A commenter named Mark Sadowski sent me this very useful info:

Another piece of the puzzle is core eurozone bond yields. If one looks at 10-year bond yields for Austria, Belgium, Finland, France, Germany, Luxembourg, and Netherlands you will observe that all have fallen by about 70 basis points since last June and about 30 basis points in just the last three weeks. For example the German 10-year bond was trading at only 2.78% as of today. I take this as a sign of falling inflation expectations in the eurozone.  (The original comment included Sweden, but he later noted it was not in the eurozone.)

Now think about the media narrative.  There is supposedly a collapse of confidence in the euro that is making the euro very weak.  But here’s what puzzles me.  When there really was a collapse in confidence in the Mexican peso or Thai baht during their crises, I don’t recall yields on long term Mexican and Thai bonds falling to 2.78%.  Maybe the media narrative is worth reconsidering.

This reminds me of the international economics experts who told us that the US had to have a severe recession after our banking crisis, because most other countries have had severe recessions after their banking crises.  Yes, but in the 1990s did Thailand and Mexico and Sweden see their currencies appreciate strongly in the teeth of their crises, as the dollar appreciated strongly from July to November 2008?  To paraphrase James Carville–It’s the tight money stupid.

I know it’s hard for institutions to admit mistakes, but we need coordinated easing from the Fed, ECB, and BOJ.  Blame it on Greece.

Part 1:  Focus on prices, not rates

Many press reports are attributing the fall in oil prices (in dollar terms) to the ongoing depreciation of the euro.  I believe this is wrong.  If I am not mistaken, the standard argument goes something like this:

1.  A falling euro means a rising dollar.  (So far so good, if we are talking about the euro/dollar exchange rate then this is a tautology.)

2.  A rising dollar will, ceteris paribus, tend to lower commodity prices.  (Again, I agree.)

But here’s what people forget.  That same argument implies that a falling euro should raise the euro price of oil.  But in fact, the euro price of oil is also falling sharply.  So what is going on?
Den ganzen Beitrag lesen…

Nick Cowen must have done a good job editing my Great Depression talk, as people seem to like it.  Here is the other talk, in which Kevin Dowd also participated.  Kevin published a paper in Economic Journal in 1994 on using futures markets to target the price level. (He also has a new book.)  We discuss the current economic crisis.

Many of my students think that we can expect consumers to buy less gasoline when the price is high, and vice versa.  In fact, the opposite has more often been true in recent decades, as oil demand shocks have become more important that oil supply shocks.  More oil was being consumed when prices hit $147 (due to high demand) than a year later when prices had fallen in half (due to lower demand.)

Paul Krugman’s much too smart to make that mistake, but he comes close in this post:

Tim Duy has an interesting point about the impact of the euro crisis on the United States: in the short run, it may help, not hurt, our prospects for recovery.

Many of us have noticed that the US exports only a bit more than 1 percent of GDP to the euro zone, limiting the direct negative impact. Meanwhile, as Duy points out, the immediate impact of the euro crisis has been (a) a fall in oil prices (b) a fall in long-term interest rates. Both of these are actually positive for the US.

Technically this is correct, as Krugman and Duy are only looking at the partial effect of lower prices on imported oil.  The euro crisis has clearly lowered expected NGDP growth in the US and indeed throughout the world.  The lower expected NGDP growth will tend to reduce long term interest rates and commodity prices.  And it is true that for any given level of AD, lower oil prices are expansionary (as AS shifts right.)   But at a deeper level it is very misleading.

There is a reason why both long term rates and commodity prices are strongly correlated with severe AD shocks; both reflect the fact that output of manufactured goods and investment demand are highly cyclical.  When NGDP fell sharply below trend in late 2008 and early 2009, both (real) commodity prices and nominal long term rates fell sharply.  Those were not hopeful signs; rather they were indicators that AD was coming in far below target.

So yes, it is technically true that, ceteris paribus, lower oil prices and long terms rates can be helpful.  But if you wake up in the morning and pick the paper, and see this headline:

Oil Prices Plunge, Treasury Bond Prices Soar.

