Tuesday, March 31, 2009

Economics: A Science for Schizophrenics

An editorial in today's Wall Street Journal brings home a fact that I've known for a long time: Economists tend to be schizophrenic.

[Thanks to Greenpacks.org for the photo.]

The article mentions Larry Summers's double talk. Summers commented on Obama's latest budget by saying, "There are no, no tax increases...." The article points out that there are tax increases, namely the death tax that will be returning to its 2009 parameters, instead of disappearing as it was scheduled to do in 2011. That wouldn't be more than a fib, but the story gets worse.

In 1980, Summers co-authored a study at the National Bureau of Economic Research supporting the elimination of the estate tax.

Go figure. Schizophrenia, anyone?

Another example of economic split personality is one of my favorites: Milton Friedman, a Nobel Prize-winning genius, a great man, and one of our best economists--but just a bit split when it came to monetarism, as noted by lesser economist Edward C. Harwood.

Friedman would say things like this, quoting from "Capitalism and Freedom":

"The Great Depression in the United States, far from being a sign of the inherent instability of the private enterprise system, is a testament to how much harm can be done by mistakes on the part of a few men when they wield vast power over the monetary system of a country. It may be that these mistakes were excusable on the basis of the knowledge available to men at the time--though I happen to think not. But that is really beside the point. Any system which gives so much power and so much discretion to a few men that mistakes--excusable or not--can have such far-reaching effects is a bad system. It is a bad system to believers in freedom just because it gives a few men such power without any effective check by the body politic--this is the key political argument against an 'independent' central bank. But it is a bad system even to those who set security higher than freedom. Mistakes, excusable or not, cannot be avoided in a system which disperses responsibility yet gives a few men great power, and which thereby makes important policy actions highly dependent on accidents of personality. This is the key technical argument against an 'independent' bank. To paraphrase Clemenceau, money is much too serious a matter to be left to the Central Bankers."

Clearly, Friedman didn't believe a central bank could carry out its intended function because of an inherent defect in its makeup, i.e. its dependence upon humans.

That doesn't prevent him from recommending, in the same work, indeed in the same chapter, that human legislators be given the power to control the money supply: "... [I]t seems to me desirable to state the rule [the legislative rule for monetary policy] in terms of the behavior of the stock of money. My choice at the moment would be a legislated rule instructing the monetary authority to achieve a specific rate of growth in the money supply."

The rest of his work is so monumental that we could almost forgive him, if it weren't for the fact that the whole world took his admission of the validity of centralizing the control of money supply as a justification for their central bank--which is what got us where we are today. Sorry, Milton, but it's partly your fault.

Our third example of inconsistency is the original Accident of Personality himself, Alan Greenspan. In his chapter entitled "Gold and Economic Freedom" published by Ayn Rand in her "Capitalism: The Unknown Ideal," Greenspan says the following about the faulty reasoning of the Federal Reserve in 1927:

"The reasoning of the authorities involved was as follows: If the Federal Reserve pumped excessive paper reserves into American banks, interest rates in the United States would fall to a level comparable with those in Great Britain; this would act to stop Britain's gold loss and avoid the political embarrassment of having to raise interest rates. The 'Fed' succeeded: It stopped the gold loss, but it nearly destroyed the economies of the world, in the process. The excess credit which the Fed pumped into the economy spilled over into the stock market--triggering a fantastic speculative boom."

Strange words from a man who did exactly that in 2004.

Perhaps you can now understand why I named my economics blog after Sybil, the star among multiple personalities.

Labels: , , ,

Thursday, March 26, 2009

What Went Wrong with Commercial Banking?

Part III

In Tuesday's post, Part I of this series, I told you about economist Edward C. Harwood's 1928 prediction of the 1929 Great Depression in published and unpublished articles. He saw imbalances in the banking sector that were leading us into a breakdown of the economy through a misuse of the banking system.

In Part II of the series, I gave Harwood's description of sound commercial banking, as read in an unpublished article entitled "A Sharp Distinction Should be Made Between Capital Funds and Commercial Credit." He uses the metaphor of characters in a play. Let me remind you of their names: The Earners, the Investor, the Manufacturer, the Retailer, and the Bank. I recommend that you read Parts I and II first, so that you can make better sense of what follows.

