The Bernankean World View – As Misguided As Ever

We actually said last week we would not comment on Bernanke's truly cringe-worthy speech delivered last Thursday. Our reasoning was that he didn't say anything unexpected or anything we have not heard a thousand times before. This is certainly true, but we now feel compelled to comment anyway, if only to shine a light on what a horrible steward of the monetary system he is – while acknowledging that he certainly didn't design said system and is in equal measure its prisoner as much as its director.


Following his speech he was subjected to a soft-balling exercise (Q&A)  at the National Press Club in Washington, as Randall W. Forsyth put it in Barron's. Below we'll quote the synopsis of the important parts of the Q&A as related in the Barron's article.

The whole thing was as good an example of Bernanke's Princeton-bred sophistry as you will ever find. Princeton of course is the major hotbed of the semi-totalitarian Keynesian economic philosophy and the associated attempt to make economics more 'scientific' by subjecting it to econometric methods – measuring what can not be measured and deriving 'models' and 'theories' from these nonsensical efforts at imitating the natural sciences –  the same methods that guide the Federal Reserve in its decision making process.

Quoth Forsyth:


„Proving Lincoln's adage you can fool some of the people all of the time, Bernanke asserted to the credulous DC press corps that while the Fed's purchases of Treasury securities played a role in the rise in stock prices since last August, they did not affect the prices of commodities, notably food. Moreover, he rejected the premise that the civil unrest seen in Egypt and Tunisia could be attributed to Fed policy, which the questioner contended was responsible for higher food prices.

Commodity prices, including food, were driven by supply and demand, the Fed chairman argued. And that demand was being elevated by rising prosperity in emerging economies, which means a desire for a better diet. That, in turn, was mainly responsible for the sharp rise in food prices.

At the same time, the liquidity created by the Fed's purchases of up to $600 billion of Treasury securities was working as planned, Bernanke continued. According to the Fed chairman, QE2 has boosted asset prices, notably stocks; lowered market volatility and thus, risk; narrowed corporate-credit risk spreads; and has lifted inflation premia in the Treasury Inflation Protected Securities market. That Treasury yields are higher since the Fed started buying Treasury securities is not inconsistent with QE2's working.

That's been the Fed's story, and Bernanke was sticking to it.“


One thing must of course be admitted right off the bat – Bernanke wanted to see his inflationary policy to have clearly discernible inflationary effects in the form of rising prices, and he sure got his wish. Along with this comes the usual inflationary illusion of 'economic growth', which we think should rather be termed 'capital consumption disguised as growth' that makes it appear as though the policy was 'working'. It does so  by misdirecting scarce capital into unprofitable ventures and creating illusionary profits, while in reality impoverishing us even further.

So Bernanke is actually correct when he says that rising treasury yields are part and parcel of his 'success'. After all, what else would inflation do to treasury yields? Unmentioned remained the previously uttered conceit that the Fed can actually 'control' said yields and keep them lower than they would otherwise be. It could, of course – by stopping the money printing exercise, but not by continuing and enlarging it.

More amazing is his brazen assertion that the Fed's inflationary policies have only produced 'good' inflation – this is to say the effects of inflation that everybody, from the unwashed masses to politicians to Wall Street traders loves – in the form of rising stock prices and the ensuing, as he put it, 'virtuous circle', while refusing to countenance the notion that 'bad' inflation – in the form of sharply rising commodity prices – may have anything to do with the same policy.

As Forsyth summarizes further:


“What Bernanke didn't address was the uneven impact of the rise of equity values and commodity prices. The theory he espouses is that monetary policy works through boosting asset prices, which in turn encourages consumer spending, business investment and then hiring. He did not mention that a major channel for the transmission of monetary policy — the housing market — has broken down, which is obvious given record-low housing starts and simultaneously near-record-low mortgage rates.

