of a causal relationship between thimerosal-containing vaccines and autism.. ...the committee stated that the benefits of vaccination are proven and the hypothesis of susceptible populations is presently speculative, and that widespread rejection of vaccines would lead to increases in incidences of serious infectious diseases.

The Origins of the MMR and Autism Controversy

In 1998, Andrew Wakefield, a former surgeon, published a paper in The Lancet. The paper suggested that the connection between gastrointestinal pathologies and autism was real, but stopped short of arguing that it proved an association between the MMR vaccine and autism.

The report outlined that the parents of eight (of the 12 children with developmental disorders) had blamed the MMR vaccine. Furthermore, Wakefield argued that it was a better solution to use single vaccines instead of the MMR triple vaccine until a casual relationship could be ruled out.

General Medical Council Ruling on Andrew Wakefield

It was later discovered that Wakefield had been receiving monies from solicitors working on a class action against MMR manufacturers. Furthermore, Wakefield had registered a patent for a single measles vaccine, which would have benefited substantially if his advice against the triple vaccine MMR had been followed.

In 2010, the General Medical Council gave their verdict on a disciplinary hearing for Andrew Wakefield. He was branded a dishonest and irresponsible doctor whose work had been thoroughly discredited. The Lancet had previously retracted the published paper and Wakefield’s research had been thoroughly exposed by investigative journalist Brian Deer.

The Consequences of the MMR Scandal

The repercussions of Wakefield’s dishonesty cannot be understated. MMR vaccinations fell after his "research" received substantive media attention. His work was ceased upon and endorsed by celebrities who promulgated the case without scientific to support them. As a consequence, many children did not receive vaccinations.

Furthermore, according to Deer, Wakefield received over £400k in personal payments from solicitors (who obtained the money from public funds) to conduct the research, and also received £55k in public funding for the research work itself, but it didn’t stop there.

The Solicitor who approached Wakefield was Richard Barr, and their double-act of solicitor & lawyer proved highly lucrative for the professionals that worked for them. According to Deer
This start-up funding was part of a staggering £18m of taxpayers' money eventually shared among a group of doctors and lawyers, working under Barr's and Wakefield's direction, to try to prove that MMR caused the previously unheard-of 'syndrome.'

Similarly, according to Dr. Michael Fitzpatrick, lawyers failed to act after O’Leary’s findings (outlining how the measles virus had been detected in gut biopsies of children with autism and gastro-intestinal disturbances) had been discredited:
When the lawyers at the Legal Services Commission discovered this authoritative investigation concluding that O’Leary’s findings were unreliable they realised that, putting this together with the wider evidence against the MMR-autism thesis, the litigation had no chance.. ...the lawyers leading the campaign refused to acknowledge openly that the scientific case against the MMR-autism link was overwhelming and advise their clients to conclude the action.

In fact, the lawyers pursued the case for a further three years. The ultimate result being that he lawyers and solicitors working on this hopeless case earned £9.7m from these actions.

The Reasons behind the MMR and Autism Scandal

I think the primary cause behind Wakefield's actions is the greed and impunity-free opportunism of the legal sector. They received public funding in order to pursue a case which never had a shred of evidence, and they probably knew it. The secondary cause is the desire of the media and public to latch onto a story that has the classic (but unfounded) ingredient of corporate greed at the expense of the public.

The losers in the scandal are the taxpayers and the parents of children who did not receive necessary vaccinations. The winners are the lawyers and Wakefield. Although thoroughly discredited, I believe he makes a good living in the USA.

The lessons to be learned relate to the conduct of the legal sector and, the wilful and sensationalist seeking negligence of certain parts of the media industry.


CDC Press Release

Bloomberg Website “Lancet Study Tying Childhood Vaccine to Autism was ‘Fraud’, Report Says”  Accessed Jan 10, 2011

Deer, Brian ‘Nailed: Dr Andrew Wakefield and the MMR - autism fraud’

FDA ‘Thiomersal in Vaccines’ , FDA Website

Fitzpatrick, Dr Michael ‘The MMR-autism theory? There’s nothing in it’

World Health Organisation ‘Thiomersal and vaccines: questions and answers’ WHO website

New Scientist ‘MMR and autism not linked,finds Giant Study’

NHS ‘MMR The Facts’ NHS Immunisation Information, 2004

Saturday, January 8, 2011

A New Approach to The Causes of Inflation and Inflation Targeting

Inflation is a fascinating phenomenon from an investment perspective. Naturally most of the focus and analysis comes from the bond markets, where inflation expectations largely guide the movements in bond prices. However should the rest of the investment community analyse inflation expectations in the same way? Moreover, is the focus on headline inflation the key to understanding economic prospects? In this article, I will answer 'no' to both of these questions.

