Before I start I wish to say that I highly respect David Rosenberg at Gluskin Sheff, one of the few mainstream economists to call the crash, and whose observations about the markets are always worth reading.
This morning he came out with a long-term analysis of inflation which I don’t think is right. I urge you to read his commentary, below, but in general he sees one to two years of continuing “deflationary” pressure that favors the bond market and he says “inflation” will be at zero. He then see the beginning of “inflation” as the result of war and the need of government to fund it. The result, he says, will be high inflation and perhaps hyperinflation.
While you would think as a fellow doom and gloomer I would hop on his bandwagon, but for the most part I think Rosenberg’s analysis of the forces behind inflation and deflation are wrong. He uses historical analysis to prove his point, but he doesn’t explain the underlying factors that cause inflation or deflation, which, as I have discussed before, have to do with increases and decreases of money supply by the Fed.
He assumes that Boomers will cut back on consumption and increase savings. I agree and I went into detail on that in my Megatrends and other articles. He says that will result in “deflation.” But deflation is a monetary phenomenon, not a savings problem or lack of consumption problem. We will see deflation because money supply is declining, and it has been declining since late last year. … Continue reading The Problem With Rosie On Inflation
I’ve noticed more articles expressing concern about deflation. In addition to this article today from the Wall Street Journal (Deflation Defies Expectations—and Solutions), there was another one today from the L.A. Times. The Journal piece was written by a good reporter, Jon Hilsenrath, but it demonstrates no real understanding of what deflation is. In fact this is the premise of the article that “economists” don’t really understand deflation:
The old bogeyman of deflation has re-emerged as a worry for the U.S. economy. Here’s something else to fret about: After studying more than a decade of deflation in Japan, economists have slowly realized they have no idea how it works. …
Economists don’t have good answers. “We don’t know how deflation works,” says Adam Posen, a member of the Bank of England’s monetary policy committee who has been studying Japan since 1997. “We don’t have a way of rationalizing steady, several-year flat deflation,” he says.
Actually some economists do understand deflation. Keynesian economists don’t understand business cycles in general, inflation or deflation. Inflation and deflation are monetary phenomenon. If money supply increases, that is inflation. The ensuing and inevitable rise in prices is one of the results of inflation, not the cause. Inflation decreases the value of the currency which most people see as rising prices. It does a lot of other bad things as well.
Deflation is the opposite: it is a decline in money supply. The result is that the purchasing power of the currency goes up. In a deflation, creditors are at an advantage as loan payments don’t go down, but the debtor has to pay in dollars that are more valuable, leaving him in a worse position; in inflation debtors are favored because they can pay creditors with cheaper dollars.
Hilsenrath brings up the quandary of the Phillips Curve which says you can’t have inflation with excess industrial capacity: until industrial capacity is near full utilization, manufacturers can’t raise prices. The only problem is that this isn’t true. Stagflation in the 1970s showed that you could have excess capacity and inflation. This is because it doesn’t have anything to do with prices, but rather money supply. … Continue reading Economists ‘Don’t Understand Deflation’
This link will allow you to download a PDF version of the complete article, “Will We Have Inflation, Deflation, or Hyperinflation?” This may be more convenient for readers who which to take in the article as a whole. If you have problems with the download, please let me know. You are free to distribute [...]
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? … Continue reading Will We Have Inflation, Deflation, or Hyperinflation? Part 4 (Final)
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:
- The culture of consumption is broken and won’t return to former levels. This is the key to everything.
- Consumers will continue to increase savings to prepare for retirement.
- Declining U.S. consumer demand will continue to negatively impact the world economy.
- Deflation (deleveraging) will continue for some time.
- 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.
- Government stimulus and recovery programs only delay recovery and deepen the pain for workers.
- 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. … Continue reading Will We Have Inflation, Deflation, or Hyperinflation? Part 3
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. … Continue reading Will We Have Inflation, Deflation, or Hyperinflation? Part 2
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. … Continue reading Will We Have Inflation, Deflation, or Hyperinflation?
You’ve noticed that I haven’t posted recently. There is a lot going on in the world that I will be reporting to you. But, I decided that I needed to do some fundamental research into what I believe is the most pressing issue in the economy right now. It is an issue that will [...]
