Inflation vs. Deflation: The Verdict

We've come to the conclusion of this series. I hope that everybody who was interested in doing so has been able to follow my arguments and the logic of how everything works without my confusing things too much for you. We've pretty well reviewed the mechanics of a fiat money system and the economic quandary that the FED has put itself in. So, if you've managed to follow it all, you are pretty much up to speed, as least on the basics. In case you missed a post or two, here is the full list:

• Inflation: What It Is and What It Is Not
• Banking and the Money Supply I: Inflation
• Banking and the Money Supply II: Deflation
• Interest Rates and the FED
• The Symbology of Money
• The Origin of Economic Bubbles: The FED and the Business Cycle

I trust that, external to all of this, most folks are familiar enough with the political situation to know about the gargantuan fiscal deficits that are presently being run up by the federal government. I also trust that most will understand that, despite all the promises of the political class to the contrary, this deficit promises to widen further as our government appears to have taken on the role of insurer of every financial asset known to man. Based on our discussion of the business cycle, I hope it is clear that it is a foregone conclusion that even more losses are on the way, so we are sure to see ever more "claims" filed with our "insurer," and ever larger deficits to cover them. Simply put, the FED has put the entire economy and financial system in a position of being completely dependent on a constantly increasing money supply coupled with near zero consumer price increases and low interest rates. To anyone with a modicum of common sense, this is clearly unsustainable, yet without these three ingredients, the pricing regime we presently enjoy comes to an end. As we saw last fall, and even as far back as 1998-2000, the beginning of the end appears to be upon us. For an excellent alternative discussion of how all this works, see the latest installment of the series Leo directed us to a few weeks ago. And just as the economy is addicted to monetary inflation, the federal government is addicted to subsidized interest rates as a result of the FED purchases of Treasury debt, as well as purchases by foreign central banks such as China, Russia, and Japan to subsidize their own export markets and suppress their currencies. It has run up deficits far and away beyond any reasonable level thanks to this cheap financing which looks about to dry up. How will the FED respond? What is the likely fate of the dollar and our economy? In case you haven't yet surmised my conclusion my answer to the inflation/deflation debate is a resounding inflation. What the FED Has Been Up To In response to the financial crisis of 2008, the FED did precisely what we would expect it to have done: attempt to prop up capital prices and protect the banking system by inflating the money supply without initiating undue consumer price inflation. Thanks to the unfolding economic chaos in response to its temporary monetary tightening that clearly revealed the mistakes of the preceding years, the FED could safely assume that resumed monetary inflation would not lead to immediate consumer price increases since money would not make it down to average Joe consumer. It would stay locked up in businesses and the financial system, which had suddenly become much more worried about improving their hemorrhaging balance sheets than with aggressively expanding market share and beating out the competition. Survival was at stake, costs were slashed, and employees tossed overboard. As you now well know, the FED was completely correct and this has been exactly the case. The unprecedented explosion of the monetary base is clearly visible in the following graph, which has become rather famous of late: However, before this occurred, several other events took place which were quite revealing with respect to the character of Ben Bernanke and the fiscal propensities of the present governors of the FED, and are worth taking a look at. The 2008 Rate Cuts and the Alphabet Soup Initiatives The 2008 Rate Cuts, as mentioned in my last piece, were a bizarre response to the looming fiscal crisis that was already visible to the more observant market watchers. The FED began a policy of lowering interest rates in the face of skyrocketing oil prices and other signs of heady and imminent price inflation, but also in the face of market weakness. Major indices were already significantly off all-time highs, and a market slowdown loomed. Yet the oil price squeeze had the FED in a bind. It clearly, clearly had no room for the slightest bit of monetary loosening. (Biographical side note: this was the singular event that led to my conversion to the Austrian school of economic thought. Having been an amateur enthusiast of all things economic for a few years at this point, I looked at this scenario and realized that there was something very, very wrong with the way I understood monetary policy to work. I finally realized that the problems I had encountered in trying to digest the contortions of mainstream Keynesianism and monetarism were not my problem. They were Keynes' and Friedman's. And so my search for a correct theory began...) The ace up Bernanke's sleeve was that despite his rate cuts, he was not increasing the monetary base as is the usual response of the FED to the onset of a recession. Despite maintaining an outward appearance of monetary accommodation, he was actively, willfully encouraging recession! The next step Bernanke took in fighting off the financial crisis was to initiate the various "alphabet soup" programs, beginning with TAF, and moving on into TSLF, TARP, etc. This was another strange and unexpected move, but the effect is fairly easy to explain. Simply put, the FED traded its good assets (the ones it purchased to create the monetary base, remember?), for the bad assets held by banks, supposedly on a temporary basis. You know, all those bad loans everyone has been talking about. Yes. They were traded for the FED's Treasury debt. The mortgage debt that has been so affectionately termed "toxic waste" is what is now backing your currency! It is important to note that while these activities degraded the quality of the assets held by the FED, they did not increase the monetary base. Once again, the FED chose to act in such a way as to "take action" while avoiding any increase to the monetary base. It wasn't until TARP came along that the monetary base finally began to increase. At this point, the FED had already traded away most of its good debt, and was forced to begin making outright purchases in order to remove the toxic waste from the banking system's balance sheet. You can see the effects of these transactions in the following chart: Note the similarity in shape to the Monetary Base graph above. Note also how "Traditional Security Holdings" began to disappear and were replaced with things like "Securities Lent to Dealers" and "Term Auction Credit" long before the monetary expansion began in September-October 2008. These were the asset swaps. Before resorting to monetary expansion, Bernanke attempted to "solve" the problem through book-keeping. But if he wasn't increasing the monetary base to try and "stimulate" the economy out of recession, why would Bernanke do this? To answer this question, lets take another look at the banking system's T-account calculus. The Effect of the Crisis on the Banking System The main problem the FED is trying to solve is saving the banking system. The banking system is in jeopardy because their assets have become devalued while their liabilities, i.e. deposits, have remained constant: No matter how many defaults, repossession losses, etc. should befall a bank, it must still honor its obligations to repay depositors. Further, the eroding value of assets prevents the banking system from improving its situation by unwinding its positions through monetary contraction, i.e. selling assets, because this doesn't substantially improve their balance sheets: Meanwhile, asset prices continue to decline. Eventually, when things at individual banks get bad enough, the FED steps in and seizes control. When the FED steps in, assets are sold off, depositors paid off, and the FDIC makes up the difference, as we discussed before. Note the net effect of all of this: far from shrinking the monetary base, i.e. causing deflation, bank failure and default locks in the inflation that results from fractional reserve banking. Thanks to the FED and the FDIC, we can rest assured that defaults and bank failures will lock in fractional reserve pyramiding of inflated money on top of the monetary base. No deflation occurs. Paying off loans without re-lending is deflationary, yes, and some of this is occurring. But this is not the case for default or bank failure. The FED can pre-empt this process, or at least delay it for a time, through the alphabet soup initiatives. By swapping assets, the FED props up the bank, accepting losses due to devaluation on its own balance sheet: The same is true for outright purchase of assets: The FED is doing all of this so that the banking system will not have to properly account for losses to the value of its loans. A substantial fraction of mortgage debt once held by the banking system is now replaced by Treasury debt, which trades at very near face value, while the mortgage debt the banking system traded away gets placed on the FED's books. Any further losses will take place on the FED's books. This protects the stock prices of banks, and also went some distance in preventing a loss of confidence in the banking system, which might have led to rapid withdrawals of currency. In this respect, in performing all these activities, the FED was just doing its job -- to protect the banking industry. The problem is that this is the job of the FED in the first place. Here we see why there is so much impetus for a FED audit. This behavior looks crooked because it is crooked. With this kind of book-keeping, its hard to see how federal agents can come along and accuse others of cooking their books. But in my opinion, the whole "audit the FED" movement misses the larger point: the FED should not exist in the first place. The problem is not that it is not doing its job properly. It can't do its job properly. There is no squaring of the circle and the entire reason for the FED's existence is to perpetuate a fraud. Whatever malfeasance might be going on there is small potatoes to the larger economic issues. The FED will never work, no matter who is in charge or what it decides to do. The FED's Magical Resolution Now that we know how and why the FED is propping up the banking system, we might ask: how exactly does the FED plan to eventually resolve all of this? After all, this is a very temporary solution. It appears that the FED believes that someday, the value of these assets will be restored, and they can be swapped back onto the balance sheets of the banks that owned the debt in the first place. Everything will be more or less back as it was in 2007. This will take place, someday, when the markets are magically restored, and the old price regime is back in place, and everything is just wonderful again. Someday. Somehow. I guess the thinking is along the lines of "If we all clap our hands enough, the economy will come back to life." As we have seen, the old economy isn't coming back. The old pricing system didn't make any sense. It still doesn't. Either capital goods prices must fall, or consumer prices must rise, or both. Either way, there are huge real losses that must be realized. But since only a tiny fraction of us understand that, and none of us runs the FED, we're all going to have to wait around to see which particular way this outcome actually takes place. What the FED Is Likely to Do In the meantime, before all the economic magic/economic catastrophe occurs, the FED doesn't want all the money it created to be lent out, end up in consumers' hot little hands, and drive up consumer prices. So it will likely begin any number of sterilization programs. What is sterilization? It is a process where a central bank re-absorbs