Working Papers

2006 06

Take Out the Black Helicopters and You’ve Got Bill Gross

Caroline Baum’s Just What I Said, a collection of her Bloomberg columns from the late 1990s through to the early 2000s, contains a chapter on financial market conspiracy theories.  She also reproduces some of the correspondence she received in response to these columns:

Do you really believe the US dollar is worth anything?  Print what you want but look in the mirror if you want to see a “truly duped” conspirator!  The black helicopter you hear…it is coming for you Caroline.

Take out the black helicopter references and you’ve almost got Bill Gross.

At least some of Baum’s mailbag would appear to be tongue-in-cheek, but you can never be entirely sure:

Yes, Caroline, there are black helicopters and the day of pecuniary recompense for the filthy idolaters of usury is at hand.  Right now, even as I type, the reptilian mercenaries from Cygnet 61 and Zeta Reticuli are emerging from their base camps to lay siege to the money houses of Wall Street…Soon, you’ll start to notice iguana-like chalky stool droppings in banks and financial offices all over Wall Street.  That is the sign it’s time to get out of town and head for the nearest subterranean shelter.

posted on 30 June 2006 by skirchner in Economics, Financial Markets

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‘Excess Liquidity’ and Asset Prices

The always sensible Stephen Jen tries to give his colleagues an education on so-called ‘excess liquidity’ and asset prices:

What fraction of the financial activities (hedge funds’ long positions in risky assets, carry trades, etc.) is financed through bank credit?  I suspect that many analysts have put too much emphasis on the outdated concept of monetary aggregates driving asset prices.  It is the yield curve — the opportunity cost of liquidity — that is key, in my view, in thinking about asset prices.  Since central banks no longer have a great influence on the yield curves, it is perhaps not correct to blame the central banks for high asset prices.  So much of the financial activities are not a function of what banks do, but the non-bank financial institutions such as hedge funds.  The monetary aggregates say nothing about what these institutions are up to, what their perceived risk is, and what their risk taking appetite is. 

Further, the Marshallian-k analysis actually says that the US base money to nominal GDP ratio has declined over the past decade, and the broad money to nominal GDP ratio being flat for the past few years.  Those who believe there is a positive link between the Marshallian-k and asset prices have to explain away these facts.  Moreover, we need to be very careful about three concepts:  interest rates, asset prices and the real economy.  Clearly, they are all related, but the Marshallian-k says very little about asset prices, though it might have some implications for inflation.

I suspect that even in relation to inflation, most of the analysis based on conventional measures of ‘excess liquidity’ is mistaken.  Given the largely demand-determined nature of monetary aggregates, what is commonly thought of as ‘excess’ liquidity is more likely to be an ‘excess’ demand for money, reflecting portfolio choices between money, other assets and spending that only indirectly reflect central bank policy actions.

UPDATE:  David Miles makes a similar point:

shifts in the private sector’s desire to hold a part of its total wealth in a subset of assets labelled ‘money’ (bank deposits of various sorts) are many and varied. To a large extent they reflect portfolio movements that are driven by shifts in the perceived attractiveness of a very wide range of assets. Quite what the interpretation of a shift in broad money for spending and inflationary pressures should be is absolutely unclear, until you drill down to what is driving it.


posted on 29 June 2006 by skirchner in Economics, Financial Markets

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The Inflation Scare in Perspective

In the period since Bernanke’s appointment as Fed Chair, we have argued against the notion that Bernanke was somehow more dovish on inflation than his predecessor.  Markets seem to have finally taken this in.  Indeed, they now seem to be swinging in the other direction, with some very large hedge fund shorts in September eurodollar futures suggesting that some are looking for a 50 bp tightening from the Fed Thursday.
Alan Reynolds has a timely piece that puts the current inflation scare in perspective:

Others have expressed concern about “asset inflation” becoming embedded in core inflation. I cannot imagine how that idea ever gained credibility. The U.S. stock market boom of 1997-2000 was not followed by higher inflation. Neither was Japan’s land and stock boom of the late 1980s. Strength in asset prices in 1929 was perhaps the world’s worst predictor of inflation.