[Thanks to Dreamstime.com for the photo.]

I had described his understanding of the relationships among the players and how the Bank's main purpose is to facilitate the distribution of production into the hands of all who contributed to it and therefore deserve a share.

In Act I, the Bank's power to create credit is limited to an amount representing actual products or services coming to market. This is one of the essential characteristics of sound commercial banking, the foundation of any economy.

At the end of the last post, Earners had placed a small portion of their claims to production (otherwise known as purchasing power, or money) in savings accounts at the Bank. They did this for safety and convenience, and also to derive a little income from the Bank's judicial placement of these savings into the hands of proven wise investors like Investor, who is asking for some of these claims (money) to buy more stock from Manufacturer.

Manufacturer has seen that his products sell well and that he could profitably expand by issuing more stock. The savings department of the Bank agrees and offers a loan to Investor, holding Investor's stock as collateral. Note that the Bank's savings department does not create any credit here; quite the contrary. They extend claims already in existence (Earners' savings), taking only a conservative calculated risk on their return with interest.

So far, this Act I scenario represents the correct use of commercial credit and of capital funds. All's well that begins well in our sound commercial banking system.

Act II

Here the situation starts to go awry. We are 1913. Congress thinks it wise and useful to create a national entity that would have two functions: to apply modern technology to grease the wheels of check clearance, and to serve as a back-up reserve of funds to avoid the destructive effects of irrational, panicky bank runs.

Simultaneously, a war is brewing abroad and some in government foresee a need for a source of emergency financing for the military industrial sector should the US get involved.

They hit upon the formula of establishing a master bank that would have the two first functions, and a third function as well: to create credit--temporarily of course--by "monetizing debt," or "buying" US bonds with credit created out of thin air--claimless "money," if you will. (See how real money is actually claims on production in Wednesday's post.)

This extra claimless "money" would circulate throughout the economy and become indistinguishable from real money as it flowed first through those industries that would receive government checks to arm the military machine, and then on into the rest of the economy. Our master bank is named the Federal Reserve, Fed for short.

The formula works well. The war is won, thanks in part to this stimulus scheme. The Fed must now withdraw all that excess credit; but this causes a recession and pain, like withdrawal symptoms. Instead of taking his medicine and cleaning the toxic credit from the banking system, our Fed decides to relax his standards and allow the credit to remain in circulation.

In doing so, he loses control of the amount of credit he has created and finds himself in need of a less painstaking measuring stick. He settles on the price level. This, he thinks, will be just as good a measure of the supply of money, because it is well known that excess money creates general price inflation. This is not always true; but the Fed has good intentions and lots of faith in his knowledge of things monetary. (But we know what the road to hell is paved with, don't we?)

This illusion of wealth and the apparent stability of prices deceive all of our players. The Manufacturer converts his arms factory back into peacetime production. The Investor puts all his savings, plus as much as he can borrow from the now credit-stuffed Bank, into buying the Manufacturer's stock for further expansion. Optimism reigns.

Seeing the success of the Investor and plush with cheap "cash" (really only claimless credit) issued by the Fed, the commercial department of the Bank starts to think of new ways to make money. They begin to create credit accounts for Investor's investments, instead of letting the savings department lend real savings. This credit is not collateralized by sales documents as normal commercial credit would be, but is based only on a mutual appetite for risk-taking--not the commercial Bank's proper function. Leveraging creates more claimless "money" and makes the situation even worse.

(Note that there is a place for speculative investment, but it is not within a healthy commercial banking system. True speculators are fully informed of the risks involved and must be forced to withstand the full consequences of their actions, down to the last penny.)