the money it created so that it won't cause inflation. What? You heard that right. The FED will re-borrow the money that it creates, so that the public can't get ahold of it. One of these programs is already in place. The FED now pays interest on reserves held with the FED. Right now, the rate is not high, but with this new power in hand it can easily be raised. By paying interest on reserves, the FED incentivises the banking system not to lend money to the public, which might spend it, but to lend to the FED, which buries the money in a hole and sits on it. The FED has also discussed issuing debt certificates and offering "CD's" to the banking system. Both work exactly the same way. The FED borrows money, then sits on it, so that it can't enter the fractional reserve banking system and drive up prices. Another thing the FED could do is raise reserve requirements. By doing so, it limits the amount of inflation that can occur through fractional reserve lending. The maximum money multiplier of the fractional reserve process goes down. When the FED says that it is trying to "unfreeze" credit markets and encourage lending, don't believe a word of it. The FED could easily get banks to lend. The FED wants them to do no such thing. If they start, believe me, the FED will intervene. Bernanke the Tightwad I point all of this out to make a point that you won't hear often among people of my economic persuasion: Bernanke is actually something of a monetary tightwad, at least as far as central bankers go. Despite his bailouts and spectacular increase of the monetary base, he made every attempt to avoid doing so until his hand was forced, and he has taken great pains to keep the new money out of the fractional reserve system. It is my opinion that he will fight the inflation far more than many of us Austrians give him credit for, even as he tries to prop up the banking system. He will try to have it both ways, but he cannot. Eventually, his hand will be forced, and just as he eventually had to increase the monetary base to continue his alphabet soup activities, I expect he will find the same with respect to the rest of the economy. If he wants to prop up asset prices, he will have to continue to expand the monetary base. Money has to circulate to drive up prices, and it is nearly impossible to hermetically seal one market away from the others. Eventually, the money will leak out. Inflation will win. 'The Deflationists' There is a group of economists out there who, acknowledging all of this to be the case, would still claim that we are looking at serious deflation in our future. From what I can surmise, their basic position is "Yes, the FED will increase the monetary base, but it will fail in its attempt to cause inflation. We will have deflation despite the best efforts of the FED." Their position, if I understand it correctly (which I may not), rests on the idea that money created by the central bank cannot make its way into the economy if economic conditions are bad enough. The monetary contraction of banks trying to call in loans coupled with a general revulsion towards borrowing for fear of losses in such a bad economy will outweigh every attempt of the FED to pump more money into the system. The FED may increase reserves all it wants, flooding the system with money, but the banking system will simply sit on it. Fractional reserve banking will seize up and stop working. This is sometimes called "pushing on a string." To a degree, this has been true. For all that the FED has increased reserves of late, there hasn't been much lending going on. There also hasn't been much in the way of consumer price increases. So, might the deflationists be right? The Borrower of Last Resort The fly in the ointment for both Bernanke and the deflationists may well be President Obama and Uncle Sam. We all know that Washington is on a spending spree. We also know that Washington can't pay for what it is buying. Which means that Washington is borrowing, and in a big way. The deficit this year is on the order of $1.6 trillion, or a tad over 10% of both the present accumulated debt (~$11 trillion and change) and GDP (~$14 trillion, give or take). Where is this money coming from? Private lenders, the FED, and the banking system. Washington is displacing private borrowers and absorbing all the available credit. State activities are displacing the economy. But you already knew all that. The point with respect to this discussion is that what Washington borrows, Washington spends. Uncle Sam writes checks, and those checks go into private deposit accounts, where the money can be spent into the economy and drive up prices. It does not matter that when the money is spent it re-enters the banking system, where Bernanke can siphon it off with his sterilization programs. He can't stop politicians from spending money. I am convinced that no force in the known universe can. So long as Bernanke is creating money, Uncle Sam will be trying to spend it into circulation. Bernanke will have to bid it away from Uncle Sam with higher interest rates on the FED's debt instruments, which only puts even more money into the hands of the banking system that lends him back the money he created in the first place. If nothing else does, government spending will shortcut Bernanke's monetary firewalls. As we speak, the government is buying up materials for its many projects and paying its employees to work (or not work, as the case may be). Bernanke cannot long prevent his freshly printed money from entering the money supply. The Deficit If nobody else will borrow and spend, you may rest assured that Uncle Sam will, inadvisable as it may be. And as if the on-budget debt burden were not enough at ~$11 trillion, this figure does not even include the gargantuan entitlement programs Social Security and Medicare, which constitute obligations many times this amount, variously estimated to cost anywhere from $50 to $100 trillion if discounted to present value. These programs are guaranteed to force government money into circulation as Uncle Sam writes so many checks to so many recipients, and will also require ever higher and higher deficits to finance. These two entitlement programs will eventually sink the government no matter what, as they require payouts that our economy simply cannot handle. Inflation and outright repudiation of government debt obligations are the only realistic tools available to deal with this massive overload of obligations. Before this happens, expect the off-budget deficits that constitute these two behemoths to be converted into on-budget deficits as Congress borrows the money to pay for them. What's that, you say, there is a large fund set aside to pay for these programs, composed of ultra-safe Treasury debt? I wonder how the value of those assets will be affected as inflation takes hold, interest rates begin to rise, and ever more government borrowing us used to finance shortfalls. Or when our foreign lenders finally decide that enough is enough and begin the inevitable sell-off of American debt. Slowly, or possibly not all that slowly, as deficits accumulate and interest rates rise, the mere interest payments on the accumulating debt will increase to such a degree that the FED will be forced to intervene if it is to prevent national bankruptcy. Right now, and unfortunately for most of the last 25 years, the government could borrow cheaply, and did so right up to its gills. Those days are coming to an end, and at some point the number of willing private buyers will be slim. It may seem a bit unrealistic to think of individual government actors "conspiring" to inflate the US out of its debt burden, but this is precisely what they will do, intentionally or not, simply in response to the situation they find themselves in. FED purchases of Treasury debt will most likely not be done with the explicit goal of repudiating the debt itself, but in order to continue government efforts to mend the economy. Even if the FED has no intention of inflating the US out of its debt obligations, it will be forced to do so to finance government spending "in aid of the economy" and to avoid outright national bankruptcy. Bernanke may chide government profligacy now, but his own FED is extending the financing that makes it possible. When there is little confidence in Treasury debt, you can bet that there will be little confidence in the dollar, though to some degree a substantial fall in the exchange rate may be mitigated by the equally disastrous policies of foreign central banks. The dollar is likely to fall against the broader market of currencies overall, but it may be difficult to predict whether it will rise or fall against any particular currency. At this point, virtually all of them look weak. Conclusion I see very little hope that the US can avoid substantial monetary and price inflation over the next several years. We likely face high inflation, high interest rates, high unemployment, government displacement of the private sector, and substantial wealth destruction for the foreseeable future. There is at least a reasonable probability that these conditions could emerge precipitously, become quite acute, and result in substantial political instability and strife. This is not to say that deflation is impossible. It is possible that the FED will choose a policy of monetary contraction, despite the damage that this would do to the banking system as it presently stands and the ability of the US government to repay its debts, at least on paper. Bernanke has shown that he is keenly aware of the effects of his policies on consumer prices, and if these prices begin to show strong increases in response to his actions, it is possible that he will tighten, again, despite the political damage he will do to the banking system and the government he is supposed to be serving. But this will likely be long after the "other" effects of inflation have already taken place, and the economic damage has already been baked in. Once the ball is rolling, I do not think he will be able to stop it easily, and price spikes on sensitive commodities like oil and food are highly likely, even if overall consumer price inflation remains fairly flat. But I do not think Bernanke would dare to attempt even a policy as meekly tight as this one. I think he is more likely to tread with caution, which means with inflation, and simply accept a higher level of consumer price increases and interest rates, and a general erosion of the standard of living over time. I do not think we will see deflation as a matter of the FED's inability to cause inflation. Over short stretches of time, yes, there might be small monetary contractions here and there, but I think the FED will fight these and that the larger trend will be inflation, at least over the short to mid term. For deflation to occur, I think it would have to be deliberate, and as I have said, this is not very likely. In the longer term, it is also possible that the FED may instigate substantial deflation at some fairly distant future point, as the inflation plays itself out and the FED attempts to "save the dollar" once it has achieved its objectives as it sees them, namely, that prices are now clearing markets on their own and the government is no longer in need of coercive financing. "Prices now clearing markets" is a polite way of saying that wages, standards of living, and privately held claims to wealth have been slashed to the point that constructive economic activity can take place spontaneously once again, which is basically how WWII allowed the US to escape the Great Depression. In summary, two major conditions are necessary for the US to escape the present crisis. The pricing regime must return to something reasonably approximating sustainable market prices, and government obligations must be repudiated. These two conditions will most likely be met through some substantial level of monetary inflation. This is not necessarily how the FED sees things; it will only be reacting to economic data as it understands that data, in a train of thought similar to what I have outlined here. But without resolution of these twin predicaments, there can be no real, sustained recovery. That is the bottom line.

