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

1. Inflation or deflation is a monetary phenomenon. An increase in money supply causes inflation. A decrease in money supply produces deflation. (Ceteris paribus.)
2. Price increases are a result of inflation, not inflation itself. The main impact of inflation is malinvestment.
3. The Fed has been trying to inflate the money supply to end the credit crunch.
4. The Fed’s inflation efforts have been mixed. Most banks are still not lending and credit and money supply have been declining.
5. 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.
6. 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.
7. 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.
8. 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.
9. 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.
10. Recent increases in consumer spending and consumer lending are temporary blips caused by government stimulus programs and are having no lasting effect.
11. Money supply has increased since the October, 2008 crash, but there are signs that it is beginning to decline again.
12. While the CPI has been increasing, increases are modest and are a result of the Fed’s less inflationary OMO purchases of MBS.
13. The current trend of the CPI seems to be declining.
14. 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.
15. 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.
16. 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.
17. This cleansing process is ongoing but is slow because the government has given banks incentives to delay the process.
18. 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.
19. The deflationists seem to conflate the concepts of deflation and deleveraging, which aren’t the same things.
20. A double-dip decline will put political pressure on the government to take any steps they can to thwart the decline.
21. An inevitable increase in unemployment will be politically unacceptable to the Administration and Congress.
22. The government will renew attempts at fiscal stimulus on a grander scale.
23. 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.
24. Inflation destroys real capital which will limit future economic growth.
25. The Fed has limited options to create inflation but they will attempt to do so by injecting money into the system through OMO.
26. One option is to buy Treasury paper, thus monetizing federal debt, which will ultimately create price and monetary inflation.
27. 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.
28. 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.
29. 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.

This is Part 3 of a 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 3

What Factors Will Drive the Economy?

This is the point where we need to look at some long-term trends in the economy to see how they will impact a recovery.

If our economy is based on consumer spending (70% of GDP) then GDP will see a decline in the second half of 2010.

In my article, Economic Megatrends That Will Drive Our Future, I point our seven megatrends that will impact our economy for the long term:

1. The culture of consumption is broken and won’t return to former levels. This is the key to everything.
2. Consumers will continue to increase savings to prepare for retirement.
3. Declining U.S. consumer demand will continue to negatively impact the world economy.
4. Deflation (deleveraging) will continue for some time.
5. Home ownership rates will decline to more historical levels of, say, around 66%, down from the high of 69% during the boom, which will keep a lid on home prices.
6. Government stimulus and recovery programs only delay recovery and deepen the pain for workers.
7. Massive federal deficits will double the national debt, result in higher taxes, and will act as a permanent drag on the economy.

I wrote this article in September, 2009, and it still stands. The significant things to note are No. 1 and No.2. Consumers are over-indebted and are doing their best to pay down debt. This article from the Wall Street Journal defines the issue:

After years of bingeing on debt, U.S. households are paring back. Those not doing so by choice are often being forced, because lending standards remain tight.

[T]he household sector’s debt level, which includes both consumer credit and mortgage loans, remained at about 20% of total assets in the first quarter.

In the mid-1990s that ratio was around 15%, compared with a peak in the first quarter of 2009 of about 22.5%.

Just getting debt down to 18% would require households to shed an additional $1.4 trillion of debt.

The way to pay down debt is to decrease spending and increase savings, especially when unemployment is at 9.7% and when real wages  (inflation adjusted) have been essentially flat:

J. M. Keynes referred to the phenomenon of increased savings and reduced spending as “hoarding” by consumers and believed it harmed the economy, which is why, he said, the government needs to spend in their stead. In fact, what consumers are doing is very rational economic behavior in light of uncertainty. Savings will actually lead the economy out of the recession by creating new capital to fund an economic expansion.

The main point here is that the consumption cycle for the majority of big spenders, the Baby Boomers, has changed, in my opinion, permanently. Boomers now realize that they need to save for retirement because Social Security won’t be enough, they don’t have enough financial assets, their home values will not regain their former highs, and they won’t inherit enough from their parents to help them in their old age.

This has significant impacts on the recovery and the inflation/deflation issue. That is because the politicians making policy decisions believe that Keynes is right. I’ll discuss this later.

