I'll be guest host on CNBC's Squawk Box this Friday morning from 7 to 9 AM eastern time.  Tune in if you can.

One reason I enjoyed FOMC meetings so much during my 14 years as a member was that I could always count on learning something new from Alan Greenspan, usually some quirky insight or a creative new take on familiar information.  I miss that, but fortunately I have his book.  I bought it the morning it came out, but I didn't get around to reading it front to back until a book club recently invited me to discuss it.

Under the category of quirky information, which he is famous for, is his revelation, on page 50, that the pop top on beer cans was invented in 1963, which made the transition from steel to aluminum beer cans possible.  I didn't know that.

Unfortunately for the reputation of economists with the general public is that they think the job of economists is forecasting.  That's unfortunate because economists can't forecast very well.  It just can't be done.  Economists know that, and most will admit it, but they are stuck with it, especially if they wish to be employed as an economist outside academia.

Even so, monetary policy, of necessity, has to be based in large part on economic forecasts. The Fed staff can forecast as well as anybody and better than most, but that is faint praise.  They use large sophisticated econometric models, and the chairman, who does higher mathematics for relaxation, enjoyed looking under the hood of those models. Yet, he understood their limitations, mainly that their equations are of necessity based on past relationships which change in unexpected ways since they involve human nature.

Chairman's Greenspan's finest hours, or years, at the Fed, in my opinion, was when he didn't take model's projections of imminent inflation at face value in the second half of the 1990s.  It takes courage for an economist or policymaker to say things are different this time because they usually aren't.  But the sharp rise in productivity growth beginning around 1995 did change everything.  Compared to the forecasts of all the models, including the Fed's, output and employment growth was faster while inflation and the unemployment rate was lower. Business could give wage increases without experiencing increases in unit labor costs. The Fed could allow the economy to run hotter without serious inflationary consequences.  Had the Chairman followed the models, the economy would have missed the benefits of faster real growth for several years.

I said that economists cannot forecast well.  That applied doubly to me since I was not as "quantitative" as most and had to depend on my eyes and ears to figure out what was going on and then — dare I say it — extrapolate into the future.  Most of us are closet extrapolators, although most won't admit it.  Of course, you refine your extrapolation with "straws in the wind" indicating a future slowing or speedup.

I've always been amazed at economists who presumed not only to see around a corner, but to see around more than one corner, as in "the economy will pick up through year-end, then slow for several months, and then take off again stronger than ever."  To me that sounds as silly as what they would say to the waiter after sniffing a wine cork.

There is one exception, I believe, to the inability of forecasters to see around corners.  That is, forecasts based on demographics, such as the long-run forecasts made by Harry Dent.  He has shown convincingly that demographics is destiny.  The way I think of it is you can, with demographic data, see more than one pig going through the python.

The first time I heard Harry Dent speak was some time during the boom times of the late nineties, when I was known, pejoratively in most minds, as a cheerleader for the new paradigm, or new economy.  What thrilled me was that Harry's conclusions on the economy at the time were very similar to my own, but that he reached them in an entirely different way.  I thought that, even if my analysis was wrong, my conclusions could still be right because of demographics.

All this is background for a simple Greenspan insight about forecasting that I just ran across.  On page 48 of his book, he says, "Forecasting is simply a projection of how current imbalances will ultimately resolve."  Somehow, that definition makes forecasting sound easier and more practical.  It made me think of the Herb Stein quote according to which "If something is inevitable, it will happen."  That quote in turn made me think of the huge current account deficit and how it has been inevitable for many years that it would cause the dollar to decline.  Stein's quote probably should be amended to include "sooner or later."

Greenspan's book ends with a forecast that the economy is likely to slow in the next several years from the pace we've been used to in recent years.  That conclusion seems more credible to me because it was based largely on demographics.

You can think of economic growth as growth in the labor force (hours worked) times growth in labor productivity (output per hour worked).  The first factor, labor force growth, is based almost entirely on demographics.  Productivity growth may also have a demographic component, but Greenspan places more emphasis on the limits of our intelligence.  He basically says we aren't smart enough to sustain productivity growth over 2.8 percent over an extended period of time. 

As I pointed out in another posting — The FOMC's Enhanced Transparency Reveals Old Paradigm Pessimism — the FOMC members have a similar negative expectation of growth in the next few years.  Their projections for 2010 growth published last October ranged from 2.2 to 2.7 percent, with a central tendency of 2.5 to 2.6.  As I said before, given that 2010 gives them long enough to get policy right, that's a mighty puny forecast.