In its latest outlook, the Fed said:
“Even though the recovery appeared to be continuing and was expected to strengthen gradually over time, most members projected that economic slack would continue to be quite elevated for some time,” according to the report, which doesn’t identify the specific governors or regional-bank presidents making comments.
Officials expected inflation to remain “below rates that would be consistent in the longer run with the Federal Reserve’s dual objectives” of maximum employment and stable prices, the minutes said.
They believe that as long as there is excess industrial capacity, we won’t have inflation.
The hot topic running through the halls of the Fed is: When should it dump the $1.1 trillion of mortgage related debt and securities it bought? In a program which tried to suck bad assets out of the banks to create liquidity in the system, the Fed went on a buying spree of these assets which ended in April of this year.
The data reveals that their policy has been a failure because bank credit and money supply are still declining. The result of their policy was to inject the trillion dollars in the pockets of the big banking houses who were more than pleased to dump these “toxic” assets as they were then called.
When they start to sell these assets it will be an attempt to “drain the pond” of the same trillion dollars they put into these banks. Theoretically this could lead to a tightening of the money supply which they view as being too high. The fear is that if they do it too soon, they may raise interest rates, increase the liquidity squeeze, and put a brake on economic recovery. If they do it too late they fear inflation. What’s a central bank to do with such a dilemma?
What is interesting is the Fed’s lack of understanding of the dynamics of inflation. They take the mostly Keynesian view that because we have idle industrial capacity, the risk of creating inflation right now is very low. In other words, injections of cash into the economy will not have an inflationary impact on prices because, until we are at near full industrial capacity, prices won’t rise.
This concept is wrong.
… Continue reading The Fed Has No Idea That It Causes Inflation
Another unexpected event rocks the hallways of the Treasury, the Fed and Academia as the Bureau of Labor Statistics reported today that the consumer price index unexpectedly fell 0.1% in April, the first time since March, 2009. You may recall that Bernanke, Summers, Geithner, Christina Romer, and Krugman believe that modern economics can easily [...]
I try to put the data in the news in perspective for you. One could easily be confused by seemingly conflicting data that we’re bombarded with daily. There are some signs of improvement, but most of these are related to cyclical factors or the remnants of fiscal stimulus.
The most threatening problem is the continuing credit freeze. Large banks have ceased tightening lending standards, but the smaller banks which do most of the small business loans in America are still tightening. Further, businesses aren’t taking on the risk of borrowing more money. They prefer to remain lean.
The other issue is commercial real estate. Nothing has changed here. It’s still a big threat to most small banks. In a footnote to Bernanke’s House testimony on Thursday, in the discussion about the Fed’s exit strategy, the “extend and pretend” rules under TALF for CMBS have been extended for another three months. That won’t help the recovery.
Cyclical factors indicate that unemployment is starting to soften. Firms can only fire so many people at this stage of the cycle in order to stay in business. Durable goods orders firmed up and that appears to be a response to retailer’s orders for consumer goods as the orgy of inventory depletion has run its course. Also, manufacturers are getting great deals on software, computers, and machinery. I don’t expect economic activity to improve substantially. Look for further deterioration starting sometime in Q3 or Q4.
Here’s my analysis of the significant data:
Cash For Homes Has Played Out
Home sales and home prices continue to decline. The National Association of Realtors announced that existing home sales declined 0.6% in February on a seasonally adjusted basis. This is the third straight decline after the tax credit steroid induced bump last Fall. The median home price declined to $165,100, a 1.8% decline. The credit will expire next month and it seems as if all the sales the tax credit induced has been squeezed out of the market.
[T]he Commerce Department said sales of new, single-family homes fell 2.2% in February from January to a seasonally adjusted annual rate of 308,000—the lowest level since records began in 1963.
More troubling is that the supply of homes for sale have risen to 8.6 month from January’s 7.8% supply. Inventory is rising and we still have a looming shadow market. Estimates are that more than 1 out of 4 homeowners is underwater: … Continue reading Notes On February Data: Housing, Credit, and Inflation
We think that China is an indestructible economic juggernaut but its economy is very fragile and it is sitting on a property bubble which will burst. What China does in response has major implications for their economy and the rest of the world. This is the first part of a three-part series on this topic.