The Courage of Ludwig von Mises

Lew Rockwell has penned a magnificent essay on Austrian Theory and the life of Ludwig von Mises.

This courage to say the unpopular thing marked the life of Ludwig von Mises. Today, his name resonates around the world. The tributes to him pour out on a monthly and weekly basis. His books remain massive sellers. He is the standard-bearer for science in the service of human freedom. Especially after Guido Hülsmann's biography of Mises appeared, the appreciation for his courage and nobility have grown.

But we must remember that it was not always so, and it did not have to be so. This kind of immortality is granted in no small measure because of the discrete moral choices he made in life. For if you had asked anyone about this man between 1925 and the late 1960s — the bulk of his career — the answer would have been that he was washed up, old school, too doctrinaire, intransigent, unwilling to engage the profession, attached to antique ideas, and his own worst enemy.

The moral of the story: always, always, always do the right thing, no matter what. I like these kinds of stories. Inspirational. It's a long one, but it made my day. Hat tip: Vox Day.

Another Shoe Drops

Yahoo!Finance:

CHICAGO (AP) -- Capmark Financial Group, one of the nation's largest commercial real estate lenders, has filed for bankruptcy protection amid mounting bad debt.

Expect to see more of this. Commercial real estate was expected to get hammered, just as residential real estate has been. It's been something of a mystery as to when when it would begin. Apparently, today's the day. Residential real estate is presently being propped up by FED purchases of mortgage debt. It is not even halfway through its fall. Now it appears commercial real estate is beginning its slide. I do not know if the FED is as interested in propping up this sector, but if it does not, it, too, is in for a gruesome fate, and might possibly meet it very quickly. If the FED does decide to prop up both at the same time, it will turn into quite a burden. It could prove to be unbearable. It would not surprise me if this didn't trigger the dreaded next leg down on Monday morning. Hat tip: zeno, at Vox Popoli.

A Trio of Good Reads

I came across several great reads today, & thought I'd share: Bill Bonner:

By the time Harding took office in ’21 the Panic of 1920 was taking the unemployment rate from 4% to nearly 12%. GDP fell 17%. Then, as now, the president’s subordinates urged him to intervene. Secretary of Commerce Herbert Hoover wanted to meddle – as he would 10 years later. But Harding resisted. No bailouts. No stimulus. No monetary policy. No fiscal policy. Harding had a better approach; he cut government spending and went out to play poker:

“We will attempt intelligent and courageous deflation, and strike at government borrowing which enlarges the evil, and we will attack high cost of government with every energy and facility which attend Republican capacity…it will be an example to stimulate thrift and economy in private life.

“Let us call…for a nationwide drive against extravagance and luxury, to a recommittal to simplicity of living, to that prudent and normal plan of life which is the health of the republic.”

Within a decade, Harding’s views were collectibles. But in 1921, he still saw the economic world as a moral world ordered not by man, but by God.

Jeffrey Rogers Hummel (courtesy of Gary North):

Only the naively optimistic actually believe that politicians will fully resolve this looming fiscal crisis with some judicious combination of tax hikes and program cuts. Many predict that, instead, the government will inflate its way out of this future bind, using Federal Reserve monetary expansion to fill the shortfall between outlays and receipts. But I believe, in contrast, that it is far more likely that the United States will be driven to an outright default on Treasury securities, openly reneging on the interest due on its formal debt and probably repudiating part of the principal.

And, once again, Gerard Jackson:

The problem is that people who should know better are confusing price adjustments with a contractionary policy. If they were right the dollar would be appreciating in anticipation of a rise in domestic purchasing power. What we are seeing is that the markets are distinguishing between the short term and the long term, which is exactly what Bernanke expected. He's a Keynesian but he's not an idiot.

We are told that the upside to a depreciation will be an increase in the demand for American exports which will stimulate US manufacturing. But a continuing depreciation implies an inflation rate in excess of America's trading partners. This is a calculated destruction of the currency and a policy for impoverishment, not economic growth. A depreciation leads to the rearrangement of capital goods: it cannot increase their quantity. And growth is just another term for the process of capital accumulation. Under these circumstances Americans would have to accept falling living standards.

All good reads, especially Bonner and Hummel, though the latter is fairly technical.

The Origin of Economic Bubbles: The FED and the Business Cycle

Either you believe that money, prices, interest rates and the other phenomena which result from a market system are legitimate and meaningfully related to the real-world of material transactions that make up our economy, or you do not, and you might as well do away with the entire monetary system and arbitrarily erect something else to take its place. Most people have the good sense to reject the latter. But in the true spirit of the Progressivist/fascist movement that spawned it, the FED and its economic apologists try to have it both ways. They know full well that they are playing with fire in attempting to tamper with a system of such unbelievable complexity and upon which every one of us depends for our well-being, but in their arrogance they either think that they are up to the task or they do not care. Further, they know full well that their various tamperings are useful for achieving political ends and routing resources towards favored projects and individuals. The public seems perfectly happy to accept the fictitious storyline that central banking helps to alleviate the business cycle which would otherwise render the economy a disastrous manic-depressive roller-coaster ride. So everyone goes along, ostensibly to everyone's benefit. This thinking, the supposed political modification of reality so typical of statist movements throughout history and so prone to disaster, has led us to where we are today: a banking system that fails at basic accounting, and a money system far detached from the economy it is supposed to represent. Yet the present system has been with us for so long that it has acquired the air of legitimacy simply as a matter of familiarity. Few bother to question it. There are scant few better ways to find yourself lampooned as a crank, a nutcase, and a "conspiracy theorist" than to do so. Mostly it is left to grizzled world-weary soldiers like our own esteemed ΛΕΟΝΙΔΑΣ, political outsiders like Ron Paul, and ambitionless eccentrics like me. But reality intervenes in every system built on lies, the present system not excepted. Expanding the money supply does nothing to expand the resource base. It does, however, do much to distort the way it is put to use. The piper must be paid, and the boom must eventually be followed by the bust. This distortion, the boom followed by the bust, touched off and fed by the accounting lies of the fractional reserve system and central banking, is called the business cycle. Initiating the Business Cycle So far, we have gone through several explanations of the market distorting effects of monetary expansion and interest rate suppression, looking at the phenomena from several points of view. We saw that:

• As new money enters the economy, it will increase prices in those markets which receive new money first. In the old days, we might see it in the prices of goods being offered for sale near a new gold mine rising much faster than prices distant to the mine. In our present system, monetary expansion occurs from a few specific points in the economy, the credit market and the banking system, and not across the entire economy as a whole.
• Interest rate suppression causes unprofitable business ventures to appear profitable, initiating misguided entrepreneurial ventures. Thus, the types of goods that entrepreneurs are interested in purchasing with the new money will be driven up before other goods.
• Monetary expansion and interest rate suppression act as a subsidy to debt markets, distorting the prices of debt instruments and making credit appear artificially cheap. In general, goods bought on credit will see their prices rise faster than goods which are typically not bought on credit. Buyers who purchase goods on credit will find that they have an advantage over non-credit buyers in the pricing competition of the marketplace.