A few Earners, seeing Investor becoming increasingly wealthy through his stock investments, begin to do likewise. They take their money out of the conservative savings account that now offers only a paltry interest, given that the Bank is flush with Fed "credit" and doesn't need Earners' savings anymore. Earners also start requesting loans from the Bank, and the Bank, now having lost itself in this adventure, begins to provide even more claimless credit "money," based on nothing but Earners' stocks, the Bank's optimistic and foolhardy assessment of risk, and also on the Fed's own example. Remember too that the Fed's mere existence has now "guaranteed" the banking system's equilibrium. (Economists call this "moral hazard.")

Times are good. Even Manufacturer and Retailer put a little of their profit aside to speculate in the stock market, sending stock prices sky high, even though general prices are stable. What's the first thing you think of when you get your first extra income? Buying a home, of course. Money (or this claimless credit hybrid it has become) turns towards the real estate market. A housing boom ensues.

More conservative Earners note that their wages seem to be stagnating, and that a good number of individuals around them are becoming extraordinarily rich. Manufacturers and Retailers are not expanding jobs like they used to, engrossed as they are in making it rich through speculation.

Once again, let's stop the carousel. This is starting to look like a game of musical chairs. When the drugged music of easy credit wears off, as it inevitably will (there being nothing but speculative and ephemeral gains to be claimed with all this claimless money), many Earners will be left chairless, and/or some will be sharing useless pieces of a chair when a rise in general price inflation sucks the value out of their real wealth.

Here we are in 1928, at the brink of the Great Depression.

"Act III remains to be played. Just when it will begin is a problem, but it is certain that the actors will not fail to appear. It must be confessed that this drama is a tragedy. The third act may be readily imagined by those who have seen depression before. It is unfortunate that this is what we must expect, but such will always be the price of inflation."

Harwood's phrases. "Inflation" as he uses it here refers to the inherently risky "claimless" credit expansion, to be contrasted with healthy expansion spurred by sound commercial credit creation as described in Part I.

Act III takes place one year later in 1929 with the collapse of a stock market bubble and a bursting real estate boom, much like the ones we find ourselves in today.

What makes today's situation worse than 1928 is that back then, the country observed the gold standard, which guaranteed the value of the dollar and limited the amount of risk-credit expansion that could occur. It was indeed the scarsity of gold that forced the Fed to retract credit in 1929. But both gold and the Fed were only doing their job, something the academic community dismisses today as primitive misguided meddling in free markets, which it was not. On the contrary, it was playing by the rules on a gentleman's playing field. Today, it's a game of Scoundrel Takes All, at least until the public wises up--not through more government intervention, but through a reestablishment of basic rules.

Standardization of the monetary unit referent to something of generally perceived and constant value is the second characteristic of sound commercial banking, whether it be gold or something better. (I know of nothing better.)

Today, we have no such disciplinary tools in place, and "claimless" credit expansion has been allowed to expand to a degree never before seen in history. What remains to be seen is whether the very people who allowed this expansion to take place can now persuade it to retract in an orderly manner.

(The public is not blameless. It is we who elected the 1913 Congress in the first place.)

Labels: , , ,

Wednesday, March 25, 2009

What Is Sound Commercial Banking?

Part II

In yesterday's post I told you about economist Edward C. Harwood's 1928 prediction of the 1929 Great Depression, in published and unpublished articles.

He saw imbalances in the banking sector that were going to lead the country into a quagmire (although he could not have predicted the depth to which it would sink through government and global mismanagement).

In his unpublished article entitled "A Sharp Distinction Should be Made Between Capital Funds and Commercial Credit," written in mid-1928, he gives us a layperson's understanding of sound commercial banking by explaining the relationships among the various participants as though they were characters in a play. Let me introduce you: The Earners, the Investor, the Manufacturer, the Retailer, and the Bank.

- Earners - all who are entitled collectively to a share in a country's GDP, i.e. those who participated in its production. In other words, all of us who work for a living. In reality, all of the characters are Earners, but some have different functions.

- Investor - the risk-taker who lends his capital funds to the Manufacturer in exchange for a piece of the profits.

- Manufacturer - the producer of all products, agriculture, and services.

- Retailer - the selling agent for Manufacturer.

- The Bank - the financial intermediary between Manufacturer and Earners, between Retailer and Manufacturer, and between Earners who save at the Bank and the Retailer or Manufacturer, to name a few of the relationships.

