From The Daily Capitalist
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.
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.
- Inflation or deflation is a monetary phenomenon. An increase in money supply causes inflation. A decrease in money supply produces deflation. (Ceteris paribus.)
- Price increases are a result of inflation, not inflation itself. The main impact of inflation is malinvestment.
- The Fed has been trying to inflate the money supply to end the credit crunch.
- The Fed’s inflation efforts have been mixed. Most banks are still not lending and credit and money supply have been declining.
- Banks are not lending because their balance sheets are loaded with bad CRE debt which has caused them to be concerned about their financial viability. In addition they have difficulty attracting viable borrowers.
- The government has enabled banks to postpone the inevitable write-downs of bad debt which has drawn out the credit crunch and has impeded economic recovery.
- Monetary stimulus has been achieved by the Fed’s Open Market Operations which has injected almost $1.25 trillion of new money into the economy.
- The impact of such stimulus has served to benefit the large money center financial institutions, and does not appear to have aided liquidity or to have stimulated economic growth other than the financial markets.
- Government fiscal stimulus has had little positive economic impacts on the economy, and, as the effect of government spending winds down, we are left with wasteful spending of no lasting economic benefit and high public debt.
- Recent increases in consumer spending and consumer lending are temporary blips caused by government stimulus programs and are having no lasting effect.
- Money supply has increased since the October, 2008 crash, but there are signs that it is beginning to decline again.
- While the CPI has been increasing, increases are modest and are a result of the Fed’s less inflationary OMO purchases of MBS.
- The current trend of the CPI seems to be declining.
- It appears that economic activity is slowing down as stimulus runs out and money supply declines, and that we are headed for a double-dip decline.
- Until banks’ balance sheets are cleaned up by resolving the overhang of bad CRE debt, they will continue to restrict credit and thus constrain the growth of money supply.
- The deflationists’ analogy to Japan’s experience from 1989 to 2003 is only partially applicable. The American tradition is to allow banks and businesses to fail.
- This cleansing process is ongoing but is slow because the government has given banks incentives to delay the process.
- The deflationists have yet to show that deflation has occurred as they say. While asset values are declining, mainly real estate assets, money supply has not crossed the deflation Rubicon yet.
- The deflationists seem to conflate the concepts of deflation and deleveraging, which aren’t the same things.
- A double-dip decline will put political pressure on the government to take any steps they can to thwart the decline.
- An inevitable increase in unemployment will be politically unacceptable to the Administration and Congress.
- The government will renew attempts at fiscal stimulus on a grander scale.
- The Administration and Congress will put pressure on the Fed to counteract the decline. All politicians and most Keynesians and Monetarists believe that price inflation is preferable to price deflation.
- Inflation destroys real capital which will limit future economic growth.
- The Fed has limited options to create inflation but they will attempt to do so by injecting money into the system through OMO.
- One option is to buy Treasury paper, thus monetizing federal debt, which will ultimately create price and monetary inflation.
- Another option is to buy CRE debt from smaller banks to clean up their balance sheets and allow them to resume lending activities and expand money supply which will result in inflation.
- The problem will these alternatives is that they will serve to reduce economic growth by causing malinvestment and the further destruction of real capital while at the same time create price increases, which is called stagflation.
- If inflation gets out of hand, it is probable that the government will impose temporary price and wage controls while they counteract inflation through increased interest rates and other restrictive monetary policies.
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