This is is the final part of my four part article that deals with what I feel is the primary question investors must now answer: is our future to be inflation or deflation? The answer has vast implications to our investment planning and decisions for the near term, and possibly for our long term. It is a very complex question with a lot of moving parts involving economics and politics.
Like it or not, it is economic theory that is driving macroeconomic policies and political decisions that determine whether we will have inflation or deflation. Since not all of my readers are sophisticated traders I have tried to present the issues in a direct and hopefully understandable way. To those sophisticated readers, please bear with me.
Part 4 of 4
What is Money Supply Doing Now?
Money supply will tell you if we are headed for inflation or deflation. If we look at the rates of change of M1 or Austrian True Money Supply (TMS), they are declining. In fact, M1 and TMS appears to have peaked in 2009 and have been declining on a year-over-year basis ever since. On an absolute basis, as shown previously, M1 growth is flattening. These two charts below show the year-over-year percentage change in money supply.
Courtesy Michael Pollaro
Michael Pollaro at TrueSlant.com
What Will the Fed’s Options be in a Double-Dip Economic Decline?
This is the main point. If, as I have been saying, the economy declines in the second half of 2010, what will the Fed do?
Let me paint a scenario. In any scenario with declining economic growth, unemployment will rise. If unemployment at the narrowest measure is now 9.7% and at the broadest measures (U-6) is 16.9%, rising unemployment will become politically unacceptable to the Obama Administration.
I believe the politicians will first take Paul Krugman’s advice and extend existing stimulus programs and create new ones to spur spending. All the talk about fiscal sanity and deficit warnings will be forgotten as politicians on both sides of the aisle panic. Look for further extensions of the home buyer tax credit program, and other programs that politicians believe will help businesses in their districts. Cash for [Your Industry Here] will be the byword. It will add to an already huge federal debt and will result in more wasteful spending and non-viable short-term results.
On top of all this, the politicians will hammer Bernanke to create jobs, which is one of the Fed’s mandates. But how can he do that? He will try to inflate.
The Fed has limited options in such a case. They can’t reduce the Fed Funds rate any further and they can’t force banks to lend. It is likely that banks will further restrict credit as the economy declines.
I think their only viable option is to use Open Market Operations (OMO) to inject new money into the economy. The next question is: what will they buy?
From January, 2009 to April, 2010, the Fed acquired $1.25 trillion dollars of mortgage backed securities (MBS) through OMO purchases. The only problem is that it didn’t do much for the economy. Most of the OMO money pumping has been going into the hands of the big financial institutions which has been driving the financial markets. It is no coincidence that Goldman Sachs had 63 perfect trading days in Q1. New York restaurants are recovering nicely.
There is a theory called the Cantillon Effect which says an increase in money supply doesn’t affect all prices equally: money flows initially into some assets, tends to stick there, and the inflationary effect is borne by later by consumers who get no benefit from the new money, only the burden of higher prices. Such an effect may have occurred when the Fed bought MBS from dealers which resulted in cleaner balance sheets and high profits for the big banks and left consumers with slightly higher prices. But I recognize that this idea is conjecture on my part. But, as I pointed out above, (i) OMO money pumping doesn’t have the same multiplier effect as lending by banks, and (ii) credit is still declining.
There are two other asset purchase choices the Fed may consider in its Open Market Operations. Neither alternative is good:
Alternative No. 1. Buy bad CRE loans (non-MBS) directly from regional and local banks.
If it buys CRE debt from smaller banks, it would compound the problem it already has with MBS purchases. That is, it is unlikely they could sell these assets for what they paid.
The positive effect, in the Fed’s eyes, is that banks would more quickly repair their balance sheets and regain financial health. This would then allow them to raise needed Tier 1 capital and commence lending to viable businesses (this is a big “if”). The Fed recognizes, as Monetarists, that they need to get the smaller banks lending again to spur the economy and create inflation.
This of course ignores the “moral hazard” caused by bailing out troubled banks. But I don’t think there is a lot of political sentiment to allow massive bank failures. And the political pressure on the Fed to “do something” will be intense.
Setting all this Monetarist-Keynesian folly aside, the question still remains: if these banks are artificially restored to health, would that lead to economic expansion? In my opinion it will lead to a “bomb-bust” cycle (economic stagnation and inflation).