It is important to recognize that these varying explanations are not descriptions different phenomena. They are really just different ways of saying the same thing. Monetary expansion and interest rate suppression are the same phenomenon under a central banking-fractional reserve system. Monetary expansion initiates this activity. But once the initial price distortions have taken effect, they begin having knock-on effects which can be even larger in scope than the initial distortion in credit markets. Downstream Effects of Price Distortions Like interest rates, prices are economic signals and direct the flow of money and resources in the economy. As prices increase in certain markets relative to others, we also expect to see capital and resources flow towards these new profit opportunities and away from the rest of the economy. In the old days, a boom-town attracted all sorts of business activity away from surrounding areas before promptly busting when the mine dried up. Today, the banking system and those in close economic proximit gobble up resources at the expense of those distant to the banking system. But this demand for resources results in further price distortions: the prices of the factors required to produce those resources being gobbled up by the monetary expansion. As prices rise in one market, thanks to the activities of entrepreneurs and other borrowers, still more profit seekers rush in to satisfy the new demand. Are entrepreneurs bidding up the prices of houses? Homebuilders rush to accommodate them, driving up the price of lumber and other building materials. Is lumber becoming dear? Timber companies begin bidding up the price of logging equipment. And so on it goes, from the initial round of bidding by the early recipients of the new money, on down to the late recipients. While such trains of events seem rather elementary (and they are) and not very interesting, there is a far more interesting and revealing net effect to the process. The overall effect can best be visualized with a symbolic representation of the production structure. The Production Structure Ultimately, all economic activities are undertaken with a mind towards consumption. Consumer goods are meant for direct consumption, while capital goods are used to produce consumer goods. Simple enough, right? Let's add one more layer. Subdividing capital goods, higher-order capital goods are used to produce other capital goods, while lower-order capital goods are used to produce consumer goods. Of course, there is actually a continuum of capital goods, but we'll just stick with this terminology. We can associate these goods and their distribution with the division of labor. Some laborers are employed in producing consumer goods directly, while others labor to produce capital goods. If we represent the production structure with consumer goods near the bottom and capital goods further up, we get a wedding-cake looking structure like this: The further up the cake we go, the higher the order of capital goods we are representing. Production at higher levels fuels productivity gains at lower levels, as the capital goods produced at higher levels multiplies the productivity of labor at levels further down, but also robs the lower levels of resources, as resources are necessarily limited. The taller and steeper the cake, the higher the division of labor, which corresponds to a greater variety of economic processes and a higher degree of specialization. A high division of labor economy and a low division of labor economy might look like the following: Interest Rates and the Production Structure As the price distortions spread through the economy and resource allocation adjusts to these changing conditions, the net effect is for resources to be diverted from lower levels of the production structure to higher levels. Why? Because the prices of capital goods are driven higher by monetary expansion than consumer goods, and prices of higher-order capital goods are driven even higher than lower order capital goods. Higher-order capital goods benefit not just from easy credit, but also from higher profitability as these goods serve to produce other capital goods which are themselves being driven up in price. Remember? A visual representation of the effect of monetary expansion on the production structure would look like the following: Note that this is exactly the same effect that we described before when we said that lower interest rates cause an increase in the fraction of resources allocated to capital goods. Again, these are not separate phenomena, but different ways of explaining the same thing. You can look at it in terms of money flow and a response to price effects, or in terms of resource allocation in response to interest rates. Any way you want to slice it, lower interest rates and monetary expansion lead to a lengthening of the division of labor. Malignant Growth It does not matter whether the interest rate effect is in response to time preferences or money-printing, the effect is still to lengthen the division of labor and divert resources towards capital goods. A high-division of labor production structure results from both artificial interest rate suppression and naturally low rates set on the open market. So, once again it may be asked, if the effect is the same, what is the harm in suppressing interest rates? I can now give a fuller answer. First, in the instance of legitimately low interest rates, the capital structure corresponds properly to the time preferences of the economy at large. There really are plenty of resources available for economic growth and development because they really are being set aside by real savings and aren't all being consumed. Financial reality matches economic reality. Artificially diverting resources which consumers aren't willing to part with towards capital accumulation will eventually result in an economic backlash, as we now can see all too clearly. Suppression of interest rates results in a misallocation of capital by creating the illusion of profits through overly capital-intensive production strategies. In reality, actual time preferences will not support this capital structure. Secondly, this rather crude treatment of capital obscures its complexity and intricacy. We have treated it in a way that is overly homogenizing. In reality, capital is not homogeneous and serves very specific needs and purposes. By haphazardly allocating capital according to spurious price movements, the capital structure does not serve consumers efficiently. Not only is the capital structure mismatched in terms of the available resource base, the array and proportions of goods produced does not match the actual desires of the consumer. Manipulation of the money supply does lead to economic growth -- malignant growth. It leads to growth which has little to do with the actual needs and desires of society and little regard for the available resource base. In a flurry of economic activity, it incentives the allocation of resources inefficiently and towards destructive ends. Therefore, like a cancer, this malignant growth leads to economic decay. Manias and Bubbles Thus far, we have been talking about the general effects of a monetary expansion on the production structure of the economy. This might be described as a "general economic bubble." However, for various reasons these effects can also sometimes be quite focused to one market in particular, such as in our recent housing bubble. I am not entirely clear as to why one particular market gets singled out. Some have cited social or cultural reasons, such as in the case of the Dutch Tulip Mania or the single-mindedness of many Asian economies towards export bubbles at the expense of domestic development. I suppose one might even include the case of the American housing bubble. But at least in the latter case, there are clearly other contributing financial reasons. The housing bubble has attracted economic commentary ad nauseum, a lot of it of questionable merit, in my opinion. Most seems to have focused on the lack of regulation, fraud, and overzealous "financial innovation." I do not want to rehash too much of this, but only make a few simple points. In my opinion the single largest contributor to this bubble were the activities of Fannie Mae and Freddie Mac. No, not individual lending to people of questionable creditworthiness, stupid as that behavior is. I'm talking about the bulk of their activities, which were not only completely legal, but encouraged by the government and generally popular with the public. The entire purpose of these organizations was to expand the funds available to the housing market by buying up mortgages from banks and freeing up bank funds for more lending. Investors with Fannie and Freddie got favorable tax treatment and government guarantees for their investments. Interest rates on Freddie and Fannie debt were insanely low thanks to these subsidies, and the flood of money helped push down mortgage interest rates to ridiculously low levels. It seems to me that the primary cause of the housing bubble was that these policies helped drive an oversize fraction of the FED's monetary expansion into this one single market. And not only were the FED's freshly printed bills flowing in, the American housing market attracted a fair share of overseas funds as well. Without such incentives, the inflationary effects would likely have been spread more evenly into other markets rather than focusing like a laser on this one in particular. It was as if all the inflation taking place across the entire globe were being funneled into one single market by our own Uncle Sam! What of these other activities, the fraud and "innovation?" Certainly, they weren't desirable, but these seem to me effects of the tidal wave of money flooding the housing market rather than the cause of the bubble and the later crisis itself. A sound financial spanking in the form of large losses at the hands of the market will tend to curtail the activities of people engaged in risky behavior, but if you can't lose no matter what you do thanks to a constant torrent of money, well, there doesn't seem to me to be a better way to encourage reckless stupidity. Blood in the water has a way of attracting the sharks, and easy money attracts fools and crooks. I doubt that most of this behavior would have taken place without the flood of money into the market. Better an honest money system than all the financial policing in the world. But that's just me. Bursting of the Bubble The bursting of the bubble occurs for precisely the opposite reason that the bubble inflated in the first place: the flood of money dries up. The stabilization of the money supply reveals unprofitable ventures for what they are as prices, no longer propped up by continuous flows of money, return to more appropriate levels. Bankruptcies ensue, and poorly allocated capital is "liquidated," making it available for new ventures more likely to succeed. Financial reality begins to realign itself with economic reality, and capital and other resources are realigned to better match the