We are told that China has huge housing needs, that demand will continue for decades, and that prices have nowhere to go but up. But that’s not how economics works for housing or for any other product. It may be true for China’s long term, but the short run can kill you.
Having been in that business, we were told here that America’s long term growth potential was almost limitless, that new family formations, immigration, and abundant financing would continue to drive the housing market higher. And remember, they said housing prices had never declined on a national basis in the last 60 years.
“They” were wrong as it has now been painfully revealed to us. There are many factors affecting the supply of and demand for housing. And prices do go down, dramatically. So, when you hear that China’s housing market will grow in a linear direction and that its economy will not be impacted by a housing bubble, you can evaluate that statement in light of recent history.
4 Important Things to Know About China
Before I go into the details of what is happening in China right now, there are four things about China to consider.
First, most economic statistics from China are inaccurate. This is the result of state, top-down driven economic planning. The nice thing about a planned economy is that they can pretty well dictate what GDP will be because of the way they calculate it. What they mean by “GDP” is very different than what other countries mean by GDP.
China counts the funds that are distributed from Beijing to local governments and entities as spent when distributed. Retail goods are calculated as sold when factories ship goods, not when they are purchased by consumers. This is an artifact of communist central planning that brought them the ruinous Five Year Plans and the Great Leap Forward (Backward) of Mao Zedong.
Local or regional bureaucrats responsible for allocating resources or implementing policies are often corrupt, inept, and lie about the results of their efforts. What comes to mind is the school in Sichuan province (the so-called “tofu-dregs schoolhouse”) that collapsed during the earthquake in 2008 because local officials were bribed, paid off, colluded, whatever, by the contractor who was responsible for the shoddy product. You can multiply that ten thousand times. No one knows what is really spent and what goes into the pockets of corrupt officials.
Second, local and regional governments and state-run enterprises are in serious financial trouble because of the real estate bubble. A big revenue source for local and regional governments is from land sales to developers. We’ve all heard the stories of landowners and tenants getting kicked off their land to make way for a new block of homes or condos. Their compensation is small, and you can guess where a lot of the money goes. The local entities borrowed lots of money to finance developers. Beijing is so worried about the financial solvency of local governments that Premier Wen Jiabao announced at the National People’s Congress last week that it will issue 200 billion yuan worth of bonds on behalf of local governments.
In a “worst-case scenario,” the non-performing loans of local-government investment vehicles could climb to 2.4 trillion yuan ($350 billion) by 2011, Shen Minggao, Citigroup’s Hong Kong-based chief economist for greater China, said yesterday.
“The most likely case is that the Chinese government will engineer a massive financial bailout of the financial sector,” said [Northwestern University Professor Victor Shih] who spent months researching borrowing by about 8,000 local government entities. …
Su Ning, a deputy governor at China’s central bank, said March 8 that a “fairly high proportion” of total lending last year went to the funding vehicles. Chinese banks extended a record 9.59 trillion yuan of new loans in 2009. Su sees “a big risk” from local-government guarantees for money borrowed to fund infrastructure projects that may not generate returns, he said in Beijing.
… Continue reading China’s Fragile Economy, Its Housing Bubble, and What It Means To Us: Part I
The core Consumer Price Index fell for the first time since 1982–0.1%–in January. Economists are lauding this deflation as a good thing on the theory that it gives the Fed more flexibility: in keeping interest rates low, as they have been doing, they don’t have to worry about inflation. I’m not sure what they mean by that since it has been the policy of the Fed to try to create inflation as a way to get out of our recession. It hasn’t worked.
