Claims show continued, slow improvement

Weekly claims for unemployment are important because they are very timely and can thus be early indicators of a change in the economy's dynamics. With the exception of some noisy seasonal adjustments earlier this year—when claims plunged in February only to surge in April—the trend in claims has been clearly down since the beginning of last year.

The chart above shows unadjusted claims and their 52-week moving average. Here it is easy to see how the trend in claims has been trending gradually down all year, and all indications point to that continuing.

The number of people receiving unemployment insurance also continues to trend lower, as people exhaust their eligibility and/or find a job. The total number of people "on the dole" has plunged from about 11 million early last year to about 6 million currently. This creates frustration for some, but it also increases the incentive to find and accept a job for many others.

In short, there is no sign in the claims data of any deterioration in the economy's employment fundamentals. The employment fundamentals continue to slowly improve.

Argentina's lessons for today

I first visited Argentina in 1970, when I spent my summer there visiting my soon-to-be wife. The country has intrigued, fascinated, and frustrated me ever since. Though I have been spending most of my research time on the U.S. and Europe this year, a brief dip back into the Argentine statistics today proved quite rewarding, yielding lessons that are relevant to several of today's most pressing problems.

We lived in Argentina for four years, 1975-79, during which time inflation averaged about 7% per month, if I recall correctly. During that time, the disastrous government of Isabel Perón was overthrown by a military coup, and martial law was imposed. (I recall several instances when I was stopped at roadblocks and saw soldiers all around with rifles pointed at me.) After a few years of relative stability under a military dictatorship, things began to deteriorate about a year or two after we returned to the States. (Our timing couldn't have been better.) By the  late 1980s, Argentina was spinning out of control, as its annual inflation rate peaked at over 20,000%. But inflation subsequently fell to zero by the mid-1990s, thanks to the government's decision in 1991 to peg the peso at 1-1 to the dollar.

Here's where the lessons of Argentina have relevance to the eurozone sovereign debt crisis: As the dollar appreciated against other currencies, it carried the peso along with it to levels that created severe deflationary pressures beginning in the late 1990s. Falling prices collided with huge deficit-financed government spending increases to produce one more collapse, in which the currency "floated" from 1-1 to almost 4-1 against the dollar in 2002, and the government converted all dollar-denominated deposits into pesos at a fraction of their former value. As if stealing the life savings of many of its citizens were not enough, the Argentine government subsequently defaulted on some $130 billion of its debt to foreigners, eventually restructuring the debt at about 30 cents on the dollar. (This reminds me a lot of Greece's current predicament: being tied to the euro made it easy for the Greek government to finance huge increases in spending by issuing mountains of euro-denominated debt at relatively low interest rates. Greece's now-inevitable default will have to result in the impoverishment of its citizens, whether through reduced salaries, seized wealth, or a devalued currency. That will come on top of the loss to Greece's creditors, but that is a loss that is reflected today in the market value of Greek bonds, which are trading at about 35 cents on the dollar.)

Although the Argentine economy has since recovered—after several years of extremely painful adjustment—Argentines are once again enjoying a measure of prosperity. I know, because the number of Argentina visitors to our house has increased by an order of magnitude in the past two years. Sadly, however, the government is now engaged in new tricks which promise the return of another collapse. One of those tricks involves a blatant effort to under-report consumer price inflation, beginning in early 2007. The objective was to avoid reporting a budding surge in inflation, and to keep reported inflation low to minimize public dissent in the runup to this weekend's presidential election, which current President Fernandez is almost sure to win. Keeping reported inflation low also helps the government because it also reduces the cost of inflation-adjusted pensions and healthcare benefits. In a vain attempt to deflect criticism of its CPI tinkering, the government has resorted to imposing stiff fines on any private forecaster who dares report that inflation is at least two or three times higher than the official number, which is currently about 10%.