needs of consumers. As you might guess, the result is a fall in the price of capital goods relative to consumer goods, as a lot of capital goods tend to come on to the market all at once. Including human labor in the form of unemployment. Recession is a time of revaluation. In the old days, money was "bank notes" and those notes were backed by gold or silver held on reserve with the bank. Banks could inflate the money/banknote supply with the sleight of hand of fractional reserve banking in order to collect "extra" interest on the unbacked, counterfeit currency, but this was held in check by the fact that depositors could demand gold in exchange for their banknotes. In the back of his mind, the banker knew how much gold sat in his vault, and he would only allow the expansion to go so far. A bank run could destroy a bank in a single day. Business cycles of this time period tended to be very short and punctuated, as banks first expanded, then contracted to cover their positions quickly. Expansion of the monetary base, the gold supply, was generally a slow process dependent on the mining industry. Though economic cycles were more frequent, capital distortions overall were not able to get too far out of hand thanks to this important check on the system. Even under a central banking regime, where the central bank can defend member banks by increasing cash reserves, if the central bank is on a gold standard there are still checks on its ability to increase the monetary base. Nowadays, central banks can expand the monetary base at will, independent of the gold supply or anything else. They simply have to buy something. As a result, the central bank can protect the banking system from its own fraudulent expansion by simply increasing their reserves to defend them from runs. In consequence, it is not generally nervous bankers that end a boom. The booms are allowed to go on much, much longer. The present inflationary boom has been underway for decades. Price distortions are allowed to propagate for much longer through the economy, causing much larger distortions in the capital structure. We now have entire nations, such as China, with near monomaniacal devotion to industrial export, while nations like the US suffer from a festering tumor of a financial system and a withering manufacturing sector. Today, the biggest check on inflation by central banks appears to be the CPI. Well, that and the threat of political instability. Through the 80's and 90's, monetary inflation rippled through capital markets driving up stock prices with relatively negligible effects on the CPI. By 2006, the inevitability of price inflation as a result of the monetary expansion beginning as early as 1980 (and some might argue since 1960) had become apparent. The inflation had flowed through capital markets and was in the process of driving up wages. The stock market had failed to absorb new monetary increases after about 2000 and unemployment had been driven down to near full employment. Wages were on the rise and price inflation was imminent as newly printed money was now making it directly into deposit accounts of wage earners. Sensitive industries became flooded with money. Oil prices went through the roof. In late 2006, the FED began a campaign of monetary tightening, visible in the graph below: The monetary tightening is visible as a flattening out of the AMB beginning in late 2006. The scale of this tightening is better represented by a graph of the percent change in the monetary base, year over year. This is a kind of "first derivative" of the AMB, for those of you who are familiar with calculus. The closer it approaches zero, the less monetary expansion is going on: Aside from the temporary fluctuations near 2000 (a response to the 9-11 terror attacks and the bursting of the tech bubble), the slow tightening of the period 2003-2008 was far more than the market had seen since 1982. Even then, the monetary base was still growing marginally, jut not at the rate to which markets had grown accustomed. Contrary to the popular conception of monetary dynamics, even as the FED was "cutting interest rates" through late 2007 and 2008 it was not substantially expanding the money supply to do so. The FED was not being nearly as accommodating as most observers believed on the basis of rates alone. Markets were actually experiencing the nearest approximation of a true free-market with respect to interest rates and a stable money supply they had experienced in more than 20 years. They promptly collapsed. As the Federal Funds rate sat at near 2%, the money supply remained nearly flat. Such was the level of fear in financial markets at that time. When the CPI begins to show inflation, the central bank tightens. But it takes a very long time for this particular statistic to show inflation. In the meantime, and it can be a very long time, capital markets absorb the greatest effects of the monetary inflation. They are not held to account until the FED hits the brakes. Capital misallocations build up unchecked. The Illusion of Prosperity All of this may seem a tremendous distraction to the question we initially set out to answer: do we face inflation or deflation? But now we come to the crux of all this discussion. The FED is in a bind like never before. By inflating the money supply, it has managed to create price distortions that have lasted the better part of three decades. By propping up housing prices, stock prices, and rendering a general climate of easy financial security and investment profitability, it has created an illusion of immense wealth which is simply a fantasy. The promise implied by present price levels and the values of pensions, retirement accounts, and promised social security payments is spectacularly overblown and unrealistic. An entire generation has come to believe that it will easily retire in splendid comfort. Worse, it has caused such tremendous real capital distortions that the market stands hardly a chance of meaningful recovery any time soon. The crisis is not limited to the US, either. With the US dollar as the reserve currency, and further, with central banking and its penchant for inflation the dominant monetary system throughout the world, these capital distortions span the entire globe. This is a global financial and economic crisis unprecedented in human history. There is exceeding political pressure to maintain the illusion, not just in the US, but throughout the world. Without continuous inflation, capital prices will fall and the massive correction begins. In the long run, we will be able to appropriate resources more readily towards efficient, sustainable economic development, but in the short run, our artificial world will come crashing down around our ears. We won't get to pretend we are rich any longer, and it will appear that the FED and the government have ripped our cherished images of idle bliss right from our fingertips. Yet if the inflation continues, distortions worsen and price inflation eventually destroys us, a la Germany of the 1920's or today's Zimbabwe. In short, by now we realize that inflation isn't primarily an economic problem but a political problem. The FED is in charge of it. If we're going to try to predict what the FED is going to do, we must understand the situation it faces, and the way it understands the world to function. The FED believes that its models are correct, that CPI is inflation, and that through "proper" monetary management, it can maintain the status quo. It is therefore highly likely to try. However, its models are not correct, and it cannot succeed. Eventually it will fail, though we cannot say for certain how long that will take. But by understanding the business cycle, how the FED responds to economic data, and how the economy responds to FED policy, we can better predict what is likely to happen down the road. Conclusion If you are like me, at some point in reading and thinking about all of this you have had something like the blue pill/red pill moment from The Matrix. Most of what we have been over sounded to me like plain-old common sense when I first heard it, as if it were all something that should have been obvious in the first place. But for some reason, I had to have it spelled out to me in black and white, and the implications, if true, turn the world on its head. Strange how that can happen, isn't it? While it is true that America's "free-market system" is far more productive, flexible, and resilient than those of lesser freedom throughout the world, which is to say that "it is better for the freedom that it has," it should be quite clear by now that the economy we see before us is something of a sham. Our economic freedom in many ways simply becomes a way for our activities to more quickly conform with the monetary forces exerted by central banks. The economic distortions caused by central banking are immensely, immensely powerful. Though I am a defender of free markets, I now find myself questioning ostensible capitalists who criticize those who lament such effects as outsourcing, "the forces of globalization," the massive growth of the "pink collar" and financial industries at the expense of American manufacturing, and the like as though these effects were actually the result of the free market. I'm convinced that they are not. They are the result of the free-market adjusting itself to the coercive efforts of central banks, which are in turn acting in accordance to crass political pressures and delusional economic theories. They are the warped constructs of a global economic bubble, they don't actually work, and they are destroying our way of life even as they maintain the illusion of prosperity. Though I am a staunch defender of capitalism, I must at this point admit that I'm not sure that I have any clue whatsoever as to what capitalism actually looks like. I'm not sure that anybody does. Maybe it doesn't look like Hummers and Wal-Mart and Made in China. Maybe it looks like something completely different. I don't know. At any rate, with respect to the inflation-deflation debate, the point is this: monetary inflation produces the business cycle, and this go-round the FED has created a catastrophe. By lengthening the business cycle far beyond anything we have ever seen, it has produced one of the most spectacular economic bubbles in the history of mankind, with, of course, the help of fellow central banks across the globe. In 2006, it decided to pop the bubble, but did not visibly succeed until 2008. It now has a mess on its hands. There is a widespread perception of wealth and prosperity which is simply false, though the FED and Washington are likely to do everything in their power to maintain appearances for as long as possible. However, this is in vain, and eventually the truth must be broken to the public in some fashion. It is clear that we are headed for impoverishment as the mess is sorted out, though it is not entirely clear at this point what form the impoverishment will take, or how long the illusion of prosperity can be propped up. Next time, we will wrap things up with the final verdict!