You should be afraid, very afraid.

My suggestion is that people should never reason from a price change, but always start one step earlier—what caused the price to change.  If oil prices fall because Saudi Arabia increases production, then that is bullish news.  If oil prices fall because of falling AD in Europe, that might be expansionary for the US.  But if oil prices are falling because the euro crisis is increasing the demand for dollars and lowering AD worldwide; confirmed by falls in commodity prices, US equity prices, and TIPS spreads, then that is bearish news.

The markets are telling us that the euro crisis is hurting recovery in the US, not helping.  It’s easy to laugh off the highly erratic markets.  But before doing so perhaps we should recall that the markets were also tell us that money was far too tight in September 2008.  The Fed ignored those warnings.  I have a hunch that right now they’d like to redo the September 16, 2008 meeting.

Krugman’s post was in support of an earlier post by Tim Duy.  Duy makes a good point when he notes that the Asian crisis of 1997-98 did not slow growth in America.  And I’d have to admit that the markets did not cover themselves in glory during that episode.  But I still think the Keynesian approach to AD misses something important.  Lower long term rates look like an exogenous shock that is expansionary, whereas I believe they mostly reflect lower growth expectations worldwide (confirmed by falling equity prices.)  It’s true that US exports to Europe are modest, but if the strong dollar is symptomatic of unintentional tightening of monetary policy, despite low rates, then it may not be good news at all.  An increased demand for dollars will look almost invisible from the perspective of the Keynesian C+I+G+NX approach to AD.  (I suppose it would be attributed to less “animal spirits.”)  But as we saw in late 1937, a scramble for liquidity can be highly deflationary even if the financial system is in good shape.  We are certainly not facing a crisis, but this is something the Fed needs to watch carefully.  The last time the dollar soared against the euro was July-November 2008.  And how’d that work out?

Note, please skip this self-indulgent post if you come here for economic commentary.

If you are about my age (and male) you might remember those schlocky sci-fi paperbacks from the 1950s and 60s, with cover art showing a rocket sitting on a moon of Saturn.  Perhaps the picture showed light from a distant sun shining dimly through Titan’s methane atmosphere.  Oddly-shaped rocks rise out of orange-tinted lakes of ammonia.  Did it make you want to become an astronaut?  Then go to Iceland.

I arrived in Iceland last Thursday at 3:15, and initially didn’t see anything like the scene I just described.  The airport was delightfully spacious and empty.  It had those clean, utilitarian lines one associates with Scandinavian architecture, with lots of light everywhere.  By 3:30 I had rented a (very expensive) Subaru, and was driving through the most crystal clear air I had ever seen–or should I say not seen.  Reykjavik was clearly visible 20 miles away over the water, as was the peninsula to the north, which must be 60 miles away.  Partly this reflects a lack of air pollution, but the atmosphere in the polar regions is much clearer than even unpolluted air in more temperate climes.

I drove for at least 6 or 8 miles through the outskirts of Reykjavik.  As you may know, Iceland has become virtually a city-state, with 2/3 of the population living near the capital.  I want to assure the IceSave depositors of Britain and Holland that their money was well-spent, as Icelanders are enjoying many new and attractive residences in the “Scandinavian moderne” style.

Right after leaving Reykjavik the road turned west, and I was surprised to see a huge pillar of ash rising far above the clouds in the distance.  Looking at the map, I figured the volcano must be roughly 100 km away.  I decided to see how close I could get before I ran into a government barricade to keep people away from danger.  (Later I found out that there are no such barricades, in Iceland you are quite free to drive into a pool of lava.)

Because there are almost no trees, the country seems very wide open and spacious.  It is relatively easy to find what you are looking for.  You see steam coming out of the ground, lots of rivers, ancient lava flows, etc.  When I got much nearer to the volcano, I came across the beautiful waterfall called Seljalandsfoss.  You can actually walk behind it.  As an aside, when planning a back and forth trip, always try to keep the sun at your back, it makes the scenery look much better.  Thus I drove east in the afternoon, with the plan to return west to Reykjavik the next day.  The late afternoon sun made the landscape look stunning beautiful.  And in May the “afternoon” last until the sun sets at 10:30.