The Fed chairman did assert that rising costs for food and fuel are not feeding through to so-called core inflation and, by implication, weren't a cause for concern now. As he noted, the jump in food and energy costs have not increased compensation. The Labor Department reported earlier Thursday that unit-labor costs fell 1.5% in 2010, matching the decline in 2009. That was the result of a 3.6% increase in productivity last year, a hair higher than 2009's rise.

There isn't a manager in American business who isn't getting his staff to do more with less. The vise on hiring and compensation is even tighter as costs of materials rise. And so the Fed's efforts to boost employment may backfire if companies try to offset rising input prices by holding down personnel costs.”


Let us address this bit by bit. What the 'broken down housing market' tells us is an age old truth about inflationary policy – its instigators can not control what prices exactly will rise. It is a good bet that reversing the collapse of the housing bubble was and is on the Fed's agenda, so it should be no surprise that this evident failure didn't rate a mention by the chairman. However, even if the policy did 'succeed' in this particular respect, it would only mean that the  liquidation of unsound investments in the sector has been arrested. This is not a feat to be celebrated, but dreaded – since all it would achieve would be a stay of execution during which the underlying fundamental situation would have time to worsen, necessitating an even bigger retrenchment at some point in the future. The same holds for those areas where the Fed's policy is allegedly 'succeeding', i.e., the 'virtuous circle' Bernanke maintains has been set into motion by rising equity prices, falling risk premia, and the attendant increasing willingness of consumers to consume rather than save and the willingness of businesses to invest. To these things we note: the bust was not a result of people saving too much, but saving too little. It is not as if the economy was starved for consumption, it was starved of real savings. How even more unfunded consumption (this is to say, consumption  not funded by preceding production) is going to lastingly improve the situation remains mysterious.

As to investment, we would like to remind everyone of the chart showing the amount of spending going into production of business equipment vs. that going into production of non-durable consumer goods. It shows us (admittedly in a very crude representation) that investment and factors of production are drawn toward higher order goods production to the detriment of lower order goods production. This is a result of interest rates being held artificially low by the Fed's policies, which distorts the relative prices of goods along the structure of production. Again, while this creates an illusion of growing prosperity, it will in reality destroy even more scarce capital – something that will only become obvious once the process has worked its way through to its inevitable conclusion once again.

It appears at any rate from all of that Bernanke said that the experience of the 2003-2007 boom has taught him – exactly nothing. The very same arguments he is using now to defend the Fed's loose monetary policy have been used then  by the Greenspan Fed, of which he was part. Deflation had to be avoided at all costs, a 'virtuous cycle' had to be created somewhere in the economy to get over the slump in business spending on account of the technology bubble's bursting, and back then housing provided the playground for all these allegedly salutary effects of money printing to play out. The end result was the biggest economic and financial crisis of the entire post war period, in short, a rare achievement in economic destruction.

The notion that exactly the same policies that have led to this fairly recent near-fatal iteration of the boom-bust cycle will now magically produce something sounder and more sustainable strikes us as plainly insane. To paraphrase Einstein, trying the same thing over and over again and expecting a different result is  the very definition of insanity (even though Einstein was no psychiatrist, this particular bon-mot drips with common sense).


Inflation or Deflation?

The Post War Inflationary Era

If we were to characterize the post-war era, and specifically the post 1971 era's monetary system, i.e. the period during which the last restraint on monetary expansion in the form of a loose tie to gold was thrown overboard ('temporarily', as Nixon assured everyone back then), we would call it a period of constant, accelerating credit and money supply inflation, interspersed with occasional 'deflation scares'. These scares in turn invariably involved a sharp decline in the prices of those assets everybody loves to see increase , this is to say financial assets, real estate, art, and so forth. As a rule, the deflation scares immediately led to the Federal Reserve 'opening the spigots' as the saying goes,  engendering a bout of massive monetary inflation.