If I’m not mistaken, just a few months back economists were worried about a deflationary tailspin and a further decline in employment. It was felt that whenever the Fed needed to, it could, and should, gin up a little inflation and bail us out of a deflationary spiral. There has been no shortage of credit poured into the economy by the Fed, otherwise the Fed wouldn’t need an exit strategy, yet the very thing stimulus and easy money was supposed to prevent, deflation and unemployment, stubbornly refuse to disappear. The Fed points to green shoots (GDP Q4 gain of 5.7%) such as the increase in manufacturing activity, auto sales, and health care expenditures. But …
It is not a coincidence that WalMart experienced it first ever decline in its U.S. same store sales. WalMart, which accounts for about 10% of all retail sales in the U.S., noted that heavy discounting (deflation) in food and electronics lowered the overall value of its sales. The strong corporate profits we are seeing so far have resulted from efficiencies rather than increased sales for the most part, and this can’t continue much longer–you can only fire so many people, shorten work week and cut slack to a point and then sales have to kick in. As well, inventory restocking will only boost the economy so far until the consumer goes shopping again.
According to classic Monetary and Keynesian theory, flooding the economy with money stimulates the economy, causes prices to rise, and consumer spending and general economic activity resume. Why hasn’t the Fed’s inflationary policy worked? Why is credit continuing to dramatically contract? Why are prices falling? … Continue reading It’s Supposed to Work: The CPI and Further Adventures in Keynesian Policy
The U.S. and Japan face similar economic problems and they are trying to solve them in the same way: fiscal and monetary stimulus. It hasn’t worked for Japan and it won’t work for the U.S. Japan just received a downgrade warning from S&P over their credit rating and the U.S. [...]
By Jeff Harding.
This video was sent to me by Dan Mitchell at Cato. Dan presents an excellent summary of why government spending is harmful to the economy and prosperity. Whether or not it results in deficits, the greater the spending by government as a percentage of GDP, the greater is the negative impact on the [...]
By Jeff Harding.
I get research data from McKinsey and they had this neat chart on the global housing cycle which I thought was interesting. You can see why the UK, Ireland, and Spain are in such bad shape.
It seems that housing bubbles are one of our chief exports.
Here are a [...]
Japan vs. U.S.: Compare and Contrast
By Jeff Harding.
Japan has been in decline, or at least stagnation, for 19 years. Their GDP has not grown, unless you consider 0.6% (avg.) robust annual growth. They have experienced a deflationary economy, and now, it’s happening once again. They now have the highest national debt as a percentage of GDP than any other major economy. It has been argued that the U.S. is catching this Japanese “disease” and that not only will we have continued deflation, but also stagnation.
I went back and read my background material on Japan’s economic history, starting with the Bank of Japan’s money pumping in 1986, and was startled to see the similarities between the policies of Japan to stimulate its economy and what we are now doing. My last major article on this topic, The Japanese Disease, was written in January, 2009, just as our government was ramping up their fiscal stimulus programs, and things have changed quite a bit since then.
It is easy to say that because we have adopted many of the same Keynesian policies that failed in Japan, not only will they fail here, but that the economic results will be identical. As I write this, I am not sure the economic results will not be the same, but I think there are several major differences between Japan and the U.S. that may lead us to somewhat different results. It depends what the government will do.
Here’s a quick summary of Japan’s experience (excerpted from my January article):
They started with a huge credit expansion. Their discount rate was cut from 4.4% to 2.5% in 1986-1987. The result:
- Real estate and equity prices soared.
- To counter the speculative boom, the discount rate was raised in 1989-1990 from 2.5% to 6% and their markets crashed.
- The Nikkei went from 40,000 in 1989 to 11,000 in 2005. Real estate values plummeted 80%.
- GDP grew at only 1.17% from 1992 to 2003.
- Unemployment went from 2.1% in 1991 to 4.7% by 2004 (a very high rate in Japan).
- Consumption and investment fell dramatically.
- Banks were not lending.
What was the response of the government to this crisis?
- In order to kick-start the economy, the government went on an infrastructure spending binge and cut taxes.
- From 1992 to 1995 they spent ¥65.5 trillion on projects and cut taxes.
- In 1998 they cut taxes ¥2 trillion.
- In 1998 they spent another ¥40.6 trillion on spending stimulus.
- In 1999 they spent another ¥18 trillion in fiscal stimulus.
- In 2000 they tried another ¥11 trillion spending package.
- They set up a ¥20 trillion fund to lend directly to businesses (the Financial Investment and Loan Program [FILP]).
- To try and push money into the system the Bank of Japan and Ministry of Finance bought more than half of existing government bonds from the private market at a cost of ¥2.22 trillion.