Is Credit Unfreezing?

Recently lending has increased and excess reserves have decreased. Some have suggested that this is the beginning of the end of the credit freeze but I disagree.

This chart (TOTLL, YoY) reveals an increase in lending by commercial banks in Q1 2010:

This corresponds to a like decrease in excess reserves (EXCRESNS) during the same period:

This lending is evidenced by an increase in consumer loans in Q1 2010 (CONSUMER):

What happened was that consumers went on a mild spending spree. I believe that almost all of the increase in consumer spending had to do with government fiscal stimulus: Cash for Clunkers, Cash for Appliances, and the home buyer credit which has spurred sales in home improvement goods.

New car sales have been doing better as a result of dealer incentives. The data show that nonrevolving loans (NREVNCB), the measure for (mainly) auto loans (up 7.1% in April), went up dramatically in Q1 2010:

Retail sales increased during that period, but now it is declining, much to the concern of the Fed.

The latest Fed Flow of Funds report showed renewed declines in total credit as well as consumer credit. For Q1 overall household debt decreased for the seventh consecutive month (-2.4%). Consumer credit contracted 1.5%. Nonfinancial business debt was flat after four months of declines.

The Report said revolving credit, or credit-card use, fell a 19th straight time in April, down 12.0%. Further, personal savings are increasing again after the drawdown.

It appears that the temporary increase in consumer spending was not related entirely to money supply increases. Nonrevolving loans for autos increased, but a significant portion of general spending was fueled by personal savings of consumers. The following chart reveals that the rate of consumer savings (PSAVERT) declined in response to government incentives which favored certain industries (mid-2009 to Q1 2010). It appears that personal savings is starting to rise again, but we will need to watch the data to confirm such a trend.

The Fed’s Problem

The Fed has a dilemma.

On the one hand, if they believe we are in a strong recovery, then they are worried about inflation.

There was a lot of talk about recovery and the problem of what will happen when banks start lending again: banks will use their huge excess reserves which would cause money supply to explode, thus fueling “inflation” which they define as rising prices. This is what has been popularly referred to as the “draining the pond” or the “exit strategy” problem: how can the Fed sop up excess reserves before they hit the economy and cause rising prices? It is a very serious issue.

The Fed closely monitors CPI and, as shown before, prices are growing at the rate of 2% YoY. (I’ll discuss signs of a decreasing CPI rate below.) If they decide to decrease the money supply by raising the Fed Funds rate from nearly zero percent, they believe they run the risk of jeopardizing the nascent recovery.

For many months now most of the discussion by the Fed and most economists concerned exit strategy. Now the discussion has changed almost 180°: the buzz is now all about the possibility of deflation and economic decline. (See discussion below.)

For these reasons, I don’t think they are that concerned with inflation for the near term.

The Implications of a Double-Dip Decline

Temporary Effects of Stimulus

I think the economy is headed for a decline commencing at some point in the second half of 2010. I believe the Fed is concerned about this as well. Evidence of this is starting to show up in the numbers. The reasons for this are complex, but:

1. Most of the economic gains have been the result of fiscal stimulus which is running out of steam.
2. There has not been sufficient deleveraging in the economy by which banks have repaired their balance sheets.
3. The remaining huge real estate debt hanging over banks, especially commercial real estate, has not been dealt with because of various government policies that postpone the inevitable write-downs (mark-to-make believe, extend and pretend, housing credits, and delay and pray) and will restrict lending.
4. Monetary stimulus has failed to create viable economic growth.
5. These facts inhibit the creation of credit and will act like an anchor on the economy.
6. The long-term megatrends mentioned before will reduce economic activity and cause major shifts in the economy.

There is no question that consumer spending has been stimulated by government programs. Those programs are now coming to an end. Recent data showing a decline in retail sales surprised most economists.

The Wealth Effect

Another factor is that the stock markets have had a positive impact on families’ perceived wealth which has helped consumer spending. But, it appears that most of such spending has been from the wealthier segment of the economy. A recent Gallup poll showed that consumers earning more than $90,000 accounted for the bulk of that spending increase. A market stock decline will reduce this wealth effect.

