Tyler Cowen recently linked to a FT piece that contains some great examples what goes wrong when one reasons from a price change:

It illustrates the natural tension that occurs when central banks seek to push investors out of government bonds into equities and other asset classes. The risk is that such an effort can quickly become counter-productive as bond investors dump their holdings and look for higher returns elsewhere.

Rising equity and real estate prices boost wealth, consumer confidence and overall economic activity, but there is a risk that higher government bond yields can weigh on the economy.

That’s pretty much a textbook example of how “reasoning from a price change” leads one to make fundamental errors.  The rising rates don’t “weigh” on the economy; they are a sign of faster NGDP growth expectations.  The FT confuses cause and effect.

In the US, the Federal Reserve’s initial rounds of quantitative easing pushed Treasury yields upwards, resulting in economic soft patches in 2010 and 2011.

That’s simply false.  Rates fell during the “soft patches.”

At the same time, rising interest rates could undermine the government’s attempts to improve its own finances, precipitating a fiscal crisis.

More reasoning from a price change.  The rates are rising from expansionary monetary policy, which creates expectations of inflation (or slower deflation.)  And of course inflation helps debtors.  Japan’s government is the world’s second largest debtor.  The fallacy is to confuse nominal interest rates, which may indeed rise, with real interest rates.  Inflation reduces the value of existing debt, which helps the Japanese government, and for new debt it’s a wash, as higher nominal rates reflect the Fisher effect.

Yes, the gains may be reduced if the Japanese government must bail out a few banks that suffer losses on their JGB portfolio, but at worst it’s a wash.  And the real growth generated will help both the government and the banks.

It’s not a zero-sum game!

BTW, this seems wrong:

“Through dialogue with the market and more flexible operations, we will ensure the stability of financial and capital markets,” Mr Kuroda told a seminar in Tokyo on Friday.

His comments came as the BoJ stepped into the market to buy bonds for a second consecutive day. On Thursday, as fears over rising bond yields sparked a 7.3 per cent fall in the Nikkei 225 stock index, the BoJ was forced to supply Y2tn ($20bn) of funds to nervous investors.

The graphs I’ve seen recently show a positive correlation between stock prices and bond yields in recent weeks.  Both rose over a period of weeks, and then both fell on Thursday.  Is that wrong?  Higher bond yields suggest faster NGDP growth is on the way.  Unfortunately rates are still quite low, which indicates that NGDP growth will probably increase only modestly.  The BOJ needs to do much more.

Update:  Here’s Lars Christensen:

Yes, nominal bond yields are rising – as Friedman and every living Market Monetarist said they would. However, real bond yields have collapsed since the introduction of Japan’s new monetary regime as inflation expectations have picked up. Something Mr. Koo for years has denied the Bank of Japan would be able to do.

Isn’t Koo the guy that claimed Japan was stuck in a liquidity trap?  How would he explain the recent plunge in the yen?

Karl Smith loves to do posts touting the latest breakthroughs in fracking or solar panel technology.  So I thought I’d try one of those, for modular construction.

I’ve been waiting for the famous Changsha mega-structure to actually get underway, but I can’t wait any longer.  Otherwise Tyler might scoop me.  In any case it does have a OK to go forward in August:

Architects and record-keepers had been waiting for months to learn the status of Broad Group’s “Sky City,” a 220-story skyscraper that was supposed to be built in just 90 days this winter in the Chinese city of Changsha. Thirty feet higher than the Burj Khalifa and constructed of pre-fab modules, the prospective tower languished in government-approval limbo.

The wait is over: the title of world’s tallest building really will be transferred from oil-rich Dubai to this mid-sized provincial Chinese city. Last week, Broad Group announced it has received approval from the Chinese government and will break ground on the project in August, though according to Quartz‘s Lily Kuo, Broad Sustainable Building has pushed the building’s schedule to a more modest seven months.

That pace will make for less flashy headlines, but with more than a completed floor per day, Sky City will still be a historic construction project. More importantly, this titanic arcology will cost $140 per square foot to build, one-tenth the price of construction on the Burj Khalifa.

These innovations in speed and cost are thanks entirely to Broad Group’s pioneering use of modular construction. In 2011, BG’s subsidiary Broad Sustainable Building caused an Internet sensation with this timelapse video of a 30-story hotel built in just 15 days, its factory-prepared components slotted together like giant tinker-toys. (It’s since been viewed over 5 million times.) BSB’s hotel is still the world’s tallest modular building, but the technology is spreading. A 32-story competitor is rising in Brooklyn, a 29-story imitator in London.

The implications for the future of construction, architecture and urban planning are huge. Less labor will be required, and many workers will move from the site to the factory. Architects could find their visions curbed by factory specifications. Developers and governments may also find that housing is cheaper, easier and faster to build.