Alternative No. 2. Buy Treasury paper which would have the effect of monetizing Federal debt (the government prints currency to pay for its own debts).
The monetization of federal debt on a large scale basis would certainly increase the money supply. The downside is that it would cause greater economic distortions than if they bought bank CRE debt because the effect would be to fund wasteful government projects.
Further they still have the problem of getting banks to lend and if they just buy Treasury paper from these small banks, they will sock the cash away at the Fed as excess reserves.
Will Inflation Be the Effect of the Fed’s Action?
In either alternative or a combination of the two, we would have inflation because money supply would increase. How much inflation depends on how much cash is injected into the system. Such inflation would eventually cause another artificial business cycle that would further damage the economy by destroying more capital as the new money is misdirected into businesses that would not be otherwise viable but for the effects of inflation. This is called “malinvestment.” We are presently suffering the results of malinvestment in real estate assets.
This new cycle will be less of a boom and more of a bomb. This is what happened in the 1970s when the CPI went sky high yet economic activity stagnated. Stagflation was the term devised to describe it.
The problem is this: how many times can you destroy capital before you have jeopardized the ability of investors and entrepreneurs to create new profitable businesses?
Real wealth as I discussed before, is not a piece of paper. It is goods produced that are not consumed. (See my article, “Money: A semi Fictional Fable.”) Money is just a way of holding wealth until you wish to consume something. If I am a factory owner producing silicon chips for Apple, and I save some of my profits rather than spend all of it, those savings are real capital.
It is difficult in our complex economy to measure “real capital.”
Some Austrians believe a decline economic activity indicates a decline of real capital. I would agree that is probably the case, and, I would agree the last two cycles have been destructive of real capital. I do know that more pieces of green paper will only result in malinvestment (the destruction of more real capital) and rising prices.
When will we see inflation?
This is where I believe the deflationist argument fails. The deflationists believe we will have years of deflation because of the credit freeze. Banks are still loaded with bad debt and viable borrowers are difficult to find. While I understand the similarities with the Japanese experience (massive fiscal stimulus, zero interest rate policy, low inflation, and stagnation) I believe the situation will be different here.
That difference is that we are cleaning up our mess whereas the Japanese, perhaps because of cultural reasons, let bankrupt (zombie) companies and banks stay alive. This tied up capital in unprofitable businesses (malinvestment), and new capital was not able to be directed to entrepreneurs and profitable companies.
While we may be going at it slowly, America has a rich tradition of failure, foreclosure, and bankruptcies which acts as a cleansing mechanism to rid the economy of malinvestment. This is what Joseph Schumpeter referred to as “creative destruction,” or the process by which capitalism corrects its mistakes. This process is occurring here, but the problem is that the process is being slowed down by government policies that prevent bankruptcies (mark-to-make believe, extend and pretend, delay and pray, and TARP, TALF, Cash for Clunkers, and housing subsidies).
I don’t agree with the deflationists that deflation is a decline in real estate asset values. I believe the deflationists conflate deflation and deleveraging. I agree with the deflationists that deleveraging and the decline in real estate values has and will limit economic activity because it has suppressed bank credit, but it isn’t deflation.
Further, as pointed out by Austrian economist Bob Murphy, we haven’t seen deflation yet, or at least it has not been reflected in the CPI. In fact, he says, we haven’t had deflation since the Great Depression.
At some point the Fed’s efforts to increase money supply will be effective. It is difficult to predict when that will be.
I think we are seeing current declines in money supply growth as a response to the Fed’s cessation of MBS purchases. It is possible that we may go into negative territory which would be deflation, but, with evidence of a double-dip economic decline, the Fed will do everything it can to re-inflate and I think they will succeed.
This time the result will be stagnation and inflation.
Will We Have Hyperinflation?
Is hyperinflation possible in America? The proper question to ask is if it is probable. To that question I would say no. Hyperinflation would result in the destruction of our monetary system and Ben Bernanke and just about everyone at the Fed and the Administration’s economic advisors understand this quite well. I believe they understand the mechanism of printing money as the cause of hyperinflation.
I am also aware of the implications of runaway Federal debt and the political choices the government has to pay it: higher taxes and/or inflation. The third method to pay it would be a thriving economy caused by a reduction of government’s heavy hand, but free market capitalism is out of favor right now.