posted on 27 June 2006 by skirchner in Economics, Financial Markets

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Friends the ‘Austrian School’ Could Do Without

Should we be surprised when PIMCO’s Paul McCulley writes ‘A Kind Word for the Austrian School’?  We have previously drawn attention to the rather bizarre views of the senior officers at PIMCO, not least McCulley’s call for the re-regulation of financial markets, and Bill Gross’ doomsday cultism in relation to the US dollar.  But the PIMCO crew are not only ones invoking Austrian business cycle theory on behalf of bizarre macro views.  The ‘Austrian School’ has received favourable mention from central bankers at the BIS, not exactly the traditional home of Austrian School thinking.  The Economist magazine loves to say that ‘the Austrian school of economics offers perhaps the best framework to understand what is going on,’ and a few years ago ran a special feature on the world economy that was explicitly Austrian.  One could almost be forgiven for thinking that Austrian business cycle theory is undergoing something of a revival.

It is not coincidental that all of the sources cited above have also been prominent in arguing that ‘bubbles’ are the main driver of the business cycle and asset prices.  But what causes ‘bubbles’ in the first place?  Austrian business cycle theory seemingly provides the answer: ‘it was the central bank wot done it!’  This is actually a fundamental explanation, but if people choose to label the process a ‘bubble,’ then so be it.

The notion that the monetary authority is largely to blame for business cycle and asset price fluctuations is appealing in its mono-causality, but also dangerous, because it promotes the idea that a more activist monetary policy could effectively smooth the economy and asset prices.  Needless to say, this is not the preferred conclusion of those in the Austrian School, who focus instead on changes in monetary regime.  But they should not be surprised by the misuse of their theory, which lends itself to exaggerating the importance of monetary policy to economic outcomes. 

This is especially true in a world of interest rate and inflation targeting, where monetary policy is largely an endogenous response to economic activity and the exogenous component of monetary policy is very small - so small, in fact, that many academic researchers question whether the exogenous component of monetary policy is large enough to have important macroeconomic implications.  In the Anglo-American economies, it is now probably more accurate to say that the economy drives monetary policy, not the other way around, which is actually fairly close to the Austrian ideal of a market-determined monetary system.

posted on 24 June 2006 by skirchner in Economics

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Hillary and the Candlemakers

Senator Clinton breaths new life into an old classic:

One of the most famous documents in the history of free-trade literature is Bastiat’s famous “Candlemakers’ Petition.” In that parody, the French economist and parliamentarian imagined the makers of candles and street lamps petitioning the French Chamber of Deputies for protection from a most dastardly foreign competitor:

“We are suffering from the ruinous competition of a rival who apparently works under conditions so far superior to our own for the production of light that he is flooding the domestic market with it at an incredibly low price; for the moment he appears, our sales cease, all the consumers turn to him, and a branch of French industry whose ramifications are innumerable is all at once reduced to complete stagnation. This rival…is none other than the sun.”

For after all, Bastiat’s petitioners noted, how can the makers of candles and lanterns compete with a light source that is totally free? Thank goodness we wouldn’t fall for such nonsense today. Or would we?

Last month, Sen. Hillary Rodham Clinton and nine colleagues (ranging from Barbara Boxer to Tom Coburn) endorsed a petition from — you guessed it — the domestic candlemaking industry asking the secretary of commerce to impose a 108.3 percent tariff on Chinese candle producers.

posted on 24 June 2006 by skirchner in Economics

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North Korean Missile Launches for Fun and Profit

Intrade has a contract available on a North Korean missile launch outside its airspace by 31 July, but not if Ashton Carter and William Perry get their way:

if North Korea persists in its launch preparations, the United States should immediately make clear its intention to strike and destroy the North Korean Taepodong missile before it can be launched. This could be accomplished, for example, by a cruise missile launched from a submarine carrying a high-explosive warhead. The blast would be similar to the one that killed terrorist leader Abu Musab al-Zarqawi in Iraq. But the effect on the Taepodong would be devastating. The multi-story, thin-skinned missile filled with high-energy fuel is itself explosive—the U.S. airstrike would puncture the missile and probably cause it to explode. The carefully engineered test bed for North Korea’s nascent nuclear missile force would be destroyed, and its attempt to retrogress to Cold War threats thwarted. There would be no damage to North Korea outside the immediate vicinity of the missile gantry.