It's fortunate, then, that economists really can't forecast.

Someone once said if economics made sense we wouldn't need economists.  It's true that good economics is often counterintuitive.  One example of that is the concept of labor productivity, or output per hour of work.  It turns out that the productivity of labor has more to do with capital than with labor. 

When I was about 10 years old I picked a little cotton for a week or two (that was enough) on Billy Joe Hoppers' farm. The pay was three cents a pound, and, as I recall, my goal was to get 100 pounds in a day and earn $3.00.  I don't recall whether I met that goal, but I do recall being bone tired riding to the cotton gin on top of a load of cotton with a delicious feeling of accomplishment.

In retrospect, Billy Joe was just doing my Dad a favor putting up with me.  The real cotton pickers dragged those nine foot sacks behind them and, as I recall, picked over three hundred pounds in a day, making over $10.00.  The difference between my 100 pounds or less and their 300 pounds or more was a difference in labor productivity based on labor — the skill, experience, strength, and tenacity of the workers themselves.

I'm not sure when it happened, but before long, the mechanical cotton picker arrived in Billy Joe's cotton fields, and a single operator could pick acres of cotton in a day.  That guy had enormous productivity compared to the best of the hand pickers. (He gets credit in the productivity statistics even though the mechanical picker is doing the work.)  That's generally the way it happens.  Huge productivity improvements, often based on new technology, come in chunks; it's not a gradual, linear thing, although smaller improvements come in between the big ones.

My point is that the big changes in what we call labor productivity have more to do with capital than with labor. Construction workers working with picks and shovels may work harder, but they hardly have the productivity of the heavy equipment operator.  Labor productivity rises as labor saving technologies enable fewer and fewer workers to do more and more work — or preside over the work done by capital equipment.  Recall the old joke about the factory of the future:  It has only two workers: a man and a dog.  The man is there to feed the dog; and the dog is there to keep the man from touching the computer.

If economic output just keeps pace with population growth, we may be holding our own, but significant increases in our standard of living come from a growing capital stock available to our labor force.  Growing prosperity involves a growing ratio of capital to labor. Think how the bar code and cash registers with pictures on them made pimply-faced high school kids productive behind the counter.  

To belabor the point, rising wages and incomes of workers depend, ironically, on growth in labor saving capital.  Capital investment depends on saving.  Domestic saving has been inadequate to support domestic investment for years, with the difference made up by the capital inflows that are the flip side of our current account deficit.  

We need to shrink the deficit and increase domestic saving, but that discussion is for another time.  Now, I want to focus on the burden of taxes on domestic saving and investment necessary, not only for our general growth, but for growth in the wages of rank and file workers.  Taxes on capital hurt labor, and a huge threat to worker income is the potential increase in the 15 percent tax rate on capital gains and dividends.  That rate should be lowered or eliminated altogether, but it can easily be demagogued as a tax break for the rich, as can a needed reduction in the 35 percent corporate tax rate.

The irony is that increasing these tax rates is very likely to reduce rather than increase the tax revenues to the government.  The Laffer curve works more readily on capital gains and dividend taxes than on other income because the tax payer has more control over them.

Capital gains tax rate cuts almost always pay for themselves; so raising taxes on them will not only slow capital investment, but will have a negative tax revenue effect.  It boggles the mind to know that and say, nevertheless, that "fairness" demands it.

I recently appeared on Fox Business Channel to discuss what to expect from the latest Fed meeting.  To watch the interview, click here.

I also took part in a couple of panel discussions about the Fed on Bloomberg and CNBC.  To watch Bloomberg, click here, and CNBC, here.

I was recently on the Jim Blasingame Show, talking about current economic conditions, including the competitiveness of the U.S. dollar, inflation, the Fed being pulled in two directions, and what I think the FOMC will do with interest rates.  To listen to the interview, click here.

Weak? Uncompetitive? Undervalued?

Let the Big Mac Index Decide

My "Valuing the Dollar" opinion piece in the Wall Street Journal on March 8, reprinted in my blog as "Lord Give Us a Strong Dollar, but Not Just Yet" apparently didn't rally many troops to the cause of a weak dollar, even temporarily, as it reduces our external deficit and stimulates our economy.  One notable exception, although his support was more implicit that explicit, was Marty Feldstein, one of the top economists in the world, and my choice to succeed Alan Greenspan as Fed Chairman. (No offence to Ben, who is doing a fine job.)  I figure that, with Marty on my side, we almost constitute a majority.