With Sky City, BSB has the opportunity to prove modular construction’s potential. The building’s 30,000 residents will be carried in 92 elevators to 4 helipads and amenities like schools and stores.* Segments of the building were being manufactured even before the Chinese government had issued its approval.

When I was young, almost all of the 20 tallest buildings in the world were in America (basically New York and Chicago.)  By 2020 19 out of 20 will be in Asia, and the only exception (the Freedom Tower) gets there by “cheating,” with a tall spire on top.

BTW, This is being built in a rural area outside Changsha.  In American terms that would be like building the world’s biggest mega-structure in a rural area outside of Memphis, Tennessee.

But it’s not a bubble!

PS.  Most people are Asian, so I often use the terms ‘global economy’ and ‘Asian economy’ interchangeably. I see that the Europeans are still resisting the coming onslaught of “gee-whiz” architecture.

From the NYT:

SHANGHAI “” In a major policy shift, the Chinese government is planning for private businesses and market forces to play a larger role in its economy, the world’s second-largest after that of the United States.

I believe it’s already the largest.

In a speech to party cadres containing some of the boldest pro-market rhetoric they have heard in more than a decade, the country’s new prime minister, Li Keqiang, said this month that the central government would reduce the state’s role in economic matters in the hope of unleashing the creative energies of the nation.

On Friday, the Chinese government also issued a set of policy proposals that appeared to be intended to show that Mr. Li and other leaders were serious about reducing government intervention in the marketplace and giving competition among private businesses a bigger role in investment decisions and setting prices. The overhauls, if successful, could also make China an even stronger competitor on the global stage by encouraging innovation and expanding the middle class.

Whether Beijing can restructure an economy that is thoroughly addicted to state credit and government directives is unclear. But analysts see such announcements as the strongest signs yet that top policy makers are very serious about revamping the nation’s growth model.

“This is radical stuff, really,” said Stephen Green, an economist at the British bank Standard Chartered and an expert on the Chinese economy. “People have talked about this for a long time, but now we’re getting a clearly spoken reform agenda from the top.”

The broad proposals, developed by the National Development and Reform Commission, an agency that steers many areas of economic and industrial policy, include expanding a tax on natural resources, taking gradual steps to liberalize bank interest rates and developing policies to “promote the effective entry of private capital into finance, energy, railways, telecommunications and other spheres,” according to a directive issued on the government’s Web site.

Foreign investors will be given more opportunities to invest in finance, logistics, health care and other sectors. “All of society is ardently awaiting new breakthroughs in reform,” the directive said.

For years, Western governments, banks and companies have complained that the China government has impeded foreign investment in banking and other service industries, despite promising to open up. The latest directive did not give details about what specific changes to foreign investment rules that policy makers in Beijing might have in mind.

China’s leaders are also promising to speed up efforts to liberalize interest rates and loosen foreign exchange controls, changes that are likely to reduce price distortions in the economy and allow the market to determine the value of the Chinese currency, the renminbi. On Friday, the central bank, the People’s Bank of China, issued a statement that repeated such vows.

Then comes the inevitable NYT “to be sure”:

The push does not signal the end of big government in China, experts say. The Communist Party is unlikely to abandon the state capitalist model, break up huge, state-run oligopolies or privatize major sectors of the economy that the party considers strategic, like banking, energy and telecommunications.

But one paragraph later they get back on message:

But analysts say a more market-oriented economy in which government has a smaller role in business outcomes could have far-reaching consequences for the global economy and bolster the prospects of foreign investors, multinational corporations operating in China and Chinese entrepreneurs.

Beijing seems to be pressing ahead because it has few alternatives. The economy has slowed this year because of fewer exports to Europe and the United States and slower investment growth. Rising labor costs and a strengthening currency have also reduced manufacturing competitiveness.

China’s leaders seem to believe that more government spending could worsen economic conditions and that the private sector needs to step in.

.  .  .

“Li Keqiang thinks like an economist,” said Barry J. Naughton, a professor of Chinese economy at the University of California, San Diego. “He wants the government to get out of the way. And although the growth outlook is getting worse, he says, ‘We don’t want to rely on stimulus; we want private-sector participation.’ This is what economists want.”

Behind Mr. Li and President Xi Jinping is a group of pro-market bureaucrats who seem to have gained in the leadership shuffle this year, including the central bank chief, Zhou Xiaochuan; Finance Minister Lou Jiwei; and Liu He, who is a vice chairman of the National Development and Reform Commission and director of the Office of the Central Leading Group on Financial and Economic Affairs, a body that advises party leaders on the economy. Mr. Liu is part of a team working on proposals for economic changes that could be announced in the autumn at a meeting of the Communist Party Central Committee.

The State Council, the Chinese cabinet, took action this month by releasing a list of administrative items that no longer need central government approval, part of an effort to delegate power and to ease the burden on business.