Picture this scene.  You are a few 100 meters from a tall cliff.  Straight ahead is an extremely attractive waterfall.  Other slender waterfalls flow over the cliff to your left.  To the right you look across flat farmland with Icelandic horses grazing, and out over the ocean to the jagged Westerman Islands.  Beyond that is Surtsey, which didn’t even exist until 1963.  Above the cliffs you see a dazzling glacier, and the sort of oddly shaped clouds that you see in northern regions.  Cute puffin birds circle around. Over-arching the entire scene is a huge rainbow with more colors than I recall seeing in any other rainbow.  Oh, and one other thing, if that’s not enough there was also a colossal tower of ash rising above the glacier-caped volcano, no more than a few miles away.

The ash cloud was drifting down and to the right (which is south, or out to sea.)  A few miles further on the road seemed to disappear into the ash cloud.  Just then I saw a sign for a hotel named “Anna,” which lay right at the foot of the volcano.  As I drove up I assumed there would be no rooms.  After all, the views were sublime, so I figured they must be swamped with tourists.  I was delighted to find that they did have a very nice room, and at a reasonable price.   It was a small family operation (they seemed to be farmers) with only 12 rooms.   Later I found out that I was the only person staying there.  As an aside, it is really relaxing to travel in thinly-populated, developed countries (Iceland, Australia, NZ, etc).  In the morning I walked out of my room and went to breakfast without out even closing the door to my room (which opened onto a lobby that was more like someone’s living room.)

The family was quite friendly.  They told me that there was an even more impressive waterfall just 15 km down the road.  They said you pass through the ash cloud after about 5 km, and then it is clear on the other side.  I asked whether it was a problem to take the rental car into the ash, and they said no problem.  (Later I found out that the rental car company didn’t see things that way.  Tip:  If you do what I did, drive slowly.)

When I first entered the greyish-brown curtain of ash, it seemed like a sort of fog.  After 5km, the ash cloud was getting really dark, almost like night.  A few more km and it was darker than night.  By the 10 km point it was darker than anything I had ever experienced, save for when I was young and explored a wild cave in southwestern Wisconsin.  It felt like a blanket had covered the entire planet.  You almost had the feeling that the Earth had disappeared, or that you were all alone in a post-apocalypse world.  Yet 10 miles back there was bright sunshine.  I now can understand the sort of primal fear people felt during a total eclipse of the sun, wondering whether the sun would ever reappear.  I suppose this sounds silly, but I couldn’t help wondering if the volcanic eruption had gotten worse.  After all, the Anna Hotel people lived in the area, and said it was a quick 5k drive to clear air on the other side.  But things just kept getting darker and darker.

And then came one of those serendipitous moments that you cannot plan for, but simply happen a few times in each person’s life.  On the left and straight ahead were high cliffs, perhaps 1000 feet high.  I could not see them.  And high overheard was nothing but inky blackness.  Not black like the night sky; that always gives one a feeling of spaciousness.  But rather a claustrophobic blackness.  But between the cliffs and the overhead clouds, a very faint band of light became visible.  I don’t know what color it was, probably mauve or salmon or something.  But since I’m a guy I’ll just say “orange.”  In the foreground the dim light illuminated pools of water on the left side of the road.  And rising out of the exceedingly dimly-lit orangish pools was bizarrely twisted towers of volcanic rock.  Finally, at age 54, I achieved my boyhood goal of visiting Titan.

[If you plan to recreate my little adventure, bring along some ominous music to play in the rental car.  Perhaps Gorecki’s 3rd; then the lighter movements will kick in about the time the first dim light breaks through.]

