Central Bank Madness is Contagious

Lately central banks around the world are busy slashing interest rates (if they still have any to slash), or printing money more or less outright if they have bumped into the much-dreaded zero-bound. In fact, the newest fad is to cut interest rates even if there aren’t any left to cut. The minus sign on the keyboard has turned out to be useful after all!

Not only are the Keynesian dunderheads running the SNB at it (there is absolutely no reason to elevate them to quasi-sainthood just because they kicked an untenable peg out from under the euro), but lately also Denmark’s central bank. Note here that Denmark is home to one of the biggest household and mortgage debtbergs on the planet, relative to economic output. We somehow doubt that the credit bubble will be kept in check by slashing interest rates to minus 75 basis points.


1-Denmark, Household debt to GDP-annThe Danish situation – Denmark’s household debt to GDP ratio and the central bank’s crazy negative benchmark interest rate. Note how two tiny baby-step rate increases were enough to send the credit bubble into wobble mode – click to enlartge.


As an aside to this, Denmark is also considered a major showpiece of socialism. If you feel the urge to let the State nanny you from the cradle to the grave and take most of your income if you dare to earn more than three crowns, Denmark is the place for you (some additional color on this topic can be found here: “Socialism’s Prize Nation Slave State”). The Danes, incidentally, seem to be very nice people. We know a handful of Danes personally, and they are all intelligent, witty and extremely likeable. It could of course well be that we simply know the wrong Danes, this is to say, atypical ones. Nevertheless, we keep wondering how their country landed in this socialist mess.


Let’s Bring the Laughter Back

However, we digress. We actually wanted to talk a bit about price stability and the titular Mr. Narayana Havenstein. As readers are probably aware, his real surname is Kocherlakota, but we have renamed him in late 2013 after he made a stunning u-turn earlier that year from being a slightly “hawkish” and skeptical Fed board member to becoming the board’s most wild-eyed imitation of John Law, eager to heat the home by burning the furniture.

By now the Fed seems bent on finally delivering at least one rate hike. It has been talking about this for so long, that not following through would probably be considered a communication faux pas almost on a par with the SNB’s sudden de-pegging of the CHF. It would also fail to be on message, in the sense that the Fed has frequently stressed of late that the US economy is doing very well.

In fact, the US economy isn’t doing too badly (not great by any means, but it isn’t a total disaster either) – that is, if one measures its health by “economic activity” as such. The problem with this is that the statistical aggregates used to measure the state of the economy are not telling us anything worthwhile about the quality of said activity.

As a rule, capital is actually consumed in great gobs whenever the Fed’s board is doing victory laps celebrating the “success” of its monetary pumping. Just think back to its economic assessments it produced in the years preceding the blow-up of the last bubble in 2007-2008. “Economic activity” looked absolutely great in 2006, in fact, it looked quite a bit stronger than it does now. Things were held to be so great, that there was more laughter during Fed meetings than ever before. In reality, it was actually the height of a capital misallocation orgy of truly stunning proportions.

The charts below show that FOMC members kept laughing their heads off at their monetary policy meetings right until the blow-up of a Bear Stearns hedge fund in 2007. The first chart shows the frequency of laughter per year. Note however that the ratio of laughter to transcript pages actually peaked in 2006, right along with the peak in home prices, which is probably not a coincidence. The second chart shows “incidences of laughter per meeting”. Oddly enough, the blow-up of a Bear Stearns-owned hedge fund that was trading in the equity tranches of sub-prime mortgage backed CDOs appears to have been greeted with great mirth. This mainly shows how utterly clueless the members of the FOMC board were at the time – even when the up to that point clearest warning shot could be heard, they completely failed to grasp its significance.


2-laughter annualizedLaughter at FOMC meetings, annualized. The peak in the ratio of laughter to transcript pages was in however recorded in 2006, at the height of the real estate and mortgage credit bubble.


3-laughter per meetingLaughter per individual meeting. The blow-up of a Bear Stearns hedge fund that invested in sub-prime mortgage debt was apparently considered especially funny (at the time the crisis was held to be “well contained”). While not shown here, the incidence of laughter collapsed rather quickly thereafter.