Manufacturing Recovery

I believe our manufacturing recovery has been a result of cyclical factors unrelated to stimulus programs. As nervous retailers and wholesalers cleared out inventories in the early stages of the recession, at some point they had to restock. While unemployment is high, the fact is that at least 80% of the work force have jobs and, even though they may feel insecure, they still spend on what is necessary. That boosted manufacturing. But manufacturing without renewed consumer demand and a revival of credit will not lead us out of the recession.

Also, manufacturing has been benefited by the cheap dollar which has boosted exports. Other countries, especially developing countries, have been buyers of US products. But I think this is changing because of:

1. The dollar’s rise caused by Europe’s deep economic problems will reduce our cheap dollar advantage; and
2. China’s economy is based on exports and declining US and EU economies will impact its growth. Further they are facing a serious housing bubble that will burst the hard way. China needs an American economic recovery to save them, not vice versa.

It is clear that the American economy headed for a double dip decline, which I believe will occur in the second half of 2010.

Deflation Fears

I have noticed in the mainstream media that with increasingly weak numbers coming out recently there is a lot of talk about deflation. This is important because it is a reflection of mainstream economic thinking, which includes the Fed. Ben Bernanke reads the same headlines as you and I do.

Here are some recent headlines and the issues they raise:

CPI Declines

The consumer price index dropped 0.2% last month, the Labor Department said. The “core” rate of inflation–underlying consumer prices, which strip out volatile energy and food items and are closely watched by the Fed–rose 0.1% in May. …

This concerns shows up in Core CPI YoY (CPI less energy and food):

Deflation Fears Stir in Developed Economies

Deflation makes it harder for consumers, businesses and governments to pay off debts. Principal repayments on debt are fixed but deflation is marked by falling incomes, so as deflation sets in the burden of paying off old debts gets greater. …

That’s an acute worry today. In addition to government debt, U.S. households are still trying to work off large debt burdens built up in the last two decades. A Federal Reserve report Thursday [Flow of Funds report] showed households cut their borrowings in the first quarter to $13.5 trillion, down from a peak of $13.9 trillion in 2008.

Bernanke Warns on Deficits

Deflation isn’t a concern at moment

Bernanke Calls for Deficit Plan

Advancing a theme he has emphasized in the last few months, Mr. Bernanke said that if Congress pursued more fiscal stimulus to sustain the recovery, it should be accompanied by a concrete plan to bring the deficit back into line in the long run. Without a fiscal “exit strategy,” he said, the U.S. could, “in the worst case,” see financial instability like in Greece.

The Congressional Budget Office projects the U.S. deficit will hit $1.4 trillion this year, or 9.4% of gross domestic product. Even as the economy recovers, it projects deficits in excess of $400 billion a year later this decade.

Bernanke Urges Deficit Cuts

At a moment when many economists warn that the American economic recovery is likely to be imperiled by prolonged high unemployment and slow growth, President Obama is discovering that the tools available to him last year — a big economic stimulus and action by the Federal Reserve — are both now politically untenable.

Fed Weighs Growth Risks

But fiscal woes in Europe, stock-market declines at home and stubbornly high U.S. unemployment have alerted some officials to risks that the economy could lose momentum and that inflation, already running below the Fed’s informal target of 1.5% to 2%, could fall further, raising a risk of price deflation.

Martin Wolf on the Danger of Deflation

There is no world economy big enough to offset renewed contraction in Europe and the US. Concerted fiscal tightening could, in current circumstances, fail: larger cyclical deficits, as economies weaken, could offset attempts at structural fiscal tightening. …

Policymakers must recognise that deflation is a risk, too, and that tighter fiscal policy requires effective monetary policy offsets, which may be hard to deliver today, above all in the eurozone.

Premature fiscal tightening is, warns experience, as big a danger as delayed tightening would be. There are no certainties here.

S&P Warns of Rising Corporate Defaults

Small banks are big problem in government bailout program

Business Hold Record Amounts of Cash

The Federal Reserve reported Thursday that non-financial companies had socked away $1.84 trillion in cash and other liquid assets as of the end of March, up 26% from a year earlier and the largest increase on records going back to 1952. Cash made up about 7% of all company assets including factories and financial investments, the highest level since 1963.