Beijing has also signaled that even though the economy is weakening, there is unlikely to be a major government stimulus package this year, like the one announced in late 2008, as the global financial crisis deepened. The central government worries, in part, about mounting local government debt and the possibility of a huge increase in nonperforming loans at state-owned banks.

My libertarian friends often wonder why I am so bullish on China.  It’s not because I think they have a good economic model—just the opposite.  Rather it is the fact that there has been a great deal of pro-market economic reform over the past three decades, and I fully expect the reform process to continue.  Don’t tell Noah Smith, but the Chinese government is actually rather pragmatic.

HT:  Tyler Cowen

Update:  Evan Soltas anticipated this move several months ago.  Excellent post.

Tyler Cowen links to a John Cochrane post, which discusses a WSJ piece by Andy Kessler:

The usual thinking is that bank reserves are “special.” They are connected to GDP in a way that Treasuries are not.  In the conventional monetary view, MV = PY.  Bank reserves, through a multiplier, control M. The bank or credit channel view says that bank reserves control lending and lending affects PY. The red M&Ms, though superficially identical, have more calories.

In Andy’s view (my interpretation), that is turned around now. Now, Treasuries supply more “liquidity” needs than bank reserves, and (more importantly) the supply of treasuries is more connected to nominal GDP than is the supply of bank reserves.

Part of this inversion of roles is supply. In place of the usual $50 billion, we have $3 trillion or so bank reserves. Bank reserves can only be used by banks, so they don’t do much good for the rest of us. Now, they just sit as bank assets in place of mortgages or treasuries and don’t make a difference to anything. More treasuries, according to Andy, we can do something with.

More deeply, constraints only go one way. Normally, the banking system is up against a constraint. Reserves pay less interest than other assets, so banks use as little as possible. Now, they are awash in liquidity. You can’t push on a string, as the saying goes.

It makes me a bit dizzy seeing John Cochrane using the Keynesian “pushing on a string” metaphor that Milton Friedman discredited decades ago.  More seriously, there are several fallacies in this argument.  Let’s assume for the moment that reserves and T-bills are both non-interest-bearing; why would monetary policy have any impact?  The answer is simple; markets don’t expect interest rates to be at zero forever.

OK, but why does that make base money special now, when T-bills also pay no interest?  Because base money is the medium of account, whereas T-bills are not.  In the future a change in the supply of T-bills will not (significantly) change the price level, it will merely change the nominal price of T-bills.  In contrast, a change in the supply of base money can never affect the nominal price of base money, which is always one.  Instead, the price level and NGDP adjust to changes in the market for base money.  None of this has anything to do with the lending channel.

Some might argue that this will only work if the central bank has credibility, if investors believe that QE will raise the future level of the base, and hence future NGDP.  But we know for a fact that investors do believe this, as markets react violently to even tiny hints of changes in QE.  And they do so in a way that clearly indicates that QE is expansionary.  That’s why we know for certain that Milton Friedman and the MMs are correct, and John Cochrane and Andy Kessler are wrong.  As a fellow Chicagoan, I strongly urge Cochrane to dump the Keynesian pushing on a string metaphor, and go back to the Chicagoan monetarist tradition.

I’ve frequently argued that the average person has no idea what “inflation” is, and hence public opinion polls about inflation are meaningless.  Even in the 1930s, when prices were falling fast, there was lots of concern about inflation.  Most people conflate the terms “cost of living” (price level) and “standard of living” (RGDP.)  Hence when RGDP does poorly, people (wrongly) think inflation is a big problem.

Now Carola Binder has a blog post that beautifully illustrates this confusion.  She shows that 45% of Europeans consider inflation to be a big problem, far more than those who worry about unemployment.  Even in Greece 26% view inflation as the big problem, only slightly below the 30% for unemployment.  Only the Swedes are economically literate.  And keep in mind that there is virtually no inflation in Europe, indeed the price level would probably be falling, if measured using a reasonable index.

Because people wrongly equate “inflation” with “having trouble paying my bills” (i.e. falling RGDP), the European public would actually prefer a policy of higher inflation, as it would lead to higher RGDP, and hence people would have an easier time paying their bills.  They just don’t know it.

For the same reason we should pay no attention to polls showing people don’t care about health care inflation.  With third party payment systems, the main effect of health care inflation is to keep median take home pay from rising as fast as otherwise.  If you want to understand how people feel about health care inflation, you’d be better off asking them how they feel about stagnating real incomes.  Oh wait, I forget that the public doesn’t know what real incomes are.  So ask them about inflation.  They’ll say they care a lot about inflation, which means they actually care a lot about stagnating real incomes, which means they actually care a lot about rising health care costs.

Or you could stop polling the public on economic questions, and get on with the job of fixing the economy by putting people back to work.

HT:  J