[Thanks to JohnDClare.net for the photo.]

In Act I, all goes well. Manufacturer receives a loan (capital) from Investor with which to buy his building, equipment, and raw materials. Then he plans an amount of production based on expected sales. With the help of Earners, he produces goods (or services) to ship to Retailer for selling to the public. Retailer promises to buy the products and signs the purchase order.

At shipping time, the Manufacturer wants to be able to pay Earners even though he hasn't received payment from Retailer for his products, because Retailer will need to sell the products first, and guess who are his customers? Why, Earners, of course. (What goes around, comes around.)

Here is the first point to remember about a healthy monetary system: Manufacturer always distributes 100% of his gross sales among his expenses, his profit, his Investor, and his Earners; and the only way he can do this at this point is to get a loan at the Bank, and give each Earner a claim for the value of that portion of the products each has helped to produce, so that the claimant can claim it (or its equivalent) when he wants it.

A particular Earner may not want the five cars his annual work entitles him to; he may want down payment on one car, some bread, some meat, rent money--any number of things. Money is, in essence, a claim--no more, no less, and it is generic, accepted everywhere, as long as its value is guaranteed. (More about that later.)

So to give the claims (we could have named them "purchasing power") to each participant, the Manufacturer goes to the Bank with Retailer's order for the goods. On the basis of the order the Bank grants Manufacturer a loan by creating credit out of thin air, so to speak, and puts the credit representing almost the total future sales in a checking account to allow the Manufacturer to pay Earners. (The rest is Bank's income.)

Once the goods are ready for shipment, Manufacturer pays himself and the Earners, including the Investor, in cash or equivalent; and everyone accepts these claims (paper cash bills, a check, or an electronic transfer) representing a piece of the production.

It is important to retain the notion that the income from the wholesale sale of the product is divvied up between the Manufacturer and the Earners, because they each are entitled to a share of the whole production, down to the last penny. There can be no more or less money (claims) handed out than the total wholesale price of the things manufactured. This is an essential point. Also realize that the wholesale sale value is only a part of the final retail sale value. This is normal, because there are others who are going to participate in the distribution process who will also have a right to claim a share representing the work they have done to get the product to market.

Next, the Manufacturer will require Retailer to make good on his signed purchase order and pay the wholesale price before the items are sold. So Retailer too goes to the Bank as soon as he receives the title to the goods in shipment; and the Bank, on the basis of the title, grants a loan (credit) and deposits the sum in a checking account so that the Retailer can pay Manufacturer for the goods, who in turn pays back his own loan from the Bank.

The Bank then destroys Manufacturer's loan document and finds itself with a new loan document signed by Retailer for a higher amount. The Manufacturer's loan account is zeroed out, all sums being paid. Remember, the credit previously issued to Manufacturer and paid out is now claims in the hands of those who produced the products and who deserve their share of its value.

Retailer, who now owes the Bank, sells the products within a few months and pays back his loan. The Bank then destroys the Retailer's loan document. The Retailer, like the Manufacturer, pays the remaining sales proceeds to cover expenses, then himself, his own employees (earners), and investor (another earner), and they all become owners of claims to a piece of the production value.

Soon, someone will have bought all the products that were manufactured, ending the cycle. A few of the paper claims will end up in a savings account at the Bank.

Let's stop the carousel here and take stock of things. What I have described above is the commercial relationship of every company in the world with its bank's commercial department. In the past, banks created credit (in the form of checking accounts) that was self-liquidating, as described here. They did not create any other credit. To do so would have been risky unsound banking, proven in the past to lead to trouble.

In Part III of this series on sound commercial banking, I will delve into how banks dealt with savings.

Labels: , , ,

Tuesday, March 24, 2009

The Origin of This Whole Mess: 1913

Part I

Economists disagree on the identity of the true culprit behind our current crisis. Some blame Wall Street; some blame the progressive politics that pushed Freddie Mac and Fannie Mae beyond their capacity; some blame the profiteering loan brokers, the foxy house flippers, and the naive subprime home buyers in their rush for quick profits. Some blame the Federal Reserve, including me from time to time.