posted on 22 June 2006 by skirchner in Financial Markets, Foreign Affairs & Defence

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Small Incentives Matter

Recent data have confirmed what many of us have known anecdotally for some time: the federal government’s increased incentives for new born babies has triggered a baby boom.  The number of births in 2005 was the highest since 1992.  The 2005 increase over 2004 is even higher adjusting for age-specific fertility rates.  Joshua Gans and Andrew Leigh have further quantified these effects in some well publicised research.

This comes as no surprise to economists, who have always stressed that even seemingly small incentives can have big impacts on behaviour where it counts: at the margin of choice.  The fact that small incentives impact life-changing decisions like when to have children says a lot about the likely behavioural responses to high marginal tax rates.  The case for lowering these rates has never been primarily about increasing after-tax incomes (welcome though that may be for the beneficiaries).  The importance of lowering high marginal tax rates lies in reducing distortions to behaviour, not least, the waste of resources devoted to tax minimisation.

posted on 20 June 2006 by skirchner in Economics

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Cranking Up the Wayback Machine on Stephen Roach

Stephen Roach accuses central banks of promoting ‘bubbles’ through excessively accommodative monetary policies.  So I thought I would dig up what Roach had to say at the time of the last Fed easing in 2003 (emphasis added):

the key objective for the authorities is to get the US economy back to a sustainable 4% growth pace - and hold it there for several years.  That’s the only way the deflationary gap between aggregate supply and demand can be closed once and for all.  A temporary growth spurt won’t do the trick, and yet that’s a classic symptom of a post-bubble economy.  I continue to fear that a post-bubble US economy plagued by a lack of policy traction will be unable to complete the critical transition from subpar to rapid growth.  And that underscores the ultimate risk: A persistence of subpar growth in the current climate could take the US economy further down the slippery slope toward outright deflation.

Once again, financial markets are telling me that I’m dead wrong.  The sharp run up in equities speaks of expectations of a sustained upturn in earnings that only a vigorous economy could deliver.  The recent sharp sell-off in Treasuries speaks of a bond market that now believes that the Fed has done enough to fight deflation and spark a snapback in the real economy.

Yet, if I’m even close to being right on the economy, the markets could well be blindsided by the next in a long string of relapses.

That’s the problem with Roach: you are either in a ‘bubble’ or a ‘post-bubble.’  The ‘bubble’ paradigm is an all-purpose analytical framework that explains everything and nothing.


posted on 18 June 2006 by skirchner in Economics, Financial Markets

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What Ross Gittins Won’t Tell You (or Just Plain Doesn’t Know) About Cutting Taxes

From Alan Reynolds:

More than a dozen highly regarded studies have shown that the amount of income reported by those facing the highest marginal tax rates is extremely sensitive to changes in those tax rates. This is measured by the “elasticity” (responsiveness) of taxable income…

What all this means is that cutting the top tax rate in half has resulted in much more income being reported and taxed in every country that tried it—the United States, United Kingdom, New Zealand and India, for example. Some mistakenly imagined that proved the rich suddenly became richer when U.S. tax rates fell from 1986 to 1988. What it actually proved was that the rich reported more taxable income when tax rates on an extra dollar became more reasonable. These facts are not seriously in dispute regardless what portion of this widely observed “Laffer Curve” phenomenon was due to a change in actual income (a supply-side effect) or to a change in the proportion reported to tax collectors.

In other words, supply-side economists were right all along. Their critics were wrong. Several Nobel Laureates in economics have now said as much. Get over it.

posted on 15 June 2006 by skirchner in Economics

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Permabears Seek Validation in the Cycle

Markets are sending very strong signals of late.  The yield curve inversion in the US and elsewhere, falling stock and commodity prices are all pointing to a weaker global growth outlook.  The curve flattening in particular reflects a ‘stagflation trade’ which anticipates central banks overdoing monetary policy tightening to contain inflation pressures. 