The Symbology of Money

First off, the word symbology really does exist. I looked it up. Whether or not I'm using it correctly is another matter... I haven't talked much about the roles of money and pricing in an economy, mostly because it is a very long discussion that won't interest most people, and I was more inclined to dive right into the present economic situation as fast as possible. I wanted to go on to a post on the business cycle and then finish this thing off with a post about The Crash of 2008 and my expectations with regards to inflation or deflation, but I'm finding it difficult to discuss without some basic background on money and pricing. So far, I've been taking it all for granted, but I'm beginning to think I need to take a breather on the FED and talk about basic money and pricing for a bit. Most of us have a reasonable understanding of what money is and how it functions, despite the fact that the community of economists can't seem to get it straight. That is correct: economists cannot agree on what money actually is (are you detecting a pattern here?). I'll just use a simplified definition and leave out annoying details. In a nutshell, money is the medium of exchange. Yes, there's more to it than that, and lots of great discussions can be had on what properties make for a good monetary unit, but I'll leave that for another time, and possibly for other authors. For the present, I want to talk about the business cycle and how it is related to the money system we have today, not hypothetical systems. So, I'll stick with this basic definition and take it for granted that the money we have today is the one we just have to deal with. If you are looking for some real expertise on the subject, Leo provided some excellent links yesterday to a series of posts at LRC that discuss the topic as well as its relationship to the banking system. Again, Mises on Money is another great place to get the lowdown, if you find yourself so inclined. I'll try to confine myself to a brief discussion, just so we can be settled on a few concepts that will be useful going forward. But I have a habit of being long-winded. Money and Barter Under a barter economy, there is no medium of exchange. Goods are traded for other goods in one-off transactions. This works reasonably well in a primitive economy, and it is better than trying to produce everything yourself. The problem arises when it comes to pricing. Sure, you can bargain the terms of each transaction, but in the larger scheme of things it is nearly impossible to keep track of all the zillions of exchange rates between every possible pair of goods. It is also quite impractical to make plans or projections should you have a mind to set up some adventurous profit-seeking enterprise. Accounting is difficult without any form of monetary unit. But if you are just trying to get by, barter beats the alternative. By pricing every other economic good in terms of money, an economy with a money system opens up all sorts of new possibilities. Yes, simplified pricing in money greatly facilitates economic exchange, but it also does far more than that. The symbology inherent in a money-pricing system allows us to form abstractions in our minds of myriads of possible economic transactions and to understand in vastly greater detail the workings of our economy. It allows us to conceptualize things like profitability, discounting, and interest in ways that were only dimly recognizable before goods became priced in universal money-units. All of this was muddled when we were trying to keep track of all those different kinds of goods and the complexities of their production. Money simplifies things. We only keep track of the things we are interested in, and money-system symbology takes care of the rest without our having to think about it. In a few words, money vastly expands our capacity for rational economic calculation. Not necessarily perfect calculation; perhaps estimation is a better word. But these estimations are orders of magnitude better that what is possible under a moneyless economic system. Like an architect looking at a blueprint or a schematic for a building, the information tabulated in balance sheets, income statements and cash flow allows a trained accountant to understand how a business is performing, how things might be improved and where things might be going wrong. Symbology and Economic Planning But symbology is just symbology; it is not the real-world. Taking our architectural analogy further, just as money is neither actual wealth nor the real economy, a blueprint or a schematic is not a building. It is only a series of symbols on a piece of paper. Yet the symbology contained on the paper allows the architect to understand the the layout and function of the building without ever seeing the building itself, and before it is even built. Schematics allow plans to be drawn up and errors spotted before costly mistakes are made. Suppose that an architect is drawing up designs for his next project. What happens when some jerk comes along and fiddles with his measuring tools while he is gone? Suppose he swipes the architect's ruler and replaces it with one that has slightly smaller units? If the architect does not spot the switch in time and continues with his design, his plans will be full of errors. Depending on the degree of the change, his plan could merely not come out quite right and produce a crumby building, or it could turn out to be a total disaster. If the plans are bad enough and they are implemented anyway, the building could collapse! (Hopefully, by now you see where I'm going with this...) Likewise, the symbology of money allows balance sheets, projections of future profits and the like to provide accurate expressions of the health and productivity of a business in the real world. If the data is incorrect because the money system has been tampered with and its effective symbology compromised, estimations become incorrect and successful-looking business plans are more likely to go bust. Why Not Just Make Adjustments? Everybody knows that money is inflating. Everybody knows that the FED manipulates interest rates. Why don't those shrewd old businessmen and economists just make adjustments? Here is where our analogy breaks down. An architect is not overly concerned with his measuring units. He is concerned with producing a sound, functional, and attractive building. Supposing that he did find out about the nefarious act of measuring-stick espionage, the architect would probably do his best to search out all the errors and make the necessary changes to see to it that the building turns out right. Barring that, he would probably be more inclined to start over than allow a menace to public safety be built with his name stamped on it. Businessmen, on the other hand, are only concerned with making money. Money, the unit of measure in economic design, is also the measure of economic success, and a sound, functional, and attractive business is one that makes a lot of money, however irrational its physical, real-world activities may actually be. If real-world, wealth-destructive activities render monetary profits, by golly, they're good business! Furthermore, as far as individuals are concerned, evaluations are usually concerned with the short term. Competition is fierce and quarterly reports come out every few months; who has the luxury of thinking ten years out? Who knows what will happen anyway? Better to make money today than worry too much about tomorrow. It would be irrational for businessmen to somehow altruistically make adjustments ahead of time even if it were possible, as in many cases it could very well constitute an act of career suicide. And if a businessman may know full well that he faces future losses in monetary terms and make bad decisions anyway, he certainly isn't likely to care about real-world material waste no matter how stupid his actions may look on the face of it, whether now or in the future after all the dust settles. What matters is that bottom line, and it matters today! I'll wager most of us can think about our place of employment and come up with a few shining examples in this regard... All of this presupposes that businessmen are capable of such adjustments, of which I have my doubts. When economic signals have all become unmoored from physical reality, who is to rightly say which way is up and who is responsible for acting on it? Whatever the case may be, business cannot be relied on to make adjustments for errors instigated by monetary authorities and financial systems. They are beholden to the bottom line, and rightly so. Not to behave so would be to betray shareholders and their obligations as stewards of sacred property. If false signals are sent in error, we can be sure that businessmen will act on them regardless, whether through ignorance, greed, nobility, or whatever other motive we might ascribe. In chasing down this tangent, I hope I've managed to illustrate just why it is so critical that the monetary system and its symbology be well-grounded in material reality. There are many ways that wealth-destructive and subversive activities can be made to appear profitable. All red-blooded conservatives and libertarians are familiar with ways that government meddles with pricing and money transactions in order to achieve political objectives: taxation, subsidy, regulation, welfarism, and the like. They are also likely familiar with many of the results of this meddling: waste, corruption, impoverishment, etc. Those who seek to manipulate economic outcomes through such tampering are playing a dangerous game. But even activities such as taxation and subsidy are relatively narrow in scope and magnitude. Malicious as they are, they are still quite limited. If these acts are so destructive, how much more dangerous is tampering with the entire money system itself? The FED: Money-Tamperer Extraordinaire Thought I'd gotten away from the FED, didn't you? Well, so did I, but we are talking about money. We have already seen how the FED increases the money supply, keeping inflationary fractional reserve banking afloat and suppressing the interest rate. A quick check of the historical Adjusted Monetary Base (AMB) will confirm that the FED has, almost without exception, pursued a policy of monetary expansion throughout its history. In doing so, the FED inevitably sends false economic signals that create incentives for a variety of behaviors, including:

• subsidizing debt, and therefore encouraging taking on higher levels of debt
• punishing savings, and therefore encouraging profligacy
• expanding welfarism, through finance of the welfare state (purchase of US Treasuries and suppression of interest paid on debt)
• encouraging market speculation over more productive activities by eroding the value of savings
• eroding qualities historically associated with fiscal responsibility and sound economics: thrift, prudence, discipline, the pursuit of excellence in a specialized trade