[Thanks to James Montgomery Flagg, the artist, and Wikimedia.org. The image is in the public domain.]

In reality, all of the above had their role, but they are just players in a game, the rules of which are defined by politicians. The origin of the problem lies in the rule changes that caused the demise of sound commercial banking back in 1913.

Before then, good commercial banking had been functioning well, both in England and and the US, for about a century. Business cycle fluctuations, although sometimes painful, managed to keep the profession on the right track. The invention of the Fed in 1913 was supposed to allow banks to weather business cycle downturns without going completely bust because of irrational panic withdrawals that had no justification in the real data.

Morphing onto a national stage out of private banking functions already in development, the Fed's check clearing services and temporary commercial loan facilities were indeed a clever and useful idea. But the politicians discovered that, once the Fed found it could take over the centralized monopoly of legal tender issuance and then credit creation, it could be used for other things than just stabilizing the banking system. And everyone believed the Fed could control this new-found usage and that it would not do any harm.

In preparation for WWI, the government turned to the Fed credit-creation facilities to finance the war. It was a great success. The Fed managed to wrest most of the genie back into the bottle after the war by early 1920; but the temptation was too great and the discipline and privations too onerous, so they allowed over-issuance of credit to continue, ostensibly to help the country out of the recession the war disruption had caused.

The downturn ended in 1921; but the credit issuance continued. The result was 1929. As Doug Noland says in this week's article at Prudent Bear:

"It was understood at the time [during the Great Depression] that our fledgling central bank had played an activist role in fueling and prolonging the twenties boom - that presaged The Great Unwind. Along the way, this critical analysis was killed and buried without a headstone."

How true. Very few economists today remember the Fed's role in inflating credit previous to the Depression. On the contrary, everyone, from Keynes to Friedman to Bernanke, believed and continue to believe to this day that the problem lay in too little credit.

Many base their hypothesis that the Fed did not over-expand credit in the 1920s on the fact that the price level was relatively stable. Economist Edward C. Harwood pointed out in published articles that an economy can present over-expansion of the money supply even in a climate of stable prices; and furthermore, that this held true in the 1920s. Outside factors can cause real prices to fall, while an excess of money supply camouflages these factors by keeping prices at the higher level, with no one the wiser.

Furthermore, what these theorists ignore entirely is that the Fed's newly assumed power to unleash the credit genie destroyed sound commercial banking in pretty short order. ("Power tends to corrupt; absolute power corrupts absolutely." Lord Acton)

In an unpublished article written around May of 1928, Harwood described the process by which the art of commercial banking became tainted and was eventually lost. He compared it to a play in three acts. After describing the players and the events of the first two acts, he wrote:

"To date [May 1928], recent business history has paralleled acts one and two of this drama of commerce. Act III remains to be played. Just when it will begin is a problem, but it is certain that the actors will not fail to appear. It must be confessed that this drama is a tragedy. The third act may be readily imagined by those who have seen depression before. It is unfortunate that this is what we must expect, but such will always be the price of inflation."

He correctly predicted the depression that came one year later. He is one of the few, unfortunately forgotten today.

In the next parts of this blog post, I will go into the details of sound commercial banking, how it was allowed to self-destruct by the creation of the Federal Reserve, and how its destruction led to today's crisis.

Labels: , , , ,

Saturday, March 21, 2009

Fed Credit: The Latest And Perhaps Next-To-Last Bubble

I can't claim to be the origin of the Fed Credit Bubble idea, because it occurred to me as I read a fantastic piece by one of my favorite analysts, Doug Noland of Prudent Bear.

We've just come out of a huge bubble that consisted of inflated real estate investment and speculative finance credit. The bubble burst and the market began to correct itself, menacing to take a lot of nations' economies with it.

The reaction of our economic leaders was and continues to be to try to maintain a minimum of stability by propping up the various players on the world financial stage as they began to totter, one by one: first the real estate sector with aid to Freddie Mac and Fannie Mae, then the banking sector by saving Bear Stearns and loans to other institutions, then the insurance sector by bailing out AIG, then the automobile sector with handouts to GM and Chrysler, more money and loans to the banking and real estate sectors, more to AIG, recently some more to auto supply companies, more to AIG, and now the credit card and other large ticket item credit sector--an endless list, it would seem.