- Trying monetary policy, they lowered the discount rate from 4.5% in 1991, 3.5% in 1992, 1.75% 1993-1994, to 0.5% 1995-2003.
- They set up a $524 billion bailout fund in 1998 to buy stock in failing banks or nationalize them.
It is estimated that the Japanese spent about $1 trillion about (¥135 trillion) to cure their financial problems. But the problems lingered, banks remained weak, lending and investment was severely reduced, unemployment was high, government debt went to more than 150% of GDP [it's now 200%], and the yen devalued. Nothing seemed to work.
Remember some of the hallmarks of the Japanese experience? “Zombie Banks” were banks that the government allowed to keep their doors open although they were really insolvent. “Zombie Corporations” were the companies whose debt were held by zombie banks, but were allowed to stay in business because the zombie banks didn’t write off these loans. “Window sitters,” a term applied to workers of zombie companies who showed up for work every day for a paycheck, presumably gazing out the window all day with nothing to do.
The irony of it is that they are trying the same things again in this crisis, with the same results. The Bank of Japan just predicted two years more of deflation, and unemployment is up to 5.5%. Exports, the mainstay of their economy, are falling off a cliff (11 straight months of decline). It reminds me of a definition of insanity: expecting a different result to occur from the same input, over and over again.
Does the Japanese scenario sound familiar? It should since we are doing most of the same things as they did.
- The Fed reduced the Fed Funds rate to 0.25%.
- The government has hugely increased the base money supply in an attempt to create inflation.
- The government has spent or pledged about $2.7 trillion dollars in direct loans, bailouts, debt purchases, grants, and wasteful spending projects.
- The guarantees to Fannie, Freddie, Sallie, and the FHA, plus additional backstop guarantees by the Fed and the Treasury amount to almost $10 trillion.
- The Obama Administration expects the national debt is to increase by almost $10 trillion over the next 10 years (a very conservative number considering the new national health care plans). This will get us to a national debt of about 200% of GDP.
- Programs like Cash for Clunkers, Cash for Refrigerators, and Cash for Casas are trying to stimulate consumer spending and increase consumer debt.
- Like Japan, mark-to-market accounting requirements for banks have been partially suspended.
- The Fed has been directly financing corporations through its commercial paper lending window.
- TARP, TALF and the host of other programs were implemented to keep bankrupt institutions afloat.
- They have been buying stock in financial and commercial companies.
- They have been buying U.S. debt, effectively partially monetizing the deficit.
It is not surprising that these policies have led us to many of the same results as Japan experienced:
- Deflation.
- Collapsing real estate values.
- A shrinking money supply.
- Decreased bank lending.
- Falling consumer spending.
- Falling consumer credit.
- Increased federal debt.
- Falling GDP.
- High unemployment.
One might ask, with all this faith in Keynesian policies, why aren’t they working? Why are we still having these problems? And, why aren’t we doing something different than Japan? … Continue reading Will We Have a Lost Decade(s) Like Japan?
By Jeff Harding.
Dr. Frank Shostak is Chief Economist for MF Global, the former trading arm of Man Financial, the world’s largest hedge fund. Man spun off MF Global as a stand-alone company. I believe he is the best (Austrian school) economist out there in applied economics because he makes his living prognosticating for a commercial investment firm.
I am republishing in its entirety his most recent article, “Is the Fed’s Pumping Inflationary?” from the Mises Institute site where his articles appear. It is a very important article because he believes that (1) we will see substantial inflation, and that (2) “real savings” formation is being eroded which will inhibit economic growth. Regular readers will find this material familiar.
Dr. Shostak’s writing is very clear but it is highly condensed which makes careful reading a necessity. I am adding a synopsis to make it more understandable to those not familiar with Austrian theory. I have also italicized some of this key ideas. This makes this a fairly long article, but it’s rewarding, so please bear with me.
Synopsis
The Fed has a difficult task. It flooded the financial system with credit in order to prevent what it perceived to be world financial collapse. While it believes that its efforts have succeeded, it now has to contend with the threat that this ocean of money and credit it created will result in massive inflation.
Money supply has increased 14% YoY as of August of this year. There has been a substantial amount of reserves piling up in bank balance sheets as they find themselves reluctant to lend the money because of perceived risk and new reserve requirements. It is obvious that the Fed’s attempt to stimulate business activity is not working.