Even when I reached the big waterfall at 15k, everything was still very brown and dark, but no longer completely black.  It looked like brown mud pouring over the cliff.  Ash fell like snow in my hair.  And here is the most astounding thing of all.  People live in this ash cloud!  I saw lights in people’s houses.  This is a farming region, and my sense is that the farmers (and fisherman) of Iceland are not wimps like us western urbanites, and would laugh at my nervousness on approaching the volcano. In 1973, 500o people were rescued from the Westerman islands, in the middle of the night, as a volcanic eruption was rapidly burying their houses.  They have since moved back and rebuilt.  But the ash is hurting the farmers who live near the volcano.

The next morning the ash cloud had shifted dramatically to the west, so I would have to drive through it again while returning to Reykjavik.  And the weather was now rainy.  As I approached the ash cloud, it looked like one of those Midwestern super-cells, except that it arched from one horizon to the other.  Underneath the rain became heavier–in two different ways.  First, it rained much harder.  And second, it was raining mud.  But I could actually see much more easily this time, as the rain washed so much ash out of the air that visibility was no worse than during a rainstorm.

Because my plane didn’t leave until 5:00, I was able to visit the massive Gullfoss falls, as well as Geyser.  No, I don’t mean “a geyser.”  I mean the one that all others are named after.  And also the big crack in the earth where North American and European plates are drawing ever further apart (at least while Bush was president, perhaps things have changed under Obama.)  I also did a quick tour of Reykjavik, and was back at the airport by 3:00.  Here’s my suggestion.  Anyone planning a trip to Europe should take Icelandair, and spend 24 hours in Iceland on the return.  You won’t have exactly the same experience I had, but it can’t help but provide more marginal utility than one more day traipsing around the continent.

By the way, when I arrived at the airport it was deserted.  It seems the shift in the ash clouds caused all flights to be cancelled.  So make that 48 hours in Iceland.  I spent the extra time touring Reykjavik, and also made the obligatory stop at the Blue Lagoon.  The latter is certainly amazing, but had a certain Disneyesque feel after the sublime sights I had seen on Thursday.

Things I didn’t know about Iceland:

1.  If a family of four has one boy and one girl, all four family-members will have different last names.

2.  Icelanders aren’t pure Scandinavians, they’re 40% Celtic.  The Vikings grabbed Irish brides on their way west.

3.  In 1627 Algerian pirates attacked the Westerman islands, killing 40 and taking 250 people to be sold into slavery.  Who would have thought that Africans enslaved Icelanders?  (Yes, I know that Algerians enslaved many Europeans, but I assumed those were mostly people around the Mediterranean.)  So what was the big news in the 1620s?  At the time I suppose Europeans were focusing on “Islamic terrorists.”  But in the long run it was the English settlement of Massachusetts.  This reminds me of 1979.  At the time it seemed like the Iranian hostage crisis was the big story.  But in the long run it will be Deng’s decision to move China toward a market economy.

4.  Reykjavik is much more sophisticated than the average Western metro area of 200,000.  Yes, it is the capital, but it can’t be that unrepresentative, if it has 2/3 of Iceland’s people.

5.  During the boom, Iceland attracted immigrants from places like Poland, Thailand and Namibia.  Many are still there, as the rural economy (especially fishing) is actually helped by the weak kroner.

6.  Germany attacked Iceland in 1944.  [Update, commenters tell me “one German” attacked Iceland.]

7.  To be considered a real Icelandic man, you must swim naked to an island 5 miles off the north coast, all the while holding a flaming torch and singing the national anthem.

8.  Icelanders consider other Scandinavians to be a bit too proper and uptight.

Go to Iceland.  Right now.  If you prefer Lord of the Rings sublime to sci-fi strangeness, you can take a jeep up the side of the volcano and see the lava shoot up at night.  And as an added surprise, the lava jets are surrounded by lots of lightning bolts.  I didn’t see this but talked to a tourist who did.  Oddly there is no sound.  Maybe the ash muffles the lightning.

Here’s my hotel–in real life the ash looks closer.

Here is the “safety rope” at the Gullfoss falls:

Here’s a better view:

And the first waterfall I saw (viewed from behind, note two people right center):

Approaching the ash cloud:

Getting closer: