Thursday, October 29, 2009

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: 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.

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