The Fed tries to control the amount of money and credit in the system by setting interest rates which they believe will cause the economy to grow or contract. This is set by the Federal Funds rate. When the Fed tightens rates it sells assets it holds to banks and sops up cash and reduced the money supply, thus raising interest rates. It buys assets (Treasury debt) when it wishes to lower interest rates. Its balance sheet inhibits its ability to set target rates because if they push or pull too much, they will affect the Fed Funds target rate which upsets their monetary policy.
In order to get around this, the Fed has come up with the idea that they will pay banks interest on their excess reserves. This way, they believe they can keep their interest rate target intact yet sop up the cash in the system or at least prevent bank reserves from being lent out to flood the system with cash and cause inflation. In essence they think they are cutting the tie between interest rates and monetary expansion.
If only it were that simple.
Dr. Shostak skewers this concept. First, if the Fed believes it is not creating money by expanding the money supply because the banks are sitting on reserves, they are dead wrong. All things being equal, in order to keep the interest rate at the target rate, the Fed has to create money to keep interest rates from going up. When banks lend money they need cash so they sell some assets (such as Treasury bills) that comprise their excess reserves to fund the loan. This cash will end up in bank accounts eventually which increases the money supply. Unless the Fed increases the money supply, interest rates will go up, thus upsetting the Fed’s target rate of interest. Thus this huge pool of reserves created by creating money (i.e., “printing” money) is an inflationary time bomb.
Secondly, paying interest on bank reserves will not prevent banks from lending to customers. It’s pretty obvious that banks know they can make more on a commercial loan than with the Fed so they have every incentive to lend. Also, they are in the business of lending and if they don’t take care of their customers at a point when other banks are willing to do so, they will lose their customer base.
Thus, there is nothing really stopping this new money from working its way into the economy and causing inflation. Shostak sees this as a recipe for disaster, threatening to destabilize the entire economy. While it’s difficult to predict when this cash will work its way into the economy, when banks’ balance sheets are repaired and the mass of debt created during the boom is more or less liquidated, there is nothing to stop banks from lending.
Shostak points then to the most important aspect of all this and that is the inhibition of the formation of real savings. “Real savings” is primarily an Austrian theory concept of what savings and capital really are. It’s not money. Real savings are consumer goods produced by a manufacturer that are not sold or consumed. For example, the blacksmith makes 10 hammers, sells 6, and keeps 4 for the future. Perhaps he will trade them for a new bellows to increase production. In more modern times the 4 saved hammers was replaced by commodity money such as gold. But the “real savings” were the 4 hammers, not the pieces of gold. To further understand this concept, please see: Shostak, “What is the Condition of U.S. Savings?“
If the gold is replaced by paper dollars as we have today, then the printing of dollars doesn’t create wealth, only more paper. Only real savings is wealth. But what deflated dollars and low interest rates does to real savings is distort the role of interest rates by sending a signal to producers to produce even if there are no real savings, no real wealth.
That is what Shostak believes is happening now. He thinks that real savings are being wasted or not being created. Inflation causes people to consume, not save. Today, while consumer savings are increasing, he believes that these savings are not necessarily real wealth and the lack of real savings will jeopardize any recovery and slow economic growth.
Is the Fed’s Pumping Inflationary?
Mises Daily by Frank Shostak | Posted on 9/16/2009 12:00:00 AM
Given the recent, massive increase in commercial banks’ excess reserves, many commentators are of the view that banks will sooner or later start employing these reserves in lending and thus cause an increase in the inflation rate.
Even former Federal Reserve Chairman Alan Greenspan is alarmed by the massive pumping by the Fed and other central banks. Speaking via satellite to a conference in Mumbai on September 8, 2009, Greenspan said that central banks need to defuse the large increases in their assets.
He stated that failing to shrink central-bank balance sheets could lead to very high price inflation: “I am not talking 3–5 per cent inflation; I am talking double-digit inflation in the US.”
In August 2008, excess reserves stood at $1.9 billion. At the end of August 2009, excess reserves stood at almost $800 billion. By early September 2009, they had reached $823 billion.