To prevent runaway inflation the Fed would raise interest rates, increase reserve requirement, and sell assets to stabilize money supply. The hit to the economy would be worth the risk. This is essentially what Volcker did back in 1979-1980. If it really got rough, price and wage controls would be instituted on a temporary basis to cool things down. I am aware of the implications of such controls and the massive price distortions they cause, as is Mr. Bernanke. But it would politically acceptable on a temporary basis. That famous Republican, Richard Nixon, did this in 1971. We all understand that such controls only further distort the economy because only market prices enable us to make economic decisions, which is why such controls would be short lived.
Summary
- Inflation or deflation is a monetary phenomenon. An increase in money supply causes inflation. A decrease in money supply produces deflation. (Ceteris paribus.)
- Price increases are a result of inflation, not inflation itself. The main impact of inflation is malinvestment.
- The Fed has been trying to inflate the money supply to end the credit crunch.
- The Fed’s inflation efforts have been mixed. Most banks are still not lending and credit and money supply have been declining.
- Banks are not lending because their balance sheets are loaded with bad CRE debt which has caused them to be concerned about their financial viability. In addition they have difficulty attracting viable borrowers.
- The government has enabled banks to postpone the inevitable write-downs of bad debt which has drawn out the credit crunch and has impeded economic recovery.
- Monetary stimulus has been achieved by the Fed’s Open Market Operations which has injected almost $1.25 trillion of new money into the economy.
- The impact of such stimulus has served to benefit the large money center financial institutions, and does not appear to have aided liquidity or to have stimulated economic growth other than the financial markets.
- Government fiscal stimulus has had little positive economic impacts on the economy, and, as the effect of government spending winds down, we are left with wasteful spending of no lasting economic benefit and high public debt.
- Recent increases in consumer spending and consumer lending are temporary blips caused by government stimulus programs and are having no lasting effect.
- Money supply has increased since the October, 2008 crash, but there are signs that it is beginning to decline again.
- While the CPI has been increasing, increases are modest and are a result of the Fed’s less inflationary OMO purchases of MBS.
- The current trend of the CPI seems to be declining.
- It appears that economic activity is slowing down as stimulus runs out and money supply declines, and that we are headed for a double-dip decline.
- Until banks’ balance sheets are cleaned up by resolving the overhang of bad CRE debt, they will continue to restrict credit and thus constrain the growth of money supply.
- The deflationists’ analogy to Japan’s experience from 1989 to 2003 is only partially applicable. The American tradition is to allow banks and businesses to fail.
- This cleansing process is ongoing but is slow because the government has given banks incentives to delay the process.
- The deflationists have yet to show that deflation has occurred as they say. While asset values are declining, mainly real estate assets, money supply has not crossed the deflation Rubicon yet.
- The deflationists seem to conflate the concepts of deflation and deleveraging, which aren’t the same things.
- A double-dip decline will put political pressure on the government to take any steps they can to thwart the decline.
- An inevitable increase in unemployment will be politically unacceptable to the Administration and Congress.
- The government will renew attempts at fiscal stimulus on a grander scale.
- The Administration and Congress will put pressure on the Fed to counteract the decline. All politicians and most Keynesians and Monetarists believe that price inflation is preferable to price deflation.
- Inflation destroys real capital which will limit future economic growth.
- The Fed has limited options to create inflation but they will attempt to do so by injecting money into the system through OMO.
- One option is to buy Treasury paper, thus monetizing federal debt, which will ultimately create price and monetary inflation.
- Another option is to buy CRE debt from smaller banks to clean up their balance sheets and allow them to resume lending activities and expand money supply which will result in inflation.
- The problem will these alternatives is that they will serve to reduce economic growth by causing malinvestment and the further destruction of real capital while at the same time create price increases, which is called stagflation.
- If inflation gets out of hand, it is probable that the government will impose temporary price and wage controls while they counteract inflation through increased interest rates and other restrictive monetary policies.
After Part 4, I will publish the entire article as one downloadable PDF.
APPLAUSE!!
the thought of a grander stimulus package to come is really depressing. im grateful you are willing to forecast and make predictions without hesitation. great reading!