We Are Not To Be Out-Printed …

This brings us to Mr. Kocherlakota, who has apparently decided to stick with his 2013 shtick and is at the moment singing from a different hymn sheet than the rest of the central planning committee. According to a Reuters report, it seems he would like nothing better than to restart the printing presses without delay:


The Federal Reserve should consider restarting its controversial bond-buying stimulus if inflation does not start moving back to 2 percent once downward pressure from the recent drop in oil prices dissipates, a top Fed official said on Tuesday.

The Fed should first promise to keep rates low until it is convinced inflation will return to its 2-percent goal within a year or two, and until market-based measures of inflation expectation have risen back to normal levels, Minneapolis Fed President Narayana Kocherlakota told reporters after a speech.

If that doesn’t get inflation moving back to the target with alacrity “then I think we should be reconsidering asset purchases,” he said.

Kocherlakota’s view is likely in the minority at the Fed, which stopped its bond-buying program last October after the U.S. unemployment rate dropped faster than expected. Most Fed officials now believe it is only a matter of time before inflation, which is running well below the Fed’s target, will improve as well.

Kocherlakota said Tuesday that it is a mistake to assume that just because the real economy is healing, inflation will automatically return to healthy levels.


(emphasis added)

We are still waiting with bated breath for an explanation as to why an arbitrary percentage of annual monetary debasement these people have essentially picked out of a hat is considered “healthy”. What’s so bad about prices that actually don’t rise all the time? The term “healthy inflation” is downright Orwellian. Of course we are only asking rhetorical questions here. The idea that an economy-wide decline of money’s purchasing power of 2 percent per year represents “price stability” and is “healthy” is simply an article of faith that has become deeply ingrained in the economic orthodoxy of the planners.


Kocherlakota-HavensteinNarayana Kocherlakota-Havenstein: transformed from skeptic into a wild-eyed money printer.

Photo credit: Craig Lassig / Bloomberg / Getty Images


There exists neither theoretical nor empirical proof for this notion – which is presumably why no explanation is offered. Occasionally the hoi-polloi are presented with the reasoning behind the “falling prices are bad for you” meme, which is so ridiculous that anyone with even a modicum of common sense should be shaking his head in slack-jawed disbelief. It is quite ominous that people believing this tripe are actually in charge of monetary policy.

Perhaps though Mr. Kocherlakota is just experiencing a bout of printing envy at present. Maybe he is looking at all those other printing presses around the world that are suddenly humming around the clock again, and it irks him that the Fed is currently the odd man out. How dare they out-print us! There is a very good chance though that he really believes that money’s purchasing power needs to continually drop if economic nirvana is to be attained.


4-US-TMS-2,y-y-growthThe year-on-year growth rate of the US true broad money supply aggregate TMS-2. The annualized rate of monetary inflation currently stands at approximately 7.8% – click to enlartge.


The Dangerous “Price Stabilization” Policy

People sometimes ask us if a policy trying to ensure price stability wouldn’t be desirable in principle. For instance, let us say that the nonsensical “target” of a two percent devaluation of money were dropped and replaced with a new target of zero percent – i.e., actual price stability. Wouldn’t that be a good idea?

First of all, one needs to be aware that there actually is no such thing as a “general level of prices”. What there is, is a huge array of price ratios between money and goods/services. Money is merely a convenient medium of exchange. At the time of its origin, the most marketable commodity was chosen to fulfill the function of money. Various commodities have been used as mediums of exchange over time, from cattle to furs to salt, until actors in the economy finally settled on precious metals (presumably because precious metals have numerous advantages over other money commodities).

This happened without any committees getting together and deciding “these commodities shall be money” – money emerged from the market process. It is interesting to note in this context that people all over the world eventually chose to use precious metals as money, without any “planning” or interference from the State. As the Abbé Ferdinando Galiani (1728-1787) remarked to this in his work “Della Moneta”:


“[…] those who insist that all men had once come to an agreement, making a contract providing for the use, as money, of the per se useless metals, thus attaching value to them. Where did these conventions of all mankind take place, and where were the agreements concluded? In which century? At which place? Who were the deputies with whose help the Spaniards and Chinese, the Goths and the Africans made an agreement so lasting that during the centuries which have passed the opinion never was changed?”