I learned of Marty's position on the dollar when he made brief reference to it in a CNBC interview.  However, he didn't make the rookie mistake that I had made in calling it a "weak" dollar; he said we need a "competitive" dollar. (Imagine the sound of the palm of my hand slapping forehead hard.) Of course, I thought words matter, and his word, was much better than mine even if they meant the same thing.  And, to make matters worse, I had read Frank Luntz's book, "Words That Work: It's Not What You Say, It's What People Hear."  Of course, no one wants a weak dollar, but they might want a competitive dollar.

Our dollar has not been competitive in recent years because capital inflows have kept it from declining to competitive levels, i.e., to levels that would permit us to pay for our imports with exports.  Instead, we've been going into hock to foreigners to pay for them. As I've said in previous postings, the foreign exchange market has produced a dollar exchange rate that equilibrates debits and credits in our balance of payments, but one that includes a huge imbalance in trade in goods and services.  Our dollar has balanced our imbalances, but the imbalances themselves are important.

Economists long ago came up with a concept of the equilibrium value of currencies as exchange rates that would tend to equalize the value of similar baskets of goods and services in different currencies.  The concept is called "purchasing power parity (PPP)."  You have parity in the purchasing power of different currencies if their exchange rates adjust to give similar things a similar price taking exchange rates into account. Our currency has not been permitted to adjust to PPP and thus has been "overvalued" for several years, according to international institutions like the International Monetary Fund.

However, for the past twenty years or so, the Economist has published an index of the relative purchasing powers of currencies substituting a single common item as the market basket. That item is the Big Mac, which is sold throughout the world. Here is the Economist's explanation:

The Economist's Big Mac Index, a light-hearted guide to how far currencies are from fair value, provides some answers.  It is based on the theory of purchasing-power parity (PPP), which says that exchange rates should equalize the price of a basket of goods in any two countries.  Our basket contains just a single representative purchase, but one that is   available in 120 countries: a Big Mac hamburger.  The implied PPP, our hamburger standard, is the exchange rate that makes the dollar price of a burger the same in each country.  [The Economist, July 5, 2007]

The Economist goes on to point out that Big Mac prices depend on many local conditions, and that countries of similar stages of development probably should be used to draw inferences about the exchange rate.  Unfortunately, July 2007 is the last publication of the Big Mac index, which means it won't capture much of the recent depreciation of the dollar.  However, the results in July 2007 are still interesting.

They put the price of a Big Mac in the U.S. at $3.41, which is used as the base for comparison.  (All this would have more relevance to me if it had been the Quarter Pounder or the Fish Sandwich or the Egg McMuffin.  The Good Lord didn't intend for hamburgers to have three slices of bread-too many carbs.)

The weighted average Euro price of a Big Mac just prior to July 2007 was €3.05.  The actual dollar exchange rate on July 2 was $1.36 per Euro, compared to a theoretical PPP exchange rate of $1.12 per Euro.  Therefore, the Euro was overvalued against the dollar by over 21 percent.  Conversely, the dollar would be undervalued against the Euro by 17 percent in terms of Big Macs.

Of course, the Dollar price of Euros has risen significantly since then.  Assuming no change in the local prices of Big Macs, the PPP exchange rate would still be $1.12, but using the more recent exchange rate of $1.56 per Euro, the Euro would be overvalued by 39 percent.  Conversely, the Dollar would be undervalued by 28 percent in terms of Big Macs.

(Admittedly the assumption of no change in Big Mac prices may be unrealistic, especially in the U.S., but I'm not going to Euro land to check.  I couldn't afford it.  However, when I've been there or any other place in the world, no more than two days can pass without my searching out a McDonalds, usually for breakfast.  Of course, I did that in Las Vegas last week as well.)

In Britain, a Big Mac cost £1.99 last July when the pound cost $2.01 (Let's round those to 2 each, shall we?). PPP would have the Big Mac cost half as much in pounds as in dollars, but the ratio was £2 to $3.41-not £2 to $4. The Pound, according to the Economist chart, was overvalued by 18 percent relative to the Dollar-assuming, of course, that Big Macs are typical.

Elsewhere in Europe, the largest currency overvaluations in the Big Mac index were in Switzerland (53%) and Norway (152%).  High prices in Europe don't surprise me.  Think how much bigger these numbers would be if the retail exchange rate on the streets or in the airports were used, rather than the wholesale rates.