The permabears have been busy recasting their long-running structural bear call into a cyclical one, hoping the cycle will finally validate them.  It is increasingly likely that the cycle will finally oblige them on at least some counts.  If nothing else, they have the law of averages on their side.  Yet markets have not yet delivered much joy to the purveyors of macroeconomic anti-Americanism.  Just ask anyone who followed their advice and bought non-USD denominated asset markets, particularly Asian equities, as a hedge against USD weakness.  So far, the USD has been a beneficiary of recent market developments and Asian equities have been crunched.  Some hedge!

posted on 14 June 2006 by skirchner in Economics, Financial Markets

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The Wisdom of Crowds and Insider Trading

Henry Manne argues that the success of prediction markets supports the legalisation of insider trading:

The implications of what we already know of this “wisdom of crowds” approach to price formation, as against the traditional marginal pricing/arbitrage approach, are apt to be startling. We should rethink any current policies based on a view of pricing in which we exclude the best-informed traders and discard the wisdom of the many. For instance, we now have a new and more powerful argument than we had in the past for legalizing most insider or informed trading.

Since such trading clearly makes the market process work more efficiently, it aids capital allocation decisions and informs business executives through market-price feedback of the best predictions about the value of new plans. Furthermore, the Supreme Court’s “fraud on the market” theory of civil liability under the federal securities laws and Congress’s ideas of correct civil damage claims for insider trading no longer have any intellectual merit. The same is true of any other part of our securities laws implicitly based on the notion of the marginal trader as a rational arbitrageur of price.

The new approach would suggest that it is undesirable to have laws discouraging stock trading by anyone who has any knowledge relevant to the valuation of a security.

posted on 13 June 2006 by skirchner in Economics, Financial Markets

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Why the Kiwis Have Not Become Tigers

The New Zealand Business Roundtable has released Frederic Sautet’s report, Why Have Kiwis Not Become Tigers?  Sautet concludes:

New Zealand has not become a growth dynamo like Ireland because the reforms implemented did not go beyond OECD standard practice. To become tigers, Kiwis must adopt more radical reforms. Unfortunately, the Labour-led government in its 2005 Budget (and in its new incarnation after the September 2005 election) shows little inclination to improve the institutional environment in which entrepreneurial activity takes place. Rather, it prefers to continue increasing the size of government and, through regulation, to tinker at the margin with the rules of the economic game.  In the absence of changes, New Zealand’s economic outlook seems likely to be mediocre rather than exciting.

posted on 13 June 2006 by skirchner in Economics

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Ebay and Online Gaming Regulation

Radley Balko on Ebay’s lobbying efforts in relation to on-line gaming regulation:

Thiel and Levchin’s vision for PayPal is long dead. But it lives on in similar, offshore companies like Neteller and FirePay. These companies are safe and reliable (FirePay is traded on the London Stock Exchange), but aren’t subject to U.S. law, and so can be used for all sorts of goods and services the U.S. government has determined Americans aren’t grown-up enough to purchase. The most notable of these is Internet gambling.

Once your money leaves your bank account for a Neteller or FirePay “online wallet,” there’s no way to know how you then spend that money. Your bank doesn’t know you’ve set up an online poker account, or bought a plane ticket or a bottle of wine.

Enter Rep. Goodlatte. Goodlatte’s bill bans the use of financial services to facilitate Internet gambling sites. It’s already illegal to operate a gaming site on U.S. soil. But most experts agree it’s still legal to “place” a bet. Goodlatte wants to put up a wall between the domestic “bet placing” and the offshore “bet taking,” which FirePay and Neteller make possible.

If banks and other financial institutions are going to be responsible for policing what their customers do online, as will happen should Goodlatte’s bill become law, it’s safe to assume that they’ll comply by simply banning all transactions with offshore payment services.