The central banks of the world, to a varying degree, are performing their propping-up role as the ultimate insurance company, the lender of last resort; and the US Fed, given the universal role of the US dollar as reserve currency, is the one that will be the buck-stops-here Last Lender of All Last Resorts.

As Noland points out, however:

"Our federal government has set a course to issue Trillions of Treasury securities and guarantee multi-Trillions more of private-sector debt. The Federal Reserve has set its own course to balloon its liabilities as it acquires Trillions of securities. After witnessing the disastrous financial and economic distortions wrought from Trillions of Wall Street Credit inflation (securities issuance), [it is possible that] the Treasury and Federal Reserve have set a mutual course that will destroy their creditworthiness - just as Wall Street finance destroyed theirs."

He's saying that the Fed is going to create the Bubble of All Bubbles, right there in its own house.

[Thanks to Bouncehousesnow.com for the picture]

But just how much air can the US Fed balance sheet withstand, without bursting its own skin? The inflationist central banks are acting on the assumption that they can right the "market failure" (see PS below) through this "temporary" remedy, that the market cannot right itself alone, or at least not without disastrous consequences. But aren't they trying to add air to an already burst bubble?

Instead of curing the problem, they are acting contrary to the market's instinctive corrective hiatus and will end up distorting events even further. How can arbitrarily selective bailouts and the forced financing of government projects--projects that otherwise most likely would not have been financed--do anything except further distort the admittedly slow and cumbersome but essential market reevaluation process?

"[T]he seductive part of [the optimistic] view is that unprecedented policy measures may actually be able to somewhat rekindle an artificial boom – perhaps enough even to appear to stabilize the system. But seeming 'stabilization' will be in response to massive Washington stimulus and market intervention – and will be dependent upon ongoing massive government stimulus and intervention. It’s called a debt trap. The Great Hyman Minsky would view it as the ultimate 'Ponzi Finance.'”

Precisely. The ultimate Bubble, created by those who are supposed to help us avoid them altogether.

So how will the world react when this latest bubble bursts? At some point, investors looking to preserve the value of their wealth will realize that there is no investment denominated in an existing national currency that does the trick, and they'll turn to gold, always the last fat lady to sing before the curtain falls and reality sets back in. (By now, you've figured out that I'm somewhat of a gold bug.)


PS: We have no market failure here. On the contrary, the market is functioning perfectly. It is waiting to discover the real price of toxic assets, if only the government and its allies would let it. Rather, it is the market players who have failed us, and more specifically those who would pretend to manage our monetary units. For more on the true source of the real estate and credit bubbles, find yourselves a copy of the March 16, 2009 Research Reports out of the American Institute for Economic Research (annual subscription), and read the piece by Walter M. Cadette entitled "Greenspan the Goat."

Labels: , , , ,

Thursday, March 19, 2009

The Inflation Boat Is Leaving the Dock

Last night we learned that the Federal Reserve is going to put into practice its announced plan to buy US government debt. Today's Financial Times article by Krishna Guha gives the gory details.

Everyone knows that this action by the Fed increases money supply, and most are aware that it increases the probability that at some point in the future the amount of money created will be excessive with regard to the actual needs of the marketplace, which in turn will tend to lead us towards a state of price inflation, or bubble inflation. Another article by Javier Blas on the early signs of this in the commodities markets is a fun read on the subject.

As the Fed sees the problem, then, they must feed us with money supply while the banks are frozen in a state of rigor vivus, and then in future, just at the right moment, they will take steps to prevent the normal outcome of price or bubble inflation by reversing the process.

[Thanks to 1stchoicecufflinks.com for the nice photo.]