At the other end of the spectrum are countries with undervalued currencies against the dollar:  - 58% in China; -55% in Hong Kong.  Interestingly, the undervalued currency group, which usually comprises poor countries, includes Japan (-33%).  The Economist attributes this anomaly to the carry trade, while acknowledging that the Big Mac measure is not representative of Japanese prices, which tend to be high like European prices.

What does the Big Mac index tell us-other than I'm getting hungry?  The dollar is undervalued in many places, primarily old Europe, and overvalued in others, primarily Latin America, China and Russia.  There is no single dollar exchange rate; nor should the dollar move the same way or degree against most currencies. The dollar is the numerare-the currency against which others are measured.  Each should seek its own equilibrium with the dollar.  Perhaps the best way to do that is through Big Mac arbitrage-like gold arbitrage of yore.  But we shouldn't get too religious about it.  No single rate is sacred.  It only balances imbalances, which are not unique.  Let us not crucify man on a cross of hamburger!

I don't intend here today to try to prove the case for free trade all over again.  It's been done many times before, but it doesn't seem to stick.  For academic types, I simply refer you to the absolute advantage arguments of Adam Smith, and their refinement into comparative advantage by David Ricardo. Somewhere in there we should place Frederic Bastiat, whose arguments for free trade were not only correct, but fun to read.  If he were alive today, he would be a frequent guest on Kudlow and Company.

Briefly and simply, absolute advantage says we benefit if we do what we do best and trade for the rest.  Smith said the cause of the wealth of nations was the division and specialization of labor, which is limited by the extent of the market.  International trade extends the market enhances the benefits of specialization.

Comparative advantage carries the argument a step further and says that it pays to specialize and trade even if one party can produce everything more cheaply than the other.  My favorite example from school was the executive and his secretary (showing my age with that word).  Even if he can type faster and more accurately than she can, it probably still pays for him to leave the typing to her since his advantage over her as a typist is not likely as great as his advantage as an executive.  Comparative advantage is a most-best or least-worst phenomenon.

Notice I haven't mentioned jobs or trade balances.  The benefits of opening up trade are indicated more by the increased volume of trade than which party develops a surplus or deficit.  It's hard to predict the net impact on jobs initially, but over time it will tend to even out since more imports tend to stimulate exports and more exports tend to stimulate imports.  The net number will tend to end up the same, but presumably they will be in areas of comparative advantage instead of areas protected by barriers to trade.

Bastiat's Petition on behalf of the candle makers to the French Parliament is the classic defense of free trade.  He points out how unfair it is for the French candle makers to have to compete with the sun for the provision of light and argues for a law requiring the shutting of blinds and shutters to level the playing field.  He goes into great detail about the secondary benefits that spread from the candle makers to other related industries and create a general prosperity.  (See Why Bastiat is my Hero in 2001 speeches at http://www.bobmcteer.com/.)

While Bastiat's arguments for free trade are more fun, a more succinct statement was provided by Henry George, who pointed out that protectionists want to do to their country during peacetime (close its borders to imports) what the country's enemy would want to do to it during wartime.   

Most educated people understand the benefits of free trade, and that probably includes educated politicians.  However, many who understand are only too willing to pander to the many more that don't.  The reason many don't is that the benefits of free trade are widely dispersed while the costs are more concentrated.  Free trade helps almost everyone a little bit, but hurts a few a lot.  Furthermore, the higher standard of living associated with, and attributable to, free trade is not easily identified — while a job lost at a plant moving to China is easily associated with it.

Theoretically, those benefited could use a portion of those benefits to help those harmed get trained for the new jobs created by trade.  But, alas, it's easier for politicians to feed the ignorance than to try to educate their constituents, and that seems true for two-thirds of our presidential candidates.

*Originally appeared as an NCPA Brief Analysis

Economists often refer to the U.S. trade deficit and the federal budget deficit as problems of inadequate domestic saving.  They speak of these deficits "crowding out" domestic investment.  They allude to unspecified relationships between these deficits but seldom explain them, confusing everyone.

What is often left unsaid is that the trade deficit (when more goods and services are imported than exported), the budget deficit (when government spends more than its tax revenues), and the balance between domestic saving and investment are related to each other.  In fact, their sum must equal zero.  A change in any of them affects all of them.  For example, tax incentives to encourage saving would likely stimulate investment, lower both the budget and trade deficits, and also reduce reliance on foreign capital.  Think of three fat men filling up a telephone booth.  When one inhales, the other(s) must exhale.