Which means that Goodlatte’s bill’s main effect will be to shield PayPal, a domestic company, from foreign competitors (foreign competitors that, ironically, are doing exactly what PayPal’s founders envisioned).

What’s more, the letter eBay government relations director Brian Bieron sent to Goodlatte announcing the company’s support of his bill actually goes above and beyond what any gambling foes in Congress have called for. Bieron in fact calls for the actual prosecution of Internet gamblers themselves, a policy which could only be enforced by allowing law enforcement officials to essentially begin monitoring everyone’s online activity, including tracing visited websites back to IP addresses.

A law similar to what Bieron is advocating hit the books in Washington State this month. It makes online gambling a Class C felony, on par with child pornography.

The funny thing is, even as eBay has joined Rep. Goodlatte’s moral crusade against gambling, the company’s overseas operations are moving into the gaming business. According to the gaming industry publication igamingnews.com, PayPal Europe has recently entered into agreements with two online gambling services to allow PayPal to be used by Europeans who want to gamble online.

Industry insiders estimate that as much as 4 percent of the U.S. population participates in online gambling. That’s about 12 million people. It’s likely that a good percentage of those 12 million active, online users also patronize eBay. I wonder what they’d think if they knew that eBay has called for them to be arrested and prosecuted?

posted on 11 June 2006 by skirchner in Economics

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Digesting Dow 36,000

Dan Gross eats James Glassman’s words - literally.

posted on 11 June 2006 by skirchner in Economics

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What Kind of Bird is That?

Bird-watching with James Hamilton:

What does Bernanke really believe? Well, for starters, that:

“the evidence of recent decades, both from the United States and other countries, supports the conclusion that an environment of price stability promotes maximum sustainable growth in employment and output and a more stable real economy.”

That’s what he believes, that’s what he’s going to do, and you can take that to the bank. If that makes him a “hawk” in your book, so be it. But he also has no desire to plunge the U.S. unnecessarily into a recession. So then he’s really a “dove”? Then the limitation is in the vocabulary with which you’re determined to describe him, not in the quality or consistency of his ideas.

Some people find that level of complexity unsettling. But personally, I prefer to have the U.S. Federal Reserve run by a human rather than a bird.

posted on 11 June 2006 by skirchner in Economics

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Bernanke and Inflation

No one ever accused Allan Meltzer of being soft on inflation:

Allan Meltzer: I think the best measure of Mr. Bernanke’s credibility is the bond market, and there is no sign there that traders expect big inflation or even much inflation.

There are enough anti-inflationists at the Fed that even if Mr. Bernanke were mild on inflation—and I don’t think he is—there would not be a majority supporting that position. So I don’t think inflation-fighting credibility is Mr. Bernanke’s problem.

posted on 09 June 2006 by skirchner in Economics

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A Not So Tragic Current Account Deficit

Opposition Treasury Spokesman Wayne Swan piles on the hyperbole following the release of the Q1 current account deficit:

“I think it is a matter of national tragedy that, given we have a global commodities boom and the best trading conditions in a generation, that we are importing into this country more then [sic] we are exporting,” he said.

If this is a national tragedy, it is a long running one, since Australia’s balance on goods and services has averaged -1.1% of GDP since 1960, little different from the -1.8% of GDP seen in Q1 2006.

Now that the current account deficit is actually narrowing, the sub-editors have switched their attention to record foreign debt levels for their headline grabs.  Record foreign debt levels should be no more newsworthy than the record levels of exports of goods and services that go with them: both series are subject to a secular expansion.  Press releases announcing record exports each financial year are a favourite trick of National Party trade ministers, who can practically write the press release a year in advance.  All you have to do is fill in the export numbers.