This we can all understand without delving much deeper into the topic. Simple recognition of the consequences of persistent erosion of the monetary unit will suffice to explain these more obvious effects. But wait, there's more! We have already covered how new money enters the economy specifically through credit markets. By entering at a specified point, and not somehow "across the board," the entry of new money has very focused effects on pricing in certain markets and not simply a general effect on all prices as a whole. Suppression of interest rates and monetary expansion via the credit market sends rippling effects throughout the economy by warping the pricing system, causing changes in economic behavior and the allocation of resources and wreaking economic havoc as it goes! The Fallacy of Neutral Money This simple observation should put the lie to a popular economic fallacy that Austrians like to call "The Fallacy of Neutral Money." Simply put, expansion of the money supply does not affect all prices equally, as believers of the fallacy would have it. Monetary expansion is not neutral in its effects. It raises prices where it enters the market first, then these price increases slowly spread outwards through the economy as later actors receive the money and perform new transactions. Economic actors, especially entrepreneurs, investors, and businessmen, respond to the new price differentials by changing their behavior in the pursuit of profits. This results in changes in investment patterns and the allocation of resources, which can be summarized by noting that markets with rising prices tend to attract more capital. Since these changes do not reflect actual changes in the real world, but are only responses to fleeting, illegitimate financial incentives, these new capital allocations are in all likelihood bad decisions. By investing capital and resources in response to these deceptive signals, investors and the economy suffer a wave of malinvestment. When the monetary expansion ends and the price changes have run their course, the malinvestments are revealed. The boom ends and the bust begins. The process of asset liquidation commences, including high unemployment of both capital and labor which we call a recession. And usually, right alongside, so does the process of interest rate suppression and reinflation by the central bank as it tries to "ease the pain" and "stimulate the economy." That, in a nutshell, is how and why monetary expansion and suppression of the interest rate cause the business cycle. But I'll go into more detail in another post. For now, I only want to point out that monetary expansion distorts market signals, including not just interest rates and the debt market, but warps the pricing regime of the entire economy. It undermines the symbology of money in a way that is far more pernicious than virtually any other action government could take. The effects are far reaching and difficult to detect, with highly destructive results. Conclusion By making rational economic calculation possible, the money stands as one of the most important human advances of all time. The modern world would not be possible without it. Tampering with the money supply and manipulating interest rates interferes with the pricing system and undermines rational economic calculation. This results in a disconnect between financial incentives and economic reality. Money is not neutral. By systematically creating price distortions, monetary expansion creates the destructive phenomenon we know as the business cycle. The disconnect between the financial world and economic reality results in the misallocation of resources known as malinvestments. The buildup of malinvestment eventually requires a period of liquidation known as a recession in order to more closely realign the capital structure with economic reality. Now we are ready for a closer look at the business cycle...