Obviously, human beings not only make subjective assessments of the valuation of various goods which primarily have use value to them, but employ the same process in evaluating money itself, which is mainly demanded for its value in exchange (it is easier to envisage this if one thinks of money as a good rather than a piece of government scrip). In short, money is just as much subject to the “forces of supply and demand” as any other good. Thus, if we look at the exchange ratio of money to, e.g. a pound of copper, it reflects not only the valuation of copper based on perceptions of its usefulness and its current supply and demand situation, but it concurrently reflects the valuation of money, based on the same principles. Whenever the money price of copper changes, it is not possible to ascertain to what extent this change is due to the former or the latter evaluation process.

It follows from this that there exists no fixed yardstick by which a “general level of prices” can be measured – although it is certainly true that money possesses a certain purchasing power, which changes over time. These changes have become especially pronounced in the era of central banking, during which they have moved almost exclusively in one direction, with money becoming worth less and less over time. Since the establishment of the Federal Reserve to “ensure price stability”, the US dollar is held to have lost approximately 97% of its purchasing power.

Given what we have just said about the impossibility of actually measuring money’s purchasing power, it is clear that this is at best a rough estimate. Still, the very idea that this engine of inflation is the “guardian of price stability” is evidently laughable. Given the difficulty in measuring a general level of prices, attempts to achieve quantitative targets like a debasement of precisely 2 percent per year appear to be especially hare-brained.


How Prices Are Kept “Stable”

However, let us for the moment leave all this aside and let us assume that the “price indexes” calculated by governments are actually sensible. We concede that such price indexes can at the very least indicate the broad trend in prices over time. As mentioned above, one cannot ascertain to what extent price trends over certain periods of time are owed to monetary debasement and to what extent they reflect changes in the valuation of goods. It is clear though that monetary debasement has been the major driving force over the long term.

Let us briefly consider in this context what “economic growth” really means. It should be obvious that money is not synonymous with wealth. Prosperity is not defined by numbers in accounts. How is it material growth actually achieved?

In the simplest terms, labor and land (in the widest sense) are combined to create capital; then all three factors are combined in further production processes. Over time, the resulting structure of production tends to evolve into a complex latticework that consists of countless specialized processes of varying length and at varying distances from the end products to the production of which they contribute. Their inter-temporal coordination is crucially dependent on interest rates, which is why central bank manipulation of interest rates is so harmful.

A major goal of these market processes is to “do more with less” – in other words, to increase productivity. The more specialized and lengthier the production structure becomes, i.e., the more the “roundaboutness” of production processes increases, the more productivity tends to rise (not only that: certain goods could e.g. not be produced at all without increasing the length of the production structure).

Consider now what this implies for the money prices of consumer goods if the value of money were indeed “stable”. It would mean that the prices of all products and services would tend to decline over time (there would be fluctuations in individual prices, signaling to market participants where to direct their productive efforts, but generally, prices would be in a mild downtrend). In short, a falling trend in prices is a hallmark of a progressing economy.

Occasionally, there are extraordinarily strong spurts in productivity growth. This was e.g. the case in the early 20th century, as an enormous number of new production methods and great inventions appeared on the scene. It was again the case when it became feasible to introduce computerization into virtually all production processes, as well as creating computer-based consumer goods.

In such time periods, prices will tend to be under especially strong downward pressure. Central bank orthodoxy however demands “price stability” – not only are prices not supposed to fall, they are actually supposed to increase by two percent year after year. How can this be achieved? Obviously, the only way to do this is by debasing money especially fast. The only way a central bank can ensure that this happens is by growing the money supply at exorbitant rates. In a fiat money system this usually also involves an especially fast credit expansion. How much credit expansion the growth of the money supply entails, depends largely on whether it is mainly driven by the inflationary lending of fractionally reserved commercial banks or by direct central bank intervention (“QE”).


5-Commercial banks, all loans and leases,y-yTotal bank credit, year-on-year growth rate. As can be seen above, growth in inflationary bank credit has accelerated greatly in 2014. The acceleration is most pronounced in the commercial and industrial segment. This is the main reason why money supply growth has not faltered further last year, in spite of the cessation of “QE” – click to enlartge.


Given that the central bank uses a “general price index” for determining how much monetary pumping is required to achieve “price stability”, another noteworthy effect can be observed. As productivity growth is so large in some industries that the prices of the goods they produce are declining in spite of continual monetary debasement, other prices must rise at extraordinary rates to balance this phenomenon out if price indexes such as CPI are to rise. We can see this nowadays in the exploding costs of education, health, and many other services that are not easily tradable and are not subject to the great strides in productivity the manufacturing sector has achieved.