As the crises of the 'unanchored' fiat money system have grown, so have the Fed's reactions to them. The biggest such reactions yet have been encountered after the bursting of the Nasdaq bubble, when the growth of the Austrian true money supply measure TMS (or TMS-2 as we now call it, following Michael Pollaro's terminology to differentiate it from 'narrow' Austrian money AMS – or TMS-1 – as formulated by Frank Shostak) shot to 21% annualized, and the period following the 2008 bust, when annualized growth of TMS-2 has been at or above 10% in 23 months of the past 24.

A recent paper by Vijay Boyapati needs to be considered here in the context of  what the future may bring. The paper is entitled  “Why Credit Deflation Is More Likely than Mass Inflation: An Austrian Overview of the Inflation Versus Deflation Debate” and can be reviewed in its entirety via the preceding link. An excerpt was posted at the Mises Institute under the title “The Politics of Deflation”. The excerpt contains what to our mind is the more important part of Boyapati's argument.


Credit Inflation Technicalities

Still, we briefly want to comment on Boyapati's technical comments regarding bank credit inflation, in which he references Steve Keen's 'chain of credit inflation causality' to show that an increase in free, or 'excess'  bank reserves at the Fed on account of quantitative easing is of no import to the inflation argument. To summarize, Keen  first drew attention to himself by enunciating what some people declared to be a revolutionary insight: namely, so Keen, 'banks expand credit first, and go about acquiring the necessary reserves later'.

Our first thought upon hearing this was – 'so what?'. After all, since 1995, there have de facto been no reserve requirements whatsoever. The necessary administrative ruling was implemented by the Greenspan Fed in that it allowed the banks to make use of so-called 'sweeps'. Henceforth, the unused portions of sight deposits, which traditionally bore the greatest impediment to bank credit inflation since a 16% reserve had to be held against them, could be reclassified as 'savings accounts' (or to use the precise designation, 'money market deposit accounts' or MMDA's) for the purpose of lowering the reserve requirement to essentially zero. To read up on this inflationary sleight of hand in detail we refer you to a report by Charles Hatch, 'Inflationary Deception: How Banks Are Evading Reserve Requirements And Inflating The Money Supply' (pdf). This essentially explains how it was possible for the money supply to expand parabolically from 1995 onward without a commensurate increase in required bank reserves at the Fed. If one wanted to look for a limiting factor in the creation of fiduciary media by the banks, one had to look at the Basel capital adequacy rules.

Naturally, the banks were quite ingenious in circumventing those rules as well, by separating loans and securities based on loans from their balance sheets with the help of SIVs and similar constructs, methods in which they acquired a great alacrity. Likewise, securitization as such allowed banks to retain certain income streams as servicers of the loans underlying such securities, pocketing interest rate spreads and garnering fees for marketing the securities to investors, while freeing up capital for yet more lending.

What off balance sheet constructs like SIV's and SPV's (Special Investment/Purpose Vehicles) and many run-of-the-mill securitizations and later more ingenuous mutations such as CDO's and CDO's squared all had in common was a distinct failure to actually properly disintermediate risk. Either the banks themselves furnished guarantees in order to ensure a better credit rating (and hence a bigger spread for themselves) for the vehicles and securities concerned, or alternatively risk was placed with insurers who either didn't understand its significance or were simply reckless (from the mono-lines to AIG). To the extent that the banks themselves held securities insured by such firms, they weren't properly insured due to underestimating counterparty risk. The point of this being that not even Basel rules could keep inflationary bank credit expansion in check, nor would bank managers worry about the obvious increase in their exposure to credit risk both off and on balance sheet, since they had no incentive to do so – large bonus payments and the moral hazard of the 'too big to fail' doctrine combined to produce this blatant disregard of risk. It is important to realize that the money substitutes/ fiduciary media that were created during this inflationary blitz sans any increase in reserves continue to exist. The inflation of the money supply that has happened during the inflationary credit expansion of the housing boom has not been 'taken back'. The times when a bust would actually reduce the amount of fiduciary media in the system via bank insolvencies and old-fashioned bank runs are a thing of the distant past – in modern times, both the FDIC insurance and the 'lender of last resort' – the Fed – ensure that this money once it has been created is no longer destroyed.