An Economy without Government or International Trade. To understand the interdependence of these three imbalances, first consider saving and investment in an economy with no external trade and no government.  All saving (income minus consumption) and investment (output not consumed) are domestic.  With different people doing the saving and investing, plans for each are likely to differ.  If so, market forces – such as interest rates, prices and nominal income – will adjust until actual saving and investment balance.  In this closed economy, if planned saving exceeds investment, incentives for saving (that is, interest rates) will tend to fall until saving and investment balance.  Likewise, if planned investment is greater than saving, they will be brought into balance by market forces, if the economy is at or near full employment.

Think of saving as a leakage from the income stream which, other things equal, tends to shrink income.  Think of investment as an injection into the income stream (in addition to consumption); other things equal, it tends to increase income.  Income and other variables will adjust until the leakage of saving matches the injection of investment (I = S), as shown in the top half of Box 1 in Figure I.

An Economy with Government.  Introducing government into the equation creates another leakage similar to saving in its impact; that leakage is taxes (T).  There is also another injection into the income stream in addition to investment:  government spending (G).  If taxes and government spending balance – that is, if the budget is balanced (G = T) – the net impact of government on income is neutral, and private saving and investment will also balance.

The leakages balance the injections, but the individual components aren't necessarily equal.  If government runs a budget deficit (Box 2), it will be matched by an equal surplus of private savings compared to investment (S >I).  This is how a budget deficit crowds out private investment, by competing with private borrowers for savings.  A budget surplus (Box 3) will be matched by an equal deficit in saving compared to investment (S < I).

An Economy with Government and International Trade.  Now, add international trade to the analysis.  When we do, payments for imports become a third leakage from the domestic income stream while income from exports become a third injection.  An imbalance in any of the three pairs will be matched by an opposite imbalance in the other two taken together.  The principle is the same as in previous examples, but the interactions become more complex.

As shown in Box 4 (Figure II), any excess of investment over saving (I > S) is matched by a combination of budget and export surpluses (G < T and X > M).  The budget surplus is positive government saving, and capital flows out to be invested abroad.  This economy is sacrificing some consumption today for greater prosperity tomorrow.

The U.S. Deficits.  Box 5 (not drawn to scale), depicts the current situation in the United States:  The shortage of private savings (I > S) to finance domestic investment is exacerbated by negative government saving (the budget deficit, G > T).  However, both these shortfalls are met by the trade deficit – or, more precisely, the inflow of foreign investment that finances the trade deficit.  In other words, the United States is relying on foreign savings to supplement domestic savings.  The U.S. economy consumes more goods and services than it produces thanks to foreign credit.  One result is that each year's external deficit adds that amount to net foreign holdings of U.S. dollar assets.  This is not necessarily a bad thing.  Foreign investment has historically played an integral part in U.S. economic growth and shows that America is attractive to investors.  In addition, external investment mitigates the crowd-out effect of government borrowing by expanding the pool of available credit.

The situation can become unsustainable, however, because foreign investment is funding increasing government budget deficits (government dissaving) and inadequate private saving.  The growth in foreign claims on the U.S. dollar relative to U.S. claims abroad makes the U.S. economy vulnerable to the actions of foreign central banks and, possibly, sovereign wealth funds.  Better to reduce that vulnerability sooner rather than have to go cold turkey later.

Reducing the Deficits.  What are the policy implications of these interdependent imbalances?  Here are three:

-Tax incentives to encourage saving would likely also stimulate investment and lower both the budget deficit and the trade deficit.

-Reducing the budget deficit would reduce the vulnerability of the U.S. economy to foreign creditors; rising deficits could lead to foreigners dumping dollar assets, causing equities to decline, interest rates to spike and the dollar to plunge.

-Reducing the budget deficit doesn't necessarily mean higher tax rates; marginal rate cuts reinforced by slower government spending growth would be ideal incentives.

Unfortunately, the recent tax "rebates" designed to stimulate the economy dealt a setback to budget discipline.  Most people probably understand that.  What they probably don't understand is that the increased budget deficit will also tend to worsen our international balance of payments and weaken the dollar.  The hip bone is connected to the thigh bone; so policymakers need to study these interconnected deficits.  They need to borrow my boxes.

On April 4, I was a guest host on CNBC's Squawk Box; Larry Kudlow was also on the show.  To view our discussion on how well of a job Fed Chairman Ben Bernanke has done, click here.  To see my commentary on the employment outlook, click here. 

To see some of our panel discussions from the show, click here and here.

And don't forget to check out my latest blog posting below.