Dumb question. Where do you get these charts?
http://research.stlouisfed.org/fred2/
Great series of articles… but I have one bone to pick. In #16, which I think is your principal argument against deflation, you say that the USA today is unlike Japan for its two lost decades because we allow failed banks and enterprises to fail. But in other places, I think you are strongly making the case that the government is not in the mood to allow failures and will pull all the stops to bail out failed and failing banks (if not industrial enterprises).
B/K happens despite the government’s actions, but they do slow it down and that hinders recovery. This is one of the reasons I publish banks failure statistics. They can’t stop it.
Thanks for reading!
Hi Jeff,
Great series of articles!
Like other commenters one thing I’m not sure about is your #16. The evidence of late is not encouraging and reeks of crony capitalism.
The auto industry bailouts. The backdoor bailouts to Goldman and other AIG counterparties. The Fed eating the losses on MBS, and now possibly CRE as well. There seems to be no end.
Much of this unfortunately is very similar to Japan not allowing firms to fail and kicking the can down the road. If only the U.S. had Japan’s export model and near zero external foreign held debt then perhaps we could drift along in a happy malaise for decades too.
The bailouts, money printing, and crony capitalism cut deeper than simply undermining the efficient allocation and growth of capital. Perhaps more importantly, all these things destroy the sense of fair play and justice in the American economic model. I wonder if there is a connection between the growing number of strategic defaults and America’s crony capitalism? MSNBC’s Dylan Ratigan certainly believes there should be as he’s encouraging Americans to seek justice by strategically defaulting.
Even if Americans continue to tolerate the crony capitalism, bailouts, and money printing, the rest of the world may not. Exhibit A here is the increasing purchase of gold by central banks around the world. India, Saudi Arabia, Russia, China, etc. are all rapidly increasing their gold reserves. This is the rest of the world voting with their reserves against the U.S. dollar. I certainly can’t fault them for doing so. The increasing price of gold is the canary in the U.S. dollar reserve status/fiat regime coal mine.
I wish I could be more optimistic about the U.S.’s prospects. This country must to learn to take the relatively short-term pain and bitter medicine necessary to build long-term, sustainable economic growth. The one silver lining I have seen recently is Congress’s inability to pass yet another stimulus. Tea party success, November mid-term elections — whatever it is it seems to have scared some incumbents from passing any further largesse.
Disclosure: long gold and silver.
Two thoughts
How are you coming to the conclusion that we will continue our tradition of letting businesses and banks fail? I see no evidence of this over the past 18 months and since purchasing CRE seems a likely option in the future, where is the evidence that this is going to happen in the future.
Isn’t the cause of hyperinflation simply one of faith? Is it really that farfetched to believe that faith in the monetary system will be lost after another round of CRE purchases, bailouts and trillion dollar deficits?
B/K happens despite the government’s actions, but they do slow it down and that hinders recovery. This is one of the reasons I publish banks failure statistics.
Hyperinflation is where the government needs to print at greater and greater rates in order to keep up with price increases. Faith diminishes when folks realize their paper won’t buy as much as it did last month, last week, or even yesterday. At this point the CPI is within manageable boundaries. More money pumping will produce more price increases. Spending and bailouts just increase taxes which act as a damper on economic growth. I really can’t answer your question because I don’t know what the Fed will do, but my guess is that we won’t get to “hyper” yet.
Jeff
I agree with your definition of Inflation and Deflation. Therefore, monetary policy used by the Fed would be to counter act the effects of on or the other as the Fed measures in the economy.
Inflation or deflation is a monetary phenomenon. An increase in money supply causes inflation. A decrease in money supply produces deflation. (Ceteris paribus.)
The next point therefore would not compute with me
The Fed has been trying to inflate the money supply to end the credit crunch.
If the current OMO decisions from the FED is to increase the money supply, with ZIRP, they can only be reacting to the present of deflation in our economy since both are a monetary phenomenon.
Maybe you can help me understand why the FED would need to inflate the money supply if deflation was not present.
They believe the Monetarists whereby you can counteract a recession by pouring money into the system. Friedman’s research blamed the Depression on the fact that the Fed allowed the money supply to collapse after the crash and said they could have prevented the worst of it by inflating. Bernanke believes this and the Fed always does this. Greenspan did it after dotbomb and that’s why we had the boom-bust cycle of 2003-2008. The rate of increase of money supply decreases as credit decreases so, the theory goes, they start pumping and printing. The rate of money pumping is as important as the overall level. That’s why we look at YoY percentage changes. You can have increases in money supply but the rate of increase can drop drastically and impact the economy. The Fed doesn’t need “deflation” as a reason to print. ZIRP and OMO are two different ways to inflate. ZIRP didn’t work for the reasons I mentioned. Good comment.