For the sake of completeness note here also that prior to the 2008 crisis, there were practically no excess reserves kept with the Fed, due to these reserves representing 'dead money' – they earned no interest. This has changed since 2008, when the Fed altered its policy on bank reserves by henceforth paying interest on excess reserves.

A  few more words on excess reserve technicalities. First of all, they don't form part of the money supply, since they sit idly with the Fed. Basically these are bank cash reserves, deposited with the Fed. As far as inflation of the money supply is concerned, they represent only 'potential inflation', since the commercial banks could in theory use them as the basis for creating more inflationary bank credit. There are a a number of factors mitigating against this at the moment. For one thing,  the banks still suffer from the after-effects of the crisis. The previously biggest source of credit expansion – real estate lending – is frozen. Losses continue to be incurred in this segment of the credit market as more and more borrowers default. Banks are well aware how interbank lending came to a standstill during the crisis, which is one more reason to keep precautionary cash balances in place. Also, the Fed currently pays 25 basis points in interest on such excess reserves while the effective Fed Funds rate remains most of the time below the upper range of the target rate of likewise 25 basis points. This reduces the incentive to  lend out excess reserves in the interbank market. Lastly, the Fed keeps insisting that it will eventually 'exit' from its extraordinary debt monetization measures; such an exit would tend to lower excess reserves, so keeping them in place may also be a precaution against this particular eventuality. If you believe there will ever be an 'exit',  think of a certain bridge that's for sale in Brooklyn. The Fed's balance sheet has historically often expanded, but it seldom shrinks (seldom enough that we might just as well  have said 'never').

Nevertheless, we can state that at the moment, monetary expansion is not 'firing on all cylinders', to paraphrase Michael Pollaro. The Fed's QE effort creates additional bank deposits to the extent that bonds are bought from non-banks, and banks in turn have begun to buy securities, but lending to the private sector is still not growing appreciably at the moment. This has however not kept the true money supply from rising by more than 30% cumulatively since August of 2008; in short, the Fed's extreme monetary pumping has more than made up for the reluctance of the commercial banking system to expand lending to the private sector. Inflation of the money supply has not only continued unabated, it has in fact accelerated markedly relative to the 2004-2007 period. This is a fact. There is no guesswork involved.



Excess reserves held by commercial banks at the Fed; a small uptick recently, but QE 2 has  not translated into a 1:1 increase in these reserves, as the banks are buying securities to 'ride the yield curve'. Meanwhile, non-banks also receive funds from the QE exercise, which increases both bank reserves and fiduciary media in the system – click for higher resolution.



Banking or Political Interests?

This brings us to the second major – and far more important – point made by Boyapati, namely that the interests of the political and the banking establishment are not necessarily congruent when it comes to the topic of inflation. We think this particular argument is substantially correct. The banking establishment favors 'slow inflation', but can not possibly be eager to see out-of-control inflation. We can also safely assume that the banking establishment knows better than the average politician how the system works and what could possibly provoke an uncontrollable loss of purchasing power of the monetary unit. This includes to the Fed itself, which sits at the center of the banking cartel. If it lost control over inflation,  the danger of making the bulk of its reserves and the currency it issues worthless would in fact endanger its very existence.

In that sense, Boyapati is correct that perhaps a policy of 'controlled deflation' as he calls it (similar to the BoJ's long time policy) would be more palatable to the banks than the risk of inflation getting out of hand.

However, if we look at the Federal Open Market Committee that is responsible for the setting of monetary policy, then we note that its membership consists of academics , a number of lifelong bureaucrats as well as a few bankers. As it were, the FOMC consists of seven permanent members – comprising the Fed's Board of Governors – as well as  four of the regional presidents that are getting a vote on a rotational basis (for instance, famous 2010 policy dissident , Kansas Fed president Thomas Hoenig, no longer has a vote in 2011).