Inflation Policy is Influenced by Historical Events

Political actions or ideologies only really acquire strength if they are accompanied by emotional involvement and, it takes significant macro events in order to get the public involved with the details of economic policy. However, when they happen, the ramifications can become deeply embedded.

In terms of inflation, consider the hyper inflation experienced by the Germans in the inter-war period. This has had a lasting cultural effect on the willingness of Germans to agree to anti-inflationary Governmental measures. Similarly, the inflationary period in the 70's has caused no end of academic spilt ink to be devoted to formulating headline inflation busting policies. Whatever it took, headline inflation had to be controlled.

Moreover, this approach can be seen in the remits of both the ECB and the Federal Reserve. Although the Federal Reserve is supposed to oversee growth and inflation, very few people argue for a focus on the former if it compromises-in the slightest- the latter.

Academic Focus on Inflation

However, the focus on inflation is not just limited to executive political decision making. Indeed, it is fascinating how this is the one area of policy that the free marketeers (Milton Friedman etc) will insist requires action. Friedman's work focused on the control of monetary aggregate growth as the key to beating inflation. Friedrich Hayek has suggested that currencies be allowed to 'compete' with one another, in order to impose an anti-inflationary discipline upon issuers. Most of the economists focusing on this area of research would advocate inflation targeting in order to keep the economy out of recession.

Inflation Induces Misallocations of Capital

However, it is to an earlier insight of Hayek's that I think attention should be focused. In 'The Pure Theory of Capital'. In this early work, Hayek attempts to explain the cyclical nature of industrial output in a systematic theory of capital. He warns of the dangers of misallocations of capital that are caused by the availability of cheap credit during the boom period. The resulting recession is lengthened by the difficulties inherent in restructuring this capital. Furthermore, this 'cheap credit' is induced by rapid relative movements in pricing.

So for example, if house prices are booming-after the dot com bust, housing, commodities and hedge funds became the new 'dot-com'-then credit issuers will be psychologically induced to issue cheap credit. I need not explain the outcome of this and how much misallocated capital was thrown at new house build in the US. Just look at this chart...

The greatest insights into how economic agents are induced into doing this is given in the behavioural finance research of Kahneman and Tversky. They demonstrate how people tend to use heuristics in order to make decisions under uncertainty and, rapidly changing prices (inflation) are a significant cause of uncertainty.

In this article, I am arguing that it is the effects of these misallocations that are the symptoms and the cause is the psychological inducements. However, you can have these misallocations-with significant effects-without having head line inflation.

Inflation without the Inflation?

As noted above, for historical reasons, the focus on fighting inflation has been on the headline numbers. However, it strikes me that recent history has highlighted the dangers of inflation without, err, the inflation! Combating head line inflation is, in my opinion, far too narrow a political course to guide. In the last few years, we have seen inflation in the risk seeking within housing, mortgage bonds, CDO's etc. All of which was watched over by the Federal Reserve.

 Indeed, Greenspan spoke of a 'bond conundrum' as he had tried to raise rates only to see the markets keep market rates low. Ultimately, was this a problem to Greenspan, given that his remit is headline inflation? I suspect not, or at least, not enough to propel him to act further. Unfortunately, the inflation remit of the Federal Reserve is set up to fight yesterday's battles.

Similarly, with European Sovereign Debt, the market merrily priced in peripheral debt at close to Bund levels for most of the naughties. The Greeks never had it so good. Again, the subsequent misapplications of capital are being dealt with today. Again, the ECB's inflation busting remit does not allow it to make considerations. Bizarrely of all, the history of Communist control in China has created an environment whereby their central authorities can look at these issues in isolation. 

Fighting Inflation in Future

I think a fundamental rethink in inflation targeting is needed. I do not argue for an abandonment of current head line inflation targeting however I do think that policy responses-as with Greenspan and the 'bond conundrum'-should be encumbered because of a narrow focus on inflation targeting. Indeed, Greenspan repeatedly warned of the dangers of derivative issuance. Moreover, Mervyn King has been devastatingly succinct on what he thinks about the banking system.

It's time to rethink Central Banks remits and, to stop forcing them to fight yesterday's battles.


Hayek, F.A "Denationalization of Money: An Analysis of the Theory and Practice of Concurrent Currencies" , Hobart Papers, Transatlantic Arts, 1977

Hayek, F.A "The Pure Theory of Capital", The Collected Works of F.A. Hayek, University of Chicago Press, 2007

Kahneman, Daniel and Tversky, Amos "Judgement Under Uncertainty: Heuristics and Biases", Cambridge University Press, 1982