You get the drift: the economy is not going as the Fed and most economists have predicted so naturally they talk about deflation. They are worried about the possibility of experiencing deflation similar to what occurred in the Great Depression.

Why Most Economists Have it Wrong

Most economists believe that more fiscal stimulus is needed now and that Bernanke’s cries for fiscal sanity must not be heeded or we will sink into a depression. This is a normal Keynesian reaction to the world. In fact the arch knee-jerk Keynesian of our time, Paul Krugman’s last three editorials have spoken to this issue. Across the pond Martin Wolf of the Financial Times has been beating the same drum.

I wish they would explain why all the fiscal and monetary stimulus the government has done since October, 2008 hasn’t worked yet. Krugman would just say government hasn’t spent enough. But then he always says that. Perhaps he should read some of Rogoff and Reinhart’s research on what government debt does to a country’s ability to recover. The fact is fiscal stimulus never works and never has. But it will leave us saddled with huge debt.

It would be a mistake to credit government spending on fiscal stimulus projects for any lasting economic gains. Since the government can ultimately only obtain money from taxpayers, it is only a shift of capital from individuals (i.e., the folks that make the economy function) to the government to fund projects it deems politically beneficial.

Government fiscal stimulus projects do not create any lasting economic benefit. While it is true that new roads and safe bridges benefit the economy, that is not the purpose of fiscal stimulus. The purpose of fiscal stimulus is to create “jobs” and stimulate consumer spending. Such stimulus is wasteful and never creates a viable economic enterprise which would continue after the money dries up.

One must ask what the private economy would do with the $62 billion already spent through the American Recovery and Reinvestment Act ($202 billion contracts, grants and loans awarded to date). I urge anyone who believes the spending through ARRA would stimulate the economy to check out the various contracts and grants that are being awarded. The main web site is Recovery.gov. You will see that most are repairs to federal facilities or grants for federal programs. I recommend you hold your nose while doing this. They are outrageous wastes of your tax money and they will damage the ability of the economy to recover and will place a great burden on future generations to pay them.

If government spending were the key to economic wealth then we should all be rich.

Tomorrow, Part 4. The Fed’s response to a decline, money supply, and the likely outcome.

After Part 4, I will publish the entire article as one downloadable PDF.

This is Part 2 of a 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 2

The Inflation Argument

The argument for inflation rests on the money supply charts. The inflationists show various measures of money supply increasing, including the version used by Austrian theory economists, called True Money Supply (TMS)[1]:

Note: The M1 chart shown in Part 1 more clearly shows the trend in the M1 money supply increase.

Again, the YoY percentage change is more revealing:

The inflationists also point to the Consumer Price Index (CPI) which shows price increases:

The YoY rate of change of the CPI clearer:

As the chart reveals, prices have been rising since mid-2009. Even the measure of Core CPI (CPI less energy and food, CPILFENS) appears to be rising:

The inflationists would say that this effect of inflation, rising prices, is a classic measure that proves new money is hitting the economy and that has caused, among other things, prices to rise.

The Deflation Argument

The deflationists have a different take on the data. They point to theories by economist Steve Keen which states that first banks make loans, and then the Fed increases money supply to meet demand. According to Keen and Mish, money supply is created first by banks making loans, then by the Fed supplying the money, because you can’t increase money supply without getting it into the economy. If there is no lending the money supply remains unchanged. Thus it is a rise in credit that leads to money supply growth.

Mish also argues that excess reserves don’t really exist; they are a fiction created by the Fed, a mere computer entry. If you consider all the loans made by lenders, and the actual or potential defaults of their loans, those losses would absorb all the “excess” reserves. Therefore, those “reserves” are more or less spoken for and don’t represent money for making new loans.

Mish also believes that reserves aren’t the problem with banks; rather it is their shaky capital base. Lending is constrained by their lack of capital and financial instability rather than by reserves.

The deflationists say that because the size and breadth of the crash in the real estate markets and related debt, the problem is too big for the Fed to handle. Until debt is deleveraged and banks and businesses repair their balance sheets, the Fed’s effort to increase the money supply is like pushing on the proverbial string.

The result is that real estate asset prices are declining and that results in deflation. They say it is similar to what the Japanese experienced in the late ‘80s and ‘90s, when they experienced almost zero growth, no inflation, and declining asset values. Banks, they say, are not going to lend until this deleveraging occurs and businesses become solvent and creditworthy.

The deflationists say that the current measures of prices are inaccurate because they don’t reflect the declining values of real estate. If real estate was factored in, then prices would be shown as declining. The only measure of real estate in the CPI computation is what is called the real estate rental equivalent which measures the rental value of homes rather than their asset value.

They suggest that prices are indeed falling anyway if you look at Core CPI (CPI less energy and food) on a year-over-year percentage change basis:

Obviously there is some evidence of declining prices as shown by this chart.

Which is it: Inflation or Deflation?

Let me suggest a way of looking at the problem.

We understand that inflation or deflation is a monetary phenomenon, not just an increase or decrease in prices. And, in order to cause inflation new money must find its way into the economy.

There are several ways the Fed can do that.

The Fed can make cheap money available by lowering the interest rate on money it lends out, which increases money supply. Even with the Fed Funds rate at 0.18%, effectively zero, this doesn’t seem to be working.

The Fed can make it easier for banks to lend. This seems to be a problem for the Fed right now. As we have seen previously, lending is way down, excess reserves are high, and the money multiplier has fallen dramatically. This hasn’t worked either.

Yet money supply has been increasing despite the failure of these policies.

There is another tool in the Fed’s arsenal called Open Market Operations (OMO) whereby it buys and sells securities with its primary dealers. For example, buying Treasury paper from dealers increases money supply and selling decreases money supply.

Starting in January 2009, the Fed began a program of buying mortgage backed securities (MBS) issued by Fannie, Freddie, and Ginnie Mae. At its peak, they bought $1.25 trillion of these assets, pumping up money supply by that amount. The purpose was to get liquidity into the economy and try to revive credit and economic activity. Further it absorbed the risk of these “toxic” assets, relieving the former holders of their bad investment decisions.

This form of money inflation does not have the impact of the money multiplier were those funds in the hands of bankers who would lend out the new money, but it does represent a substantial amount of new money injected into the system.

This money infusion is being used by the very willing sellers of these toxic assets, the big investment banks or the investment banking operations of the big commercial banks, not so much for  making loans, but for their own investment purposes; this money has been driving the financial markets.

Deflationists vs. Inflationists vs. Modified Inflationists

This is the point where the inflationists and deflationists part. The inflationists believe that the Fed can and will increase the money supply any time they wish through open market operations. The deflationists believe it doesn’t matter what the Fed will do because banks are not in a position to resume lending, thus counteracting the Fed’s attempts at increasing the money supply.

I have a different take on this, but it is a bit complicated to explain. To try to put it in a nutshell:

1. I don’t agree with the deflationists that we will be just like Japan: continued deflation which would be the result of keeping alive bankrupt (zombie) banks and corporations.
2. I part a bit with inflationists because I don’t believe Open Market Operations will have the inflationary impact they believe will occur. I believe that bank lending, the best tool for inflating money supply will remain constrained and be a drag on the economy.
3. I believe that as the economy goes into a double-dip recession, the Fed will create ways to inflate that will be effective.

I refer to my position as Modified Inflationism.

Predictions and a Decision Tree

Here is the problem in trying to forecast what will happen in the future: tell me what the Fed and the government will do. Remember the Freakonomics’ humorous take on forecasting:

The future will be different from the present to some degree and some point, and I have anecdotes and hearsay to prove it.

Austrian types don’t believe that you can use econometric models to predict the future because such models are usually wrong. You can’t distill millions and millions of economic decisions down to a simple or even complex formula of human behavior because the data set is too vast to be useful. We believe you have to understand why individuals do things in the economy first before you can study data. These were some of the breakthroughs of the great economists Mises and Hayek.

To figure out what the Fed might do involves a lot of probabilities. And that is my method of analysis: what are the probabilities that the Fed will do one thing rather than another when faced with different circumstances. It is much like constructing a decision tree to see where they can go. If X happens, then the Fed’s choices are A, B, and C. What are the consequences of each and what is more likely to happen.

Stick with me.

Tomorrow, Part 3. The double dip economy, the Fed’s choices, and their fear of deflation.

After Part 4, I will publish the entire article as one downloadable PDF.

[1] The True Money Supply (TMS) was formulated by Murray Rothbard and represents the amount of money in the economy that is available for immediate use in exchange. It has been referred to in the past as the Austrian Money Supply, the Rothbard Money Supply and the True Money Supply. The benefits of TMS over conventional measures calculated by the Federal Reserve are that it counts only immediately available money for exchange and does not double count. MMMF shares are excluded from TMS precisely because they represent equity shares in a portfolio of highly liquid, short-term investments which must be sold in exchange for money before such shares can be redeemed. It includes: Currency Component of M1, Total Checkable Deposits, Savings Deposits, U.S. Government Demand Deposits and Note Balances, Demand Deposits Due to Foreign Commercial Banks, and Demand Deposits Due to Foreign Official Institutions. There are different takes on TMS. See http://mises.org/content/nofed/chart.aspx?series=TMS.

This article is presented in four parts. It 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 1

The Problem

The economy is not acting according to plan. At least not the plan devised by the Fed or the Obama Administration. According to the plan we should have liquidity flowing through the economy and the credit crunch should be over. In fact we should have moderate inflation by now. Government likes inflation because it gives the false impression that things are doing better than they really are: people confuse rising prices and wages with economic gain. As well, debtors, especially the government, can pay down debt with newly minted dollars. But the signals from the economy are mixed: mild inflation yet we still have a credit crunch as credit has continues to contract. Initial enthusiasm for a “recovery” is now giving way to concerns about deflation.

So what is it to be: inflation or deflation?

The Dispute

There is a rather significant running argument going on in the Austrian economics theory community about whether we are experiencing inflation or deflation. Further there are the gold bugs who are predicting, as they have for many years, hyperinflation. The deflationists are led by Mike Shedlock, known as “Mish” who argues that we are seeing deflation and that it will continue for some time. The inflationists are a variety of folks, but the loudest voice and harshest critic of Mish is Gary North. The most credible inflationists are Bob Murphy, a well known Austrian school economist, and Frank Shostak, chief economist for MF Global, formerly the trading arm of Man Financial, the world’s largest hedge fund. They insist that we are seeing inflation now and that more is coming.

I will side with the inflationists but I think Mish makes some valid points and that his timing has been good. I would say that some inflationists have been excellent on theory, but less accurate on timing. I call my position Modified Inflationism.

Predictions: All Signs Point to Yes

It’s easy to make predictions, but difficult to get it right. A recent Freakonomics column in the NY Times by Stephen Dubner gave this humorous quote on economic prognostication:

The future will be different from the present to some degree and some point, and I have anecdotes and hearsay to prove it.

My point is that it is not easy to make accurate predictions about the future, and when intelligent people make them they are sticking their necks out, a brave thing to do, but fraught with uncertainty which few of them are willing to acknowledge. We need to consider the implications of randomness in our world where it is hard to know if the prognosticators were right or just lucky. I am not saying that it is impossible to differentiate between luck and skill, but that it is very difficult.

I have found that the best economists and prognosticators derive from the Austrian School of economics, to which I subscribe. These free market gurus stem from a remarkable intellectual tradition, and are the only ones, I believe, to have created a valid theoretical background on human social behavior, which, if one thinks about it, is what economics is.

The problem with forecasting inflation is that we need to be able to predict what the Fed will do under certain circumstances, and how the Fed’s bosses, the politicians, see the world.

With those caveats in mind, I am going to stick my neck out.

What is Inflation?

The first thing we need to understand is what inflation is. It is not rising prices, but rising prices are an indication and one result of inflation. There are impacts other than rising prices. The most significant impact is that capital is misdirected into activities that, but for lower interest rates, would otherwise be unprofitable (malinvestment).

Inflation is purely a monetary phenomenon. It is an increase in the supply of money, assuming that demand for money remains the same.

If everyone woke up one morning with twice as much money as the day before, then people would be buying goods at an increased rate and, since the supply of goods aren’t infinite, prices go up. The fact that we all have twice as much money doesn’t mean we are all wealthier, it just means that we have more pieces of paper to spend. For those who wish to understand why our paper money is not wealth, then please see my article, “Money: A semi Fictional Fable.”

The greatest problem people have with understanding inflation is confusing it with rising prices. For example, the argument goes that if oil prices increase it causes inflation because oil’s use is so pervasive in the economy that it causes all prices to rise. But that isn’t the case. If money supply remains constant, and if I have to spend more money on gasoline, then it means that I will have less money to spend on something else. Thus there is less demand for the goods that I would have otherwise bought and their prices decline. This is a response to supply and demand of goods: some prices go up, some go down. But it isn’t inflation.

Deflation is the opposite of inflation. All things being equal, if the supply of money declines, then prices will also decline because there is less money chasing the same amount of goods.

Money Supply and the Credit Crunch

To cause inflation then, we need to increase the supply of money. To have deflation we need to decrease the supply of money. There are many complexities to the theory and disagreements within the Austrian community, but I’ll stick with my general definition for the moment.

This article is not meant to be a treatise on money and banking, but a few concepts are important to understand.

It is relatively easy to see what money supply is doing. While there are many components to it, and it is a complex topic, there are measures of money that most people use.

Money base[1] is the primary monetary measure of currency in banks and circulating in the economy, and bank reserves held at the Fed. When the Fed starts pumping money into the system, this shows up as money base.

This chart (BASE) shows what the Fed has been doing since the October 2008 crash. As you can see they doubled the money base, and then increased it again to 2.5X by Q1 2010.

The rate of year-over-year (YoY) change in money base is shown in this chart below. You will note the volatility as shown by the verticality of the increases and decreases.

This shows how the Fed was countering the contraction in money supply and credit during the initial stages of the crash. The idea was to provide enough liquidity for financial institutions so they wouldn’t go bankrupt. Economists refer to this as “quantitative easing,” (QE) or monetary stimulus which is a concept of Monetary theory (Milton Friedman and Irving Fisher), of which Ben Bernanke is a follower. Mr. Bernanke also seems to also be Keynesian in his acceptance of fiscal stimulus.

The crash, the rapid decline of real estate asset values, and the questionable value of real estate and consumer loans, led to the credit crunch. As we all know credit dried up, consumers retrenched, business contracted, loan defaults took off, and only the biggest institutions had access to credit at the Fed’s commercial paper window (Commercial Paper Funding Facility). At one point the Fed was responsible for about 90% of the U.S. commercial paper market—almost $350 billion. Major institutions were also backed up with TARP money.

Money base must find its way into the economy to affect the supply of money. The M1 money supply measure (currency in circulation plus demand deposits) immediately jumped.

But the problem was that much of this cash didn’t find its way into the economy. Take a look at what banks did with the new money: they held much of it as excess reserves (EXCRESNS):

The significance of excess reserves is that it is a good indicator of liquidity in the system. These reserves are considered “excess” when they exceed the regulatory requirement for the reserves a bank must hold. As you can see, prior to the crash, excess reserves were nil, reflecting banks’ willingness to lend.

The reason for high excess reserves was that banks were not lending, for very good reasons.

First, their own balance sheets were in jeopardy. Their loan losses grew and in order to meet regulatory requirements, they were uncertain how much capital they would need. Banks didn’t understand the depth of the crash and the impact of the world’s biggest debt induced boom would have on their loans. An uncertain future caused banks to pull in their loans in order to preserve capital. It was obvious that as their loans soured, good borrowers were harder to find. Bankers respond rationally to uncertainty: protect their depositors and their loans. If you don’t think a lender will be able to pay you back, you won’t lend money.

Second, they were unsure what the response of the regulators would be regarding capital requirements, especially what is called Tier 1 capital. It made good sense to hold on to the vast amounts of credit the Fed was providing in order to hedge regulatory uncertainty.

As I have been saying, there were valid economic reasons for banks to hold large reserves; there was nothing “excess” about them.

The impact of high excess reserves shows up as a decline in the M1 multiplier which means that bank lending collapsed. The M1 Multiplier is the multiplier effect of fractional reserve banking from an increase in the M1 money supply. If banks only have to keep 10% of deposits on hand and can lend out 90%, the money effect is multiplied many times. If Bank A has $100 of new money, it can lend $90 to Customer A. Mr. A spends the money which ends up in Bank B, thus increasing their deposits and enabling them to lend out 90% of it, or $81, and so on. The multiplier (10:1) basically turns $100 new dollars into almost $1,000 as it goes through the economy.

Post crash the M1 multiplier collapsed:

This shows the credit crunch as bank lending dropped off a cliff.

The below chart of commercial banks loans (TOTLL) shows what happened to loans:

It is easier to see from the YoY percentage change:

This is the classic credit crunch. No one can get a loan from banks. Large corporations were able to go directly to the Fed, but most businesses and consumers could not get a bank loan.

Consumer credit, the mother’s milk for consumer spending (70% of GDP) dried up:

When consumers don’t spend, the economy goes into recession.

Tomorrow, Part 2. The inflation and deflation arguments.

After Part 4, I will publish the entire article as one downloadable PDF.

[1] See the Wikipedia article on the definitions of money aggregate measures. http://en.wikipedia.org/wiki/Money_supply

In the meantime, here is more amusement for you, via Onion. Enjoy!

U.S. To Trade Gold Reserves For Cash Through Cash4Gold.com

Hat tip Byran H.

This was a longitudinal study based on surveys mailed out to over 25,000 graduates from Florida Atlantic (FAU), Nebraska-Lincoln, North Carolina (UNC), and Purdue. The surveys were done in 1976, 1986, 1996, and 2003. They broke down majors into three broad categories–economics, business, and general (not the other two majors).

They concluded that econ majors were statistically significantly likely to be Republicans. They also found that econ majors were more likely to donate money and volunteer on behalf of candidates. Further it found that business majors behaviors were no different than genral majors.

Here are the significant results:

[O]ur results clearly suggest there is more to the story than simply “being educated” – so that what people study in college, or what they choose to study, is associated with their civic behaviors many years after they graduate.

Most previous studies that look at the link between education and civic behavior simply include a control for the amount of education a person has. This implies “being educated” influences a person’s civic behavior, but it ignores the possibility that the content of what a person is learning might also influence behavior.

Our analysis shows several statistically and economically significant associations between coursework in economics, or majoring in economics or business, and later civic behavior, including party affiliation, making donations to political parties, and volunteerism. …

To briefly preview our results, those who took more economics classes or who majored in economics or business were more likely to be members of the Republican party and less likely to join the Democratic party. Those findings hold even after controlling for the higher salary, higher equity in real estate holdings, and earning a graduate degree.

Without controlling for salary, the value of real estate holdings, and graduate degrees earned, we found that with a higher number of economics classes taken increased the likelihood that a person had donated money to a political party or campaign. …

The number of economics courses completed by the graduates of these four schools significantly decreases the likelihood that a person does not join a political party and the likelihood of joining the Democratic party, while the number of economics courses is positively related to the likelihood of joining the Republican party. For example, taking five economics courses is associated with an eight percent decrease in the likelihood of joining the Democratic party and more than a 10 percent higher chance of joining the Republican party. These marginal effects are large relative to the unconditional means reported in Table 1. For example, approximately 40 percent of respondents report being members of the Republican party, so a 10 percentage point increase for 5 economics courses represents a 25 percent increase. …

However, business majors are less likely than General majors to participate in time consuming activities such as voting in the 2000 Presidential election or volunteering, and when they volunteer they volunteer for fewer hours than do General majors. … Our estimates reveal the somewhat surprising result that the attitudes of business students on public policy are more similar to General majors than to Economics majors.

I think what this means is that if you have some understanding of how the economy works, you realize that business and commerce is harmed by legislation rather than helped by it. While we know that the Republican Party is not a bastion of free market economics, if you are painting with a very broad brush the Republicans are viewed as being more pro-business and more anti-government than the Democrats. And I think that is why econ majors tend to be Republicans.

I understand that much of what is taught in economics classes these days in Keynesian or Monetarist as far as Fed policy and the government’s role in the economy, so please don’t jump down my throat. But the basics of economics do teach supply and demand, business responses to taxation and regulation, and the role of business in creating jobs. It is interesting that the more econ courses one takes, the higher the likelihood is of being Republican.

I, for one, think this is a hopeful conclusion. Imagine if we were able to teach the basics of Austrian theory economics in every college in America. The Libertarians would win.