The Fed's Board of Governors in turn consists entirely of political appointees – they are appointed by the president and confirmed by the senate for 14-year terms. Once appointed, they can not be removed for their views on monetary policy. Not only that, these governors are expressly forbidden to hail from the banking system.  The Board of Governors is in the legal sense a pure federal entity, i.e. a government body .

This distinguishes the Board from the regional Federal Reserve Banks, which are owned by the system member banks in their respective districts.  These  banks appoint six out of nine of the directors of the regional Fed boards (however, the Board of Governors must approve the appointment of the president of the board, and it gets to appoint the remaining three board members of each regional Federal Reserve bank – these are supposed to 'represent the  public interest').

In short, even if in the course of the FOMC rotation all four of the regional presidents were arch-conservative former bankers with hawkish views, they would be outnumbered seven to four by political appointees with no ties to the banking system whatsoever.

From this we can see that Boyapati's argument has a decisive weakness – while an appointment to a 14 year term should ensure a degree of intellectual honesty if you will, it can hardly be argued that banking interests have a larger stake in the Federal Reserve's policy making than political interests. In fact, we have historically seen numerous instances of the political pliability of the Fed , with chairman Arthur Burns who served under Nixon perhaps one of the most glaring examples. Paul Volcker will always be remembered as a Fed chairman who withstood political pressures and instead  engaged in a tight policy designed to smother an incipient uncontrollable inflation, but we can not tell for sure how much of the political criticism was 'for show' and how much of it was 'for real'. Furthermore, Volcker soon abandoned his monetary rectitude , as can be gleaned from the fact that in mid 1982, money TMS –  after actually contracting slightly for one year (a truly rare exception in the annals of the Fed) –  jumped by about 170% quarter-on-quarter and nearly 50% year-on-year. So he made up for all that 'deflation' of 1980-1981 in one fell swoop in 1982. In short, after just two years of 'monetary rectitude' Volcker presided over the biggest short term expansion in money TMS of the entire post war period.

We will be the first to admit that even from a political point of view, uncontrollable inflation is not a desirable goal. Politicians may prefer an 'inflating away of the debt' in view of the government's huge and growing debt load and its even larger unfunded liabilities, but a hyper-inflation brings about a complete economic collapse and as such an outright default may be considered preferable – especially given that so many treasury securities are held by foreigners, which theoretically opens the door to a selective default. Note here that we are not even going to dignify the government's finances with the preposterous idea that they represent anything but a looming default, in whichever manner it will occur. It should be clear to everyone that no Western welfare/warfare nation government will ever be able to repay its debts. The shrinkage of government that would be necessary to achieve a repayment is entirely antithetic to the system as it is now constituted. The reality is that government is growing bigger every single day – think of it as a fungus that is slowly suffocating its host. Nothing but a final collapse will rectify – or let us say, at least change – the situation. The only open questions are how long the muddling through toward the inevitable end will take (this is unknowable, but as we noted before, if the Soviet system could last for seven decades, our 'mixed' economic system should be able to last even longer) and what form the apocalyptic final act will take.

However, to stay with the topic at hand, we note that first of all, the Fed is already a political animal first and a creature of the banking system second – at least in terms of how its leadership is appointed – and secondly, a recalcitrant Fed can always be politically commandeered. The Fed's charter can be revoked or altered by Congress at any time. Such a step would not be taken lightly to be sure – if anything it would probably only ever be considered at a time of severe crisis and faltering economic and market confidence.  Alas, the point remains that in extremis, it can be done.



The 'Volcker spike' in money supply growth in 1982 in its full glory. The 'tightfisted' chairman became extremely loose at the first opportunity. The cumulative amount of TMS-2 