Interest Rates and The FED

If you've been keeping up to this point, give yourself a big pat on the back: you're over the hump, and due a well deserved congratulations. Let's face it. Central banking is boring. Monetary stastics, and economics in general, are boring. I do my best to insert snide comments and sarcasm to keep it entertaining, but for most people, this just isn't their cup of tea. But if you've gotten this far, its is pretty much downhill from here. Now we can begin to get into the fun and interesting stuff. By slogging through to this point, you are not fooled by the popular statistical definition of inflation based on price movements. You now understand the system of transactions used by the FED to manipulate the money supply and the phony accounting system used by fractional reserve banking better than probably 99% of the population. Right now, you have the tools to answer the inflation/deflation question better than most all of your peers. You are beginning to push the limits of my own understanding. From here on out, you will be seeing a lot of rehashing and review, as you already know the mechanics of the system and we will now be turning our attention towards how these manipulations interact with the "real economy." Did I leave out a lot of details? Oh heck yes! No one could possibly give a thorough look such an in-depth topic with three measly blog posts. And frankly, I don't know it in enough detail to do the topic justice. But you're not going to start running a bank yourself tomorrow, are you? Maybe you have even bigger goals, like actually working for a central bank or setting up your own fiat monetary system. In that case -- a pox upon you! For the rest of us decent folk, this is more or less what we need to know to gain a reasonably solid understanding of the grand scam that enslaves us to corporate, government, and banking interests so that we can do our best to squeeze out from under them, keep more of what we earn by our own honest sweat, and take care of the ones we love. By understanding what has gone wrong and why, we can hopefully make better decisions in the future if and when this system falls apart and we have the opportunity to build a new one. Assuming we get that far, of course. We will know the lies when we inevitably hear them, and we will have an idea of how to answer them. And that is really the point of all of this. But just in case you really want to understand central banking in such a depth as to render yourself a giant pulsating forebrain capable of going head-to-head with the combined demonic spirits of Alan Greenspan, Paul Volcker and other Ghosts of Central Banking Past, then Money, Bank Credit, and Economic Cycles by Jesus Huerta de Soto is the book for you. I haven't read it just yet. For my own part, I'm just going to plow through and make do with practical stuff. How the FED Manipulates Interest Rates This sounds distinctly like we're going to talk about some new monetary machination of the FED, doesn't it? Didn't I just say we were through with that? Actually, if you've been reading this series of posts up to this point, you already know how the FED manipulates interest rates. It manipulates interest rates the same way that it manipulates the money supply: by buying and selling assets. Under a central banking regime, manipulation of the money supply and manipulation of interest rates are one and the same thing. They are the same phenomenon. When you hear it announced that "the FED lowered interest rates" or "the FED raised rates today," technically, this isn't true. Pretty much all the FED does is buy and sell assets. The FED targets a particular interest rate for a particular banking transaction: the overnight lending rate. What is the overnight lending rate? When a bank shuts down for the day, it has to make sure that it has met reserve requirements. Remember: a bank is legally required to have 10% of its deposits secured as reserves. This can be either as vault cash, or reserves held with a member bank of the Federal Reserve System. If a bank comes up short, it must get the funds from somewhere. This is an opportunity for banks which have not come up short to make a little money. They extend overnight loans to the banks which need money. The interest rate of this loan is the rate targeted by the FED. By purchasing or selling assets, the FED can influence the reserves of lending banks, increasing or decreasing the supply of money available for these types of loans, or covering for banks requiring a loan and thus reducing demand. By fiddling with supply and demand in this market, it can pretty well dictate the interest rate. So, the whole purpose of all those asset purchases and sales is to manipulate this obscure interest rate. It is also sometimes called the Federal Funds rate. Interest Rates: Who Cares? So, why do this? Who really cares? Remember back to our first discussion, when we talked about the different ways to define inflation? The present definition of inflation used by non-Austrians, the one based on changes in price levels, derives from a certain mindset about the way the world works that hasn't actually been around all that long, at least here in the US. It is based on the idea that the basic functions of society can be manipulated at will by government technocrats. For some reason, which I do not claim to be able to explain, a philosophy took hold near the end of the 19th century and the beginning of the 20th that embraced a sort of scientific ordering of government and society by enlightened technocracy. The simpleminded notion that an ounce of gold was an ounce of gold and the reliance on tradition and rules of ethical behavior was replaced with the idea that science and engineering could "do better than that." Modern, enlightened man's intellectual prowess allowed him to design his own economic and social systems with properties that were superior to those that had been based on barbaric codes and ancient superstitions rather than being rooted in scientific reality. Or something like that. It was perceived that turning over the regulation of our society to enlightened individuals and institutions was better than either messy democracy or sclerotic rule of law. The movement led to the election of men like Woodrow Wilson, a professor and university president, and Herbert Hoover, a talented and accomplished mining engineer, instead of the usual parade of lawyers, generals, and the like. This was the period that saw the rise of communism and fascism. It was also the period that saw the rise of the FED. Central banking had been tried sporadically across the West for several centuries, but within a few decades of the turn of the 20th century, it became universal. Perhaps it was wrapped up in the whole Progressive movement. Perhaps it was an outgrowth of the "age of reason," and overconfidence in the scientific advances of the time that brought it about. I don't know the answer. Perhaps Fran, or one of the other co-conspirators, or an enlightened commenter could enlighten me. But it happened, and it overturned much common sense that we could desperately use today. Most people still buy into this myth when it comes to economic thought, and especially when it comes to monetary theory, even those who reject other forms of Progressivism. Statistics describing the economy are taken to be more important than actual, tangible facts, and goals more important than rules of fair play. Hence we prefer a "flexible" paper currency system instead of a rigid, "barbaric" gold coin standard. "Cost of Living Adjustments (COLA)" or "adjustment for inflation" are taken to be fairer and more accurate determinations of our pensions rather than something like simple payment in a fixed quantity of gold. That last one just sounds strange, doesn't it? But really, why should it? In embracing the Progressivist mindset, we trust the management of our money and our future to politicians and professional government statistics-mongers. You know, the same ones that run the DMV and get caught breaking the very rules they were hired to enforce. Do we really trust them more than fixed payment in gold? Modern economists and government statistics-mongers are obsessed with statistics like the CPI and consumer confidence. They treat these statistics as an engineer would treat his gauges and data readouts on some complex mechanical system. They tell our economic engineers what is going on in the economy so that they can pull the right economic lever to make things work better. Or so the thinking goes. The validity of those statistics depends, of course, on the validity of the theory used to derive them, not to mention the honesty and integrity of those whose task it is to produce the statistics. We have already peered through several gaping holes with respect to inflation statistics and laughed at the economists caught with their pants down on the other side. I'll leave the question of the integrity of government bureaucrats and politicians for you to answer on your own. In their efforts to engineer economic policy, they could care less about things like the money supply. Money supply is taken to be more of a practical consideration, as in, whether or not there is "enough money" to facilitate economic exchange in a given region. The ethical component of the function of money and the consequences of manipulating it fall by the wayside. They are far more concerned about interest rates because they see interest rates both as critical statistical descriptors of the economy and as tools for manipulating it. Manipulating interest rates is the primary goal of FED policy, as these rates are critical determinants of economic behavior. Interest rate manipulation is the preferred tool for economic engineering by our central bank. Money supply fluctuations are merely a means to an end. This is why you will hear a story on every business channel when the FED "changes the interest rate," but rarely do they ever talk about the volume or direction of actual "open-market operations," which is the term used to describe the buying and selling of assets by the FED. Maintaining the "correct" interest rate is taken to be more important than the creation or destruction of money required to achieve it, because of the dominance of the mindset that the supply of money does not matter, because we believe in the lie of inflation through price changes. The broader market chooses to talk of the FED in terms of interest rates because it believes the money supply does not matter. I chose to introduce FED operations in terms of the money supply because I know that it does. The money supply is more than simply something to manage in the pursuit of a desired outcome. Interest Rates and the Economy Unfortunately, interest rates are no mere statistics, and though modern economists may have a hint of their significance, in their penchant for social engineering they also treat them as something violable that can be changed arbitrarily to suit their needs. In discussing just exactly what an interest rate is, once again, we find that economists cannot agree on a simple, fundamental topic. Theories to explain interest rates abound. If you take the time to read them, most will sound pretty reasonable. But they can't all be right. Whichever you happen to choose to believe isn't really all that important, at least from a mechanistic point of view, although it does matter a great deal from a theoretical point of view. For our purposes, the important thing is to understand what happens when the rate is manipulated. That being said, I'll go through the Austrian definition, just so you'll know. Austrian theory describes the interest rate as an expression of "time preferences." Interest is taken to be compensation for the use of saved funds over a period of time, e.g. the price a saver demands for delaying the consumption which he could otherwise enjoy today. An individual with a "high time-preference" for money would require more compensation for the use of his funds than an individual with "low time-preference." Of course, if an individual with a low time-preference can find a higher interest rate, he will, but that isn't the point here. The point is this: the availability of funds for lending is dependent on time-preferences. At some point, as time-preference increases, funds simply become unavailable. Potential lenders will not part with their money temporarily below a certain price. This is the price of their delayed gratification, and it is a brick wall. Individuals with varying time preferences interact with borrowers in the marketplace to determine exactly what the going rate of a loan will be in each individual case. In a society skewed towards individuals with lower time preferences, interest rates will tend to be lower than in a society skewed towards individuals with higher time preferences. Time preferences, and therefore interest rates, broadly determine an important partition within the economy: the allocation of resources between consumer goods and capital goods. By allocating a smaller fraction of funds towards immediate consumption, a low time-preference society will leave a larger fraction of unconsumed goods in the marketplace and place a greater level of funds available for investment and entrepreneurship. Demand is shifted away from consumer goods and towards capital goods, accelerating the rate of capital accumulation and wealth formation versus a high time-preference society. Here we see the motive behind the actions of the FED. By artificially suppressing the interest rate, the FED does the same thing: shift demand towards capital goods and away from consumer goods by using an expansive monetary policy. How does this work exactly? Interest Rates and the Debt Market Remember: under a regime of fractional reserve banking serviced by a central bank, manipulating the money supply and manipulating interest rates are the same thing! By buying assets, the FED makes more money available to banks for lending, but not to consumers for consumption. By multiplying the money supply, fractional reserve banking makes more money available for lending, but not for consumption. This counterfeit money, the product of crooked accounting and money-printing, competes with the existing money supply as entrepreneurs seek out loans for their business ventures. This drives down the interest rate that entrepreneurs must pay as an increasing pile of "savings" bids for their promised interest payments. Monetary expansion acts as a subsidy for debt markets. Bond prices are driven by interest rates. With lots of money competing for willing borrowers, interest rates are driven down and bond prices are driven up. Low interest rates are indicative of high levels of demand and plenty of available cash in the bond market. Not only does borrowing look cheap and relatively safe, if you are a lender, lending looks like a safe bet as well. After all, there is a plentiful supply of other bidders with money in their pockets, just like you. You won't collect as much in interest, but the price of your asset, the bond, is protected by a continual stream of new money pushing present interest rates down, competing for your asset and protecting its nominal value. So long as this remains the case, there is a ready market for your asset should you decide to sell. Interest rate suppression encourages taking on high levels of debt and punishes saving, as we have seen all too clearly in recent times. It also encourages entrepreneurs to go on a borrowing spree and take on new projects directed at satisfying future consumer demand that otherwise would not have occurred. What Could Possibly Go Wrong? This is actually a good idea, right? By suppressing the interest rate, we are helping capital formation and wealth accumulation, and therefore making people richer, aren't we? We are encouraging risk-taking, and entrepreneurship, and economic growth, and all that other good stuff, even according to this so-called Austrian theory that certain nutcase Eternity Road economic contributors subscribe to, are we not? Not exactly, as you might have guessed. There are a whole host of problems that are initiated when the interest rate gets suppressed, however these would be better addressed in a discussion on the business cycle. But since I'm sure that my intrepid readers are all worked up for answers and just can't wait for the next post, I'll give a quick hint or two about how and where things start to go wrong. Note that all of the arguments I have used are short term arguments. In the long run, all that lent money eventually makes its way into the deposit accounts of consumers, so expanding the money supply will eventually increase interest rates as price inflation becomes visible and savers demand a higher interest premium for the use of their money. "Stimulating growth" through suppression of the interest rate by monetary expansion has only a temporary effect. To keep it going, the expansion must continue at an accelerating rate as the new counterfeit money competes with an ever larger quantity of existing money. Note also that suppression of the interest rate sends a false signal. It is another example of a discrepancy in time expectations, similar to the discrepancy between long term lending by banks coupled with short term expectations of money availability by depositors. The lower interest rate sends the signal that capital is plentifully available and larger investment projects, especially projects with a longer time horizon, can be undertaken profitably. However, it should be clear that such resources are not available; after all, the fact remains that the interest rate is manipulated. Consumers are not willing to delay gratification to the degree that interest rates would suggest, but this does not become evident until some time has passed and those interest rates begin creeping up, rendering all those nice looking projects unprofitable. Today, it looks like businesses should run headlong into risky new ventures. Tomorrow, when they need to roll over their debts and can't get anything close to yesterday's interest rates, it becomes plain as day that they have made big mistakes. Sales funded by cheap credit dry up. Inventories build as products go unsold. This is to say nothing of the price distortions and bubble activities that are initiated by interest rate suppression and credit expansion. But I shall leave that for a future post on the business cycle. Conclusion The FED manipulates the interest rate in the same way that it manipulates the money supply. It, and most other economists, focus on interest rates rather than the money supply because they believe their own lies: that inflation is a product of rising prices, that economies and societies can be engineered on a whim, that their self-aggrandizing, delusional theories are correct, that God may safely be mocked. Suppressing interest rates requires expansion of the money supply, which flows into the banking system and results in lending at rates that do not reflect market realities. Debt levels increase, and risky new entrepreneurial ventures begin to spring up throughout the economy. And so begins the business cycle.