In light of the above, central banks are practically forced to blow one credit and asset bubble after another if they want to achieve their vaunted “price stability” targets. These bubbles will be all the greater in periods of rapidly rising economic productivity. Unfortunately, a chief effect of these policies is the distortion of relative prices in the economy, which falsifies economic calculation and leads to massive malinvestment of scarce capital. These booms induced by monetary pumping and credit expansion feel good while they are underway, but are inevitably followed by massive busts – the amplitude of which has steadily increased over time and has become especially pronounced since the adoption of a pure fiat money system. In such a system there is no theoretical limit anymore to money supply and credit expansion, and this is beginning to show.

Therefore, the price stability policy, instead of delivering stability, is in fact extremely destructive. Sure enough, in spite of the destructive effects of this policy, there has been enough genuine wealth creation over the decades to allow living standards and prosperity to continue to increase globally. As long as there are still remnants of a free market, this trend is set to continue in the long term. However, the malinvestment that characterizes booms caused by monetary pumping has impoverished us by destroying a lot of wealth concurrently.


A Distorted Production Structure

The next chart shows the ratio of capital to consumer goods production in the United States. Such aggregated data must always be taken with a pinch of salt, but the production indexes the ratio is based on can at least inform us of broad trends. During a credit-expansion induced boom, more and more factors of production will tend to be moved toward the higher stages of the production structure, and so the production of capital goods will rise relative to that of consumer goods.

Since “free capital” in the form of saved consumer goods is needed to sustain this longer production structure, the process is ultimately self-defeating. Recently, the ratio’s uptrend has begun to stall out, which may be a sign that the current echo boom is close to ending – although it is probably too early to come a definitive conclusion. Nevertheless, the tightening of monetary policy with the end of the “QE” program has definitely had an effect at the margin – for instance, numerous industrial commodities have suffered large price declines.

To what extent the recent spurt in bank credit growth can reverse the process, or whether it will be able to push the ratio to new extremes, remains to be seen. Note that while credit and money supply expansion can lengthen a boom’s duration considerably, they cannot keep it going forever. The ultimate limit to this is the economy’s pool of real funding, which comes increasingly under pressure the longer the boom lasts.


6-capital vs. consumer goods production-annThe ratio of capital to consumer goods production: note that it always contracts during recessions, as malinvested capital is liquidated and the economy’s production structure is shortened again to a more sustainable configuration.



Contrary to popular opinion, the price stability policy pursued by central banks is not only not beneficial, but is in fact extremely harmful. This should already have become clear in the wake of the Great Depression, a bust that was also caused by central banks boosting the money supply to keep prices stable and igniting an unsustainable boom as a result. However, if this lesson has ever been learned, it has certainly been forgotten again. Since the stagflation of the 1970s, “price stability” has once again become the new religion. The danger that at some point down the road it will all end with a catastrophic systemic implosion remains as great as ever.


Addendum: Captains of Industry Pleading for More Easy Money

As Marketwatch reports, assorted captains of industry are pleading with the Fed to hold off on rate increases. We are not surprised – the boom is intensely vulnerable to a further tightening of monetary policy, and their investments, bonuses, etc. would surely suffer if it came to pass.


Charts by: St. Louis Fed, tradingeconomics (inlay chart), Fed laugh tracks: original chart by Daily Stag Hunt, adapted charts by Boiling Frogs Post




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2 Responses to “Narayana Havenstein and the Lunacy of Price Stability Policy”

  • jimmyjames:

    Great report !
    I laughed all the way through .. a few good belly laughs from the authors conclusions and slam downs but way more laughs from the clueless methods of our slave masters to somehow halt the coming nastiness .. those laughs were pure cynical..

  • No6:

    The CPI doesn’t measure all prices and therefore not only do some prices have to substantially increase to balance the reduced prices of products benefiting from productivity gains, other not index included bubble prices can go to the moon.
    Of course the difference between what would have been falling prices and increased standard of living and the orthodox 2% CPI of ‘price stability’ represents pure theft, a wealth transfer from the productive to the banking and governing elites. They should be identified, charged, tried and punished.

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