From The Daily Capitalist This is Part 2 of a four part article that deals with what I feel is the primary question investors must now answer: is our future to be inflation or deflation? The answer has vast implications to our investment planning and decisions for the near term, and possibly for our long term. It is a very complex question with a lot of moving parts involving economics and politics.
Like it or not, it is economic theory that is driving macroeconomic policies and political decisions that determine whether we will have inflation or deflation. Since not all of my readers are sophisticated traders I have tried to present the issues in a direct and hopefully understandable way. To those sophisticated readers, please bear with me.
Part 2
The Inflation Argument The argument for inflation rests on the money supply charts. The inflationists show various measures of money supply increasing, including the version used by Austrian theory economists, called True Money Supply (TMS)[1]:
Note: The M1 chart shown in Part 1 more clearly shows the trend in the M1 money supply increase.
Again, the YoY percentage change is more revealing:
The inflationists also point to the Consumer Price Index (CPI) which shows price increases:
The YoY rate of change of the CPI clearer:
As the chart reveals, prices have been rising since mid-2009. Even the measure of Core CPI (CPI less energy and food, CPILFENS) appears to be rising:
The inflationists would say that this effect of inflation, rising prices, is a classic measure that proves new money is hitting the economy and that has caused, among other things, prices to rise.
The Deflation Argument
The deflationists have a different take on the data. They point to theories by economist Steve Keen which states that first banks make loans, and then the Fed increases money supply to meet demand. According to Keen and Mish, money supply is created first by banks making loans, then by the Fed supplying the money, because you can’t increase money supply without getting it into the economy. If there is no lending the money supply remains unchanged. Thus it is a rise in credit that leads to money supply growth.
Mish also argues that excess reserves don’t really exist; they are a fiction created by the Fed, a mere computer entry. If you consider all the loans made by lenders, and the actual or potential defaults of their loans, those losses would absorb all the “excess” reserves. Therefore, those “reserves” are more or less spoken for and don’t represent money for making new loans.
Mish also believes that reserves aren’t the problem with banks; rather it is their shaky capital base. Lending is constrained by their lack of capital and financial instability rather than by reserves.
The deflationists say that because the size and breadth of the crash in the real estate markets and related debt, the problem is too big for the Fed to handle. Until debt is deleveraged and banks and businesses repair their balance sheets, the Fed’s effort to increase the money supply is like pushing on the proverbial string.
The result is that real estate asset prices are declining and that results in deflation. They say it is similar to what the Japanese experienced in the late ‘80s and ‘90s, when they experienced almost zero growth, no inflation, and declining asset values. Banks, they say, are not going to lend until this deleveraging occurs and businesses become solvent and creditworthy.
The deflationists say that the current measures of prices are inaccurate because they don’t reflect the declining values of real estate. If real estate was factored in, then prices would be shown as declining. The only measure of real estate in the CPI computation is what is called the real estate rental equivalent which measures the rental value of homes rather than their asset value.
They suggest that prices are indeed falling anyway if you look at Core CPI (CPI less energy and food) on a year-over-year percentage change basis:
Obviously there is some evidence of declining prices as shown by this chart.
Which is it: Inflation or Deflation?
Let me suggest a way of looking at the problem.
We understand that inflation or deflation is a monetary phenomenon, not just an increase or decrease in prices. And, in order to cause inflation new money must find its way into the economy.
There are several ways the Fed can do that.
The Fed can make cheap money available by lowering the interest rate on money it lends out, which increases money supply. Even with the Fed Funds rate at 0.18%, effectively zero, this doesn’t seem to be working.
The Fed can make it easier for banks to lend. This seems to be a problem for the Fed right now. As we have seen previously, lending is way down, excess reserves are high, and the money multiplier has fallen dramatically. This hasn’t worked either.
Yet money supply has been increasing despite the failure of these policies.
There is another tool in the Fed’s arsenal called Open Market Operations (OMO) whereby it buys and sells securities with its primary dealers. For example, buying Treasury paper from dealers increases money supply and selling decreases money supply.
Starting in January 2009, the Fed began a program of buying mortgage backed securities (MBS) issued by Fannie, Freddie, and Ginnie Mae. At its peak, they bought $1.25 trillion of these assets, pumping up money supply by that amount. The purpose was to get liquidity into the economy and try to revive credit and economic activity. Further it absorbed the risk of these “toxic” assets, relieving the former holders of their bad investment decisions.
This form of money inflation does not have the impact of the money multiplier were those funds in the hands of bankers who would lend out the new money, but it does represent a substantial amount of new money injected into the system.
This money infusion is being used by the very willing sellers of these toxic assets, the big investment banks or the investment banking operations of the big commercial banks, not so much for making loans, but for their own investment purposes; this money has been driving the financial markets.
Deflationists vs. Inflationists vs. Modified Inflationists
This is the point where the inflationists and deflationists part. The inflationists believe that the Fed can and will increase the money supply any time they wish through open market operations. The deflationists believe it doesn’t matter what the Fed will do because banks are not in a position to resume lending, thus counteracting the Fed’s attempts at increasing the money supply.
I have a different take on this, but it is a bit complicated to explain. To try to put it in a nutshell:
1.I don’t agree with the deflationists that we will be just like Japan: continued deflation which would be the result of keeping alive bankrupt (zombie) banks and corporations. 2.I part a bit with inflationists because I don’t believe Open Market Operations will have the inflationary impact they believe will occur. I believe that bank lending, the best tool for inflating money supply will remain constrained and be a drag on the economy. 3.I believe that as the economy goes into a double-dip recession, the Fed will create ways to inflate that will be effective. I refer to my position as Modified Inflationism.
Predictions and a Decision Tree
Here is the problem in trying to forecast what will happen in the future: tell me what the Fed and the government will do. Remember the Freakonomics’ humorous take on forecasting:
The future will be different from the present to some degree and some point, and I have anecdotes and hearsay to prove it.
Austrian types don’t believe that you can use econometric models to predict the future because such models are usually wrong. You can’t distill millions and millions of economic decisions down to a simple or even complex formula of human behavior because the data set is too vast to be useful. We believe you have to understand why individuals do things in the economy first before you can study data. These were some of the breakthroughs of the great economists Mises and Hayek.
To figure out what the Fed might do involves a lot of probabilities. And that is my method of analysis: what are the probabilities that the Fed will do one thing rather than another when faced with different circumstances. It is much like constructing a decision tree to see where they can go. If X happens, then the Fed’s choices are A, B, and C. What are the consequences of each and what is more likely to happen.
Stick with me.
Tomorrow, Part 3. The double dip economy, the Fed's choices, and their fear of deflation.
After Part 4, I will publish the entire article as one downloadable PDF.
[1] The True Money Supply (TMS) was formulated by Murray Rothbard and represents the amount of money in the economy that is available for immediate use in exchange. It has been referred to in the past as the Austrian Money Supply, the Rothbard Money Supply and the True Money Supply. The benefits of TMS over conventional measures calculated by the Federal Reserve are that it counts only immediately available money for exchange and does not double count. MMMF shares are excluded from TMS precisely because they represent equity shares in a portfolio of highly liquid, short-term investments which must be sold in exchange for money before such shares can be redeemed. It includes: Currency Component of M1, Total Checkable Deposits, Savings Deposits, U.S. Government Demand Deposits and Note Balances, Demand Deposits Due to Foreign Commercial Banks, and Demand Deposits Due to Foreign Official Institutions. There are different takes on TMS. See http://mises.org/content/nofed/chart.aspx?series=TMS.
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