What matters is the ratio of net foreign debt to exports, which as the chart below shows has been steadily narrowing since the early 1990s.  Another reason I don’t lose any sleep worrying about current account deficits.


posted on 07 June 2006 by skirchner in Economics

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FDI Protectionism: Australia Gets Some of its Own Back

One of the great success stories of the Australian economy that we have sought to highlight on this blog has been the rise of Australia as a net exporter of direct investment capital, a reflection of the globalisation of Australian business.  As this story notes, Australia is the eighth largest investor in the US, with leading Australian companies like Macquarie Bank, BHP Billiton, Santos, Woodside, Westfield, Rinker and Visy owning more than $US130 billion in assets and employing more than 80,000 people in the US.

Given Australia’s sorry record of FDI protectionism on spurious national interest grounds, often at the behest of local producer interests, there is a certain justice in Australian firms now being on the receiving end of similar protectionist sentiment in the US.  As the story cited above notes:

AUSTRALIA might have a free trade agreement with the US but it hasn’t stopped this country being caught in an outbreak of xenophobia towards foreign investors, particularly Macquarie Bank…

The multi-billion-dollar leases for toll roads in the US that Macquarie is acquiring with its Spanish partner Cintra appears to be falling into the definition of “critical infrastructure” that some congressional members want foreigners banned from buying.

The notion that Australian ownership of US infrastructure poses a threat to the US is absurd, but no more so than similar arguments routinely run in the Australian context.  The Australian government proposed to limit foreign ownership in the Snowy Hydro privatisation before the whole thing collapsed amid an outbreak of nationalism and parochialism that would shame even Pauline Hanson.  Australia runs one of the most restrictive FDI regimes in the OECD and the US-Australian FTA left in place sweeping ministerial discretion over foreign investment in Australia. 

FDI protectionism is a silly game to play, especially on the part of firms with global business interests and economies dependent on foreign investment to finance their current account deficits.

posted on 05 June 2006 by skirchner in Economics

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Snowy Hydro: Myth versus Reality


‘This is an unique piece of infrastructure with a cultural ethos,’ said Bernie Fraser, governor of the Reserve Bank of Australia between 1989 and 1996, and whose father Kevin worked on the Snowy. ‘The plan to sell related around short-term fiscal gains, and that is mad ideology for this icon,’ he said in an interview.


The Snowy Hydro electric scheme is no more iconic than the Loy Yang power station, the national phone network or even the TABs. In withdrawing it from sale the Government has capitulated to the paranoid and cynical campaigns of vested interests.

As discussed in this column two weeks ago, Snowy Hydro is, in fact, an investment bank - selling derivatives and insurance products to the electricity industry. It is not even really a power company and certainly not an iconic one. The “vast majority” of its revenue, according to the company, comes from investment banking activities, in competition with investment banks.

posted on 03 June 2006 by skirchner in Economics

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M3 Revisited

I suspect very few of the fever swamp Austrians and tin foil hat brigade who lamented the demise of M3 ever actually made any serious use of these data.  Not that they would get much out of it even if they tried, as James Hamilton argues:

I have to confess that in a quarter century of teaching and research, I never had any occasion to make use of M3. It always seemed to me that this unambiguously failed the definition of an asset that is used to pay for transactions. If you’re going to include such assets in your concept of “money”, why stop there? Don’t you want to include T-bills as well, and if them, why not Treasury bonds? You have to stop somewhere, and I always stopped with M1 or M2.

In addition, a primary reason for focusing on the money supply for policy purposes is that it’s a magnitude controlled by the government. The physical dollar bills are of course printed by the government, and a bank that issues checking accounts must hold credits that could be used to obtain physical dollars (known as Federal Reserve deposits) in a certain proportion to the value of the outstanding checkable deposits. However, it is unclear how the government is supposed to control the M3 components. Balances at foreign banks, for example, are clearly outside the control of the U.S. government.

I was thus a bit surprised at the brou-ha-ha that erupted over the Fed’s decision to discontinue requiring banks to provide the data that was used to calculate some components of M3. These concerns continue to bubble up in comments from Econbrowser readers.

I’m aware of no evidence suggesting that M3 helps predict U.S. inflation or economic activity better than M2.

I discuss the extent to which we should be concerned with broad money aggregates in my review of Tim Congdon’s, Money and Asset Prices.

posted on 01 June 2006 by skirchner in Economics

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