The first chart above shows the "official" consumer price inflation rate, which has been suspiciously flat at about 10% since early 2007. Fortunately, while its not too hard for the government to game the CPI, it is almost impossible to game the overall rate of inflation which is used to calculate the economy's real growth. The true inflation rate is revealed in the GDP deflator, which is shown in the second chart. According to the deflator, inflation is now at least 30% (through June '11). No wonder everyone laughs at the government's CPI data.

All of this leads up to the third chart, which compares the level of the deflator and the CPI to the peso/dollar exchange rate. International monetary theory says that prices inevitably follow the path of currencies; if country A's currency doubles in value relative to country B's currency (for example, if country B devalues its currency by 50%), then prices in country B will eventually double also. Argentina may be a disaster as a country, but it serves as a valuable laboratory for economic experimentation: we now see that with the dollar more than quadrupling in value relative to the peso since 2001, prices in Argentina have also more than quadrupled. Q.E.D. The tinkered-with CPI, however, is woefully lagging, and now understates true inflation by about 35%.

There are several lessons here: One, a currency cannot depreciate relative to other currencies without there being a corresponding rise in inflation in the fullness of time. If the dollar continues to decline relative to other currencies, U.S. inflation will perforce increase. If the principles behind the gold standard have any validity, then the dollar's decline relative to gold almost guarantee the inflation will accelerate in the years to come. Two, controlling the value of one's currency can be an extremely effective method of controlling inflation. This has important implications for China, since it has pegged its currency to the dollar for the past 18 years, thus tying its price level to that of the U.S. It is thus quite unlikely that the yuan is significantly undervalued relative to the dollar. Three, massive sovereign debt defaults, while very likely to cause serious economic disruption, need not spell the end of the world as we know it, although they are extremely painful for many. Four, for those Argentines who worry that the peso is overvalued today relative to the dollar, yes it is. It is almost exactly as overvalued today as it was at the end of 2001, with one important difference: in late 2001 the dollar was quite strong relative to most other currencies, whereas today it is quite weak. Bottom line: although the peso is still strong relative to the dollar—and still appreciating, since the peso is falling at the same rate as prices are rising—it is weak relative to most other currencies and to commodities, so the Argentine economy is likely to suffer from continuing inflationary pressures.

Inflation and bond yields

Consumer price inflation came in a little higher than expected in September, and both the core and headline measures registered some acceleration. Inflation is alive and well, but not terribly high.

Subtracting energy, the CPI is up at a 2.9% annualized rate in the past six months, and that is almost the fastest pace in the past decade. As I've argued repeatedly, the fact that non-energy inflation is up despite the huge amount of economic slack prevailing in the economy is prima facie evidence that monetary policy has been and continues to be quite accommodative. There is no shortage of money out there, and that negates the deflationary concerns that have contributed to the market's malaise. Things could be a lot worse if we had not only a weak economy but also a general decline in the price level.

If you believe that core measures of inflation (ex-food and energy) are the appropriate ones by which to judge monetary policy (I don't necessarily agree, but the Fed pays more attention to core inflation than to headline inflation), then the chart above suggests that the bond market in the past three months has zigged when it should have zagged. Long bond yields are now only about 1% above the year-over-year rate of core inflation, when they typically exceed core inflation by at least 2% (note how the y-axes in the chart above offsets yields and inflation by 2%). The last time this happened (at the end of 2008), the decline in yields proved very fleeting, and already we have seen 30-yr bond yields jump by almost 50 bps from their lows earlier this month.

This last chart compares 10-yr Treasury yields to the core CPI over a shorter time frame, and it too shows that yields have fallen to very low levels relative to inflation. Bond market vigilantes have been lulled into complacency by the events in Europe—the threat of sovereign defaults seems to have created mass panic over the prospects of another recession and a return of deflation. But the longer we go without these fears being confirmed by terrible events in Europe—not just a Greek default, but also a wave of bank failures and a collapse of economic activity—the more upward pressure there will be on bond yields. More and more, I'm coming around to the idea that a Eurozone collapse has been so widely feared for so long that when Greece finally does default, the aftermath won't be nearly as ugly as the expectations.