Some other commentators hold that banks’ decision to sit on their massive surplus cash rather than lend it out raises the likelihood that the Fed’s loose monetary policy remains ineffective. They argue that if the policy had worked, banks would have used the pumped reserves to make loans by now.
… Continue reading Exit Strategy: Can The Fed Stop Inflation?
By Jeff Harding
The week long Treasury auction of $75 billion of new paper came off pretty well. This is significant because the Treasury needs to finance a record deficit. It’s tricky stuff.
The 3 year auction that started on Tuesday went well, as buyers such as the Chinese are [...]
By Jeff Harding
There have been a flurry of data lately which impel many commentators to declare that the recession is over. They may be right or wrong. But let me discuss the data from my perspective.
First, let’s keep in mind some underlying basic structural changes in the economy that will affect future outcomes:
- Consumer savings are still rising. While savings decreased last month to 4.6% from 6.2% it was because incomes were lower.
- Consumer spending will also remain depressed because boomers need to prepare for retirement by repairing their own balance sheets by reducing debt and increasing their nest eggs.
- Home prices, even after they bottom, will not rise significantly in the next, say, four or five years, depriving consumers of a source of funds to fuel spending.
- Deleveraging is still occurring in the economy with commercial and multi-unit real estate headed for trouble for the next two to three years.
- Credit standards have tightened significantly and will remain tight until banks have cleaned up their balance sheets (which will not happen soon).
- Taxes are likely to increase, perhaps substantially, in the near future as the government seeks ways to finance an increasing deficit. The corollary to this is that tax revenues are down substantially.
- Federal deficits are likely to drive interest rates up as the government needs to attract foreign investors to its bond auctions.
Analysis of Current Economic Indicators:
Monetizing the debt
This story ought to wake you up. In an interest post in Zero Hedge, reporting on an investigation by Chris Martenson, it appears that the Fed has been propping up Treasury bond auctions. According to Martenson:
Good grief! Just last week, when the auction results were announced it was trumpeted to great fanfare that there was “more than sufficient” bid-to-cover, “strong demand” and all the rest.
And now it turns out that 47% (!) of the bonds that were taken by the primary dealers in that auction have been quietly bought by the Fed and permanently secreted to its balance sheet.
They didn’t even wait a full week! A more honest and open approach would have been for the Fed to simply buy them outright at the auction but this way, using “primary dealers” and “POMOs” and all these other extra steps the basic fact that the Fed is openly monetizing US government debt is effectively hidden from a not-too-terribly inquisitive US press and public.
In essence, the Fed is just monetizing the debt, that is, “printing money” to cover the auction shortfalls. Contrary to what the Fed is saying, the demand for Treasury paper is weak. This can only mean increasing interest rates. Since mortgage rates are pegged on the 10 year Treasury, that means mortgage rates will rise, Which means that the housing market recovery will be depressed. Of course, we’ve talked about this for a while.
Chinese Economic Recovery
It is hoped that the Peoples Republic of China’s dynamic internal growth will help spur all economies to recovery. In some economists view, rising U.S. exports are good while rising imports (mainly from China) are bad. That’s not quite correct, but regardless, it appears that the numbers coming out of China aren’t to be believed.
First of all, demand in China is falling. According to this morning’s report of the Baltic Dry Index, which tracks shipping costs and is viewed as leading indicator for commodity prices, has had its worst week (down 17.2%) since the peak of the financial crisis last October, as Chinese demand slowed for iron ore and coal. RGE notes that recent growth in China has come from government spending and that private investment has slowed. RGE reports that banks lending has skyrocketed to 25% of 2008 GDP. But …
They have reported 7.1% growth in the first half, but according to a report in the Financial Times: “But the latest set of first-half numbers provided by provincial-level authorities are far higher than the central government’s national figure, raising fresh questions about the accuracy of statistics in the world’s most populous nation.” Apparently the statistics are concocted to please the folks in Beijing. So take these numbers with a grain of salt.
What appears to be occurring is that the government is stimulating another artificial boom, resulting in the DJ Shanghai stock index to double since January 2009 (from 200 to 400). I would say, look out below. … Continue reading Recent Economic Data Examined
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