Or one could argue that the money supply is endogenously determined via the demand for credit and has little to do with anything the FED does or does not do.
There are empirical studies that prove rather than fiat money being created first and credit money following with a lag, the sequence is reversed showing credit money is created first, and need for fiat money comes later.
Further delaying the need for fiat in a credit money economy is the ability to increase leverage. Increasing leverage allows banks or shadow banks to increase the amount of credit money with higher leverage ratios further reducing the need for fiat to support credit money growth.
All the FED is doing is backstopping the deleveraging of credit the banks (and recently the shadow banks) are not reserved for and if deleveraging continues will either have to let the banks fail or continue to print money, which is why I will agree with your conclusions to hedge long term investments against inflation.
This is the Steve Keen theory (and Mish’s)and I disagree. I think the Fed determines money supply and the banks lend according to their ability to lend because of capital ratios and deposits. They are correct that banks aren’t lending now, as I point out. But in a recovered economy, the Fed could choke the banks by jacking up the FF rate and lending would come to a grinding halt. Also, as mentioned above, Ben can inflate by dropping money from a helicopter (OMO).
Good comments.
You seem to be open minded to alternate theories, so if you have not read the following from Keen, then maybe in your spare time you can give them a read.
http://www.debtdeflation.com/blogs/2009/01/31/therovingcavaliersofcredit/
http://www.debtdeflation.com/blogs/wp-content/uploads/papers/KeenAreWeItYetPaperFinal.pdf
I am in his camp, and Mish’s only because it they better explain what we are observing in our economy today.
You are correct Ben can inflate with OMO, but you curretly have 1 trillion sitting in reserves not doing much. I can not agree just because the FED decides to inflate more will make things any better for lending.
Once enough bad debt has delerveraged and real incomes start to grow ahead of inflation will lending start to recover.
If the following is correct
Inflation or deflation is a monetary phenomenon. An increase in money supply causes inflation. A decrease in money supply produces deflation. (Ceteris paribus.)
the need for inflationary FED OMO can only be due to the fact that deflation is currently present in the ecnomony. Good luck to you I hope you enjoy the Keen links.
Jeff,
Since you said in part 1 that the “article is not meant to be a treatise on money and banking,” I will respect this, except to say that Keen/Mish are pointing in the right direction with regard to lending ‘requirements’. It is not a theory, and therefore not Keen’s; it is the operational reality of bank lending.
More to the crux, you rightly acknowledge the unwinding of a credit supercycle that “dwarfs all others,” including the Great Depression in ‘Economic Megatrends’, and do a good job of outlining the flavors in points 1-5. I therefore am puzzled by your treatment of the deflationary forces for two reasons.
1) You seem to simultaneously argue that Bernanke is both impotent (pushing on a string w/regard to credit) and at the same time omnipotent, i.e. that “at some point” his efforts to increase inflation will simply “be effective.” In Part 2 you acknowledge commercial bank lending as the “best tool for inflating money supply,” and that you dont’ believe OMO will have “the inflationary impact” like most inflationists. However in point 26 of the Summary you say OMO purchase of Treasuries “will ultimately create price and monetary inflation.” No explanation is given as to why/what would be different ‘when’ it works. To be honest, I just am not clear on your position. For disclosure, I tend to fall on the side of viewing his powers as more limited, or ‘defensive’ in posture if you will.
2) You believe the deflationists conflate deflation and deleveraging, specifically that “suppressed bank credit” “isn’t deflation.” If bank lending is the “best tool tool for inflating” then how can significant contraction thereof not be the opposite, i.e. deflation? Am I overlooking something basic here?
Truly,
Buck
I disagree with Keen. He is correct about fractional reserve banking but he doesn’t explain the inflationary effect of quantitative easing, where the Fed can increase money supply by bypassing banks and putting money into the system by buying debt from investment banks and funds. Believe me, the money will be spent. While it goes into banks, the cash is not distributed equally among banks as does the Fed Funds rate. These large investment banks may spend the money on other financial assets and don’t impact the money supply quite like fractional reserve lending.
As to Bernanke, we can say that so far he is impotent in creating inflation. But OMO will work if you pump enough into the system. See my latest article on banks (Tuesday and Wednesday). QE is a dangerous thing to do, but if you dump, say 3 to 5 trillion into the system, I believe they will be effective.
Thanks for all of your excellent comments.
I really enjoyed your article Jeff,
If we do double dip, it will be a great opportunity to load up on stocks and sleep on them until the market recovers. Sooner or later the market will recover, this would be the one “gamble” i would be taking. The economy will not crash and burn returning us to hunting and gathering…it’s this 1 bet!
Mich
Thanks, Mich. I don’t gamble any more.
Great article, Jeff. I really enjoyed it.
I think you left out one factor in the inflation/deflation equation; Our bond bubble. When folks figure out our bonds are as worthless as Greece’s and stop buying/dump them, I think the gov will have no option than to print like they’ve never printed before. I agree with you, I don’t think the Fed has the stomach to destroy our monetary system through hyperinflation. But watch out if the politicians get their hands on the presses! They will have no qualms about printing us into oblivion.
I think this is worse than you depict. You’ve analyzed the American economy in isolation, but it’s an important component of the world financial (dysfunctional) monetary system. Some points to ponder:
- In the 1970′s stagflation, America was a manufacturer, a creditor, and an exporter. Now we are none of those. In the 1970s, when prices of goods went up, workers could demand and get higher wages. Now, companies can easily move production offshore when workers demand higher wages.
- There’s the possibility (perhaps probablility) of a “sudden stop” when external creditors determine that the US has no intentions of repaying its debts, and bond interest rates skyrocket quickly. We would then have to implement our own “austerity measures” that would disrupt the one portion of our economy still creating jobs – the federal government.
- Because we are bidding for goods on the world market, we could have a decreasing US money supply coupled with rising prices if import prices (especially commodities like oil) rise in price.
I would be happy to see stagflation, but I don’t think the outcome of this will be that easy.
- Pete
I don’t agree that these are as significant factors as the ones I discuss. More later. Thanks.
It seems to me like the Fed is spending a great deal of time and energy on pumping money into the system, inflating the currency, doing everything in their somewhat limited power to keep our humongous gorilla from slipping down the hill at all; whereas if they simply had a smarter/tighter money supply to begin with, we would never be in the situation in the first place!
What I really don’t understand is this: Bernanke and crew are obviously intelligent men, why do they not see (or choose not to acknowledge) that our Keynesian madness cycle has no basis in logic and is simply not sustainable? Maybe because it’s politically unacceptable to face any sort of systemic failure? Perhaps they are simply choosing a lesser of two evils: a less valuable dollar vs. the risk of years of recession as we rid the banking system of bad assets.
It’s like getting over a heroin addiction – they would rather stuff us full of methadone rather than face a potentially devastating, but necessary, withdrawal period.
But my point is this: if the *end result* (years of inflation & stagflation) is essentially the same anyways, then really, what’s the point of intervention in the first place?
Stefan:
I think you overestimate the inmates of the Fed. Monetarist, Keynesian, or neo-classical, they won’t think outside their boxes. I think that is human nature. When everyone is drinking the same KoolAid, then it’s easy to ignore facts that are inconsistent with one’s theory.
Deflation will be out come. There is no chance in a weak economy of inflation taking hold. Banks are not lending, people do not want to borrow and are saving. The cash has failed to reach consumers.We already have growing deflationary forces and the Fed knows this and is terrified. Short of printing a few billion $ and dropping them from a helicopter to the punters which will be politically unacceptable and would create panic the authorities have and will fail to re flate the economy
HOW CAN WE DETERMINE IF WE ARE IN A DEFLATIONARY STATE ?
Not a bad question. If deflation is a declining money supply, then when it goes negative over a selected baseline, then you could say we are in deflation. Indicators of deflation are usually falling prices. The CPI is a hotly debated topic right now because the deflationists don’t think it’s accurate. I don’t either. But the CPI is declining which fits in with the fact that money supply has been declining since about January. See: http://trueslant.com/michaelpollaro/austrian-money-supply/