This sounds logical. As an obscure economist named Edward C. Harwood wrote during our last episode of purposefully inflationary Federal Reserve intervention ("the ill-fated Operation Twist in the 1960s"), during a time when we were still trying to adhere to a modified form of the global gold standard:

"Once inflationary purchasing media have been placed in circulation, there are two ways in which sound money-credit relationships may be restored: (1) by means of devaluation, that is, reducing the gold weight of the monetary unit so much that the increase in the number of (smaller) gold dollars equals or exceeds what had been the inflationary portion of total purchasing media; or (2) by means of deflation, that is by removing inflationary purchasing media from circulation." [See this article from the American Institute for Economic Research website [AIER.]

Let's take these in order. In the 1960s during the last years of the gold standard era, the word "devaluation" had by definition a specific political action attached to it. We could say it was an official public confession to a previously committed inflationary crime, the central bank's admission of guilt and acceptance of their incapacity to rectify the situation. To devalue a currency was ripe with ominous significance, and central banks were supposed to take pains to avoid the embarrassment by not inflating the currency in the first place.

Today, however, the devaluation of our currency takes place painlessly for most of us (except for importers), and effectively the Fed gets away with it on a regular basis. In fact, without a gold or any kind of standard, the inflationary purchases of debt instruments that the Fed has already made, plus those it intends now to make, are already devaluing the dollar as I write. We don't have to wait for an official recognition and adjustment of any standard; it just happens on a day-to-day basis.

Under these circumstances, an official announcement of devaluation, therefore, will have no corrective effect. Quite the contrary, inflation will take place simultaneously with the devaluation of the dollar--a double whammy, if you will.

But we don't want prices to skyrocket, so the inflation will still need correction. Let's turn to the other option, deflation. Paradoxically, the Fed is taking its present inflationary action to fight fear of deflation. They are afraid that a banking panic and a lack of credit could cause the system to collapse in what is called a "deflationary spiral." So it will be a while before they feel comfortable with using the deflationary tactic.

Nevertheless, the Fed scientists and governors do believe that it will be possible for them, at some appropriate moment in the future, to begin a controlled deflation of money supply that will not upset the apple cart.

Harwood does write this about the possibility of a controlled deflation:

"That a period of gradually declining prices can be a period also of great economic growth has been amply demonstrated in the past. For example, between 1875 and 1895 while prices decreased substantially, the Nation's productive capacity and output of goods and services increased at a very rapid rate. The often heard assertion that an economy cannot grow unless prices are rising has no basis in fact....

"With gradual deflation, a longer time would be required to eliminate all inflationary purchasing media and reach an equilibrium between the remaining (noninflationary) purchasing media and prices and wages, but the traumatic events that are a feature of rapid deflation would not occur. The Nation would 'outgrow' the inflationary condition as part of the savings of individuals, businesses, and perhaps of the Government were used to pay off inflationary bank loans and thereby cancel both the loans and the checking deposits that the loans had created. Although gradual deflation would be accompanied by decreasing prices, wages almost certainly would decline less or might even be sustained by greater productivity due to technological and other developments."

(For more on why deflation is not always bad thing, read this research by David Beckworth at Cato.)

So it would seem that a gradual well-timed deflation is what Bernanke and his cohorts are counting on. But... there are a few minefields here. One is that we are no longer on a gold standard. We have no point of reference as to where the dollar should end up. I won't go into the reasons why this makes Bernanke's task more difficult, but it does.

Second, how will we know when prices begin to inflate or when bubbles start to form? Alan Greenspan is famous for having remarked that it is impossible to detect when a bubble is appearing. It's true that we all knew the real estate mania was a bubble (or at least I did; didn't you?), but our financial wonks at the Fed either preferred not to recognize it or couldn't prove it to their own satisfaction, at least not to a point where it would have forced them to take action. (I'd add that they may have had incentives not to want to find reasons to take that action, but that would be unfair speculation, so I won't.)

And what if prices remain the same? Does this necessarily mean that we don't have an inflationary maladjustment in the money supply that maintains prices at an artificially stable but too high level? What if the stimulus package spending turns out to be wasteful to some significant degree? Isn't that like blowing bubbles? Example: Bailout-funded Wall Street bonuses.

Third, and here's the real rub, we have not practiced what Harwood calls "sound money-credit principles" since the Fed was created. These principles mandate a specific equilibrium in the commercial banking system between true reserves, deposits, savings, and short-term commercial paper on the one hand; and loans and investments that are speculative and/or based only on some form of collateral, on the other, where these more risky activities would be allowed only outside the strict commercial banking system. (For more on sound commercial banking, find a copy of Harwood's book "Cause and Control of the Business Cycle," 1974 edition, at your local library, or in the AIER catalog. I will delve into the idea of sound money-credit banking in a future blog.)

Fourth, the Fed cannot reverse its current trajectory and start to take deflationary action until the time is right and the worst of the credit crisis is past. Will nothing unexpected disturb their plans? They are relying on deflationary scenario computer models where "all else is equal," meaning when outside factors remain stable. What if the market does something surprising that will make a controlled deflation either inadvisable or even impossible, at the very moment when it must happen? For example, US treasury bonds could become radically less popular among our foreign buyers as a result of the dollar devaluation the inflation will cause; and as nations all over the world scramble to inflate their own currencies, we may find that we have a lot of competition in the bond market.

Personally, I'm betting (and I disclose that I have put a little money where my mouth is by investing in gold-related products) that the Fed will be hard-put to time and measure the controlled deflation.

Why gold? Because, as I've said many times: You can take gold out of the standard, but you can't take the standard out of gold.

Labels: , , , , , , ,

Thursday, March 05, 2009

Future Inflation: Taking Lessons From Those Who Know

When I think of the potential for future inflation from the combined current actions of the Treasury and Federal Reserve, I need a little comic relief.

[Click on the image for a larger version.]

Labels: , , ,

Sunday, March 01, 2009

Nationalization, By Any Other Name

The word "nationalization" has put fear and trembling into the American marketplace, and understandably so. It rings of socialism, of the European model, of the Third-Way progressive compromise. It's the death knell of the American form of free-market capitalism that is the foundational pillar beneath our symbolic hegemony over the rest of the world.

Apparently our current administration and its Congress don't believe this for a minute, because they haven't yet caught onto the fact that the word needs more than just denial; it needs replacement.

So far, they have been very quick to grasp the emotional impact behind words, to wit their choice of name for their stimulus package, The American Recovery and Reinvestment Act of 2009. We all know that this latest effort is really The Wild Attempt to Save Our Butts From Depression Act of 2009, but to use such blatant language would be ... well, depressing. Our savvy legislators know this, so they found a nicer name for it.

In the same vein, I wonder why no one has yet come up with the suggestion that our government's bailout actions--looking more and more like nationalization--be renamed something more palatable, rather than simply denying that nationalization is what's going on.

Let's take the example of Citigroup. So far, the government:

1. Has pumped billions of taxpayer dollars into their finances to avoid its collapse;

2. Will convert some $25 billion of preferred shares to common stock, effectively diluting existing shareholders' stake by 74%;

3. Has discussed "whether to require the removal of Citigroup Chief Executive Vikram Pandit" but decided that it is "impracticable to oust him" mainly because there's no one to replace him;

4. Is forcing the replacement of every Board member;

5. Is watching every move Citi makes, and management is trying desperately to mind their Ps and Qs.


If that isn't nationalization, I'm not sure what the word means.

Webster's relevant definition is:

"2. to transfer ownership or control of (land, resources, industries, etc.) to the national government"

So let's stop kidding ourselves. A rose, by any other name.... But wait. In fact, as any politician knows, Shakespeare was wrong. You can change the scent of a rose; all you have to do is call it something else.

So instead of watching the public wallow in self-pity as the US government denies nationalizing Citigroup, they need to find another name for it. Something "du jour," something we can empathize with and latch onto.

How about "recycling"? After all, isn't that what we do with smelly trash these days? We pull out what is useful, save it, and bury the rest. The government has no intention of "nationalizing" Citigroup; they simply want to carve out the rot and sell what's left back to its private shareholders, right? So let's not hear this "n" word anymore.

[Thanks to Ncdc.gov.uk for the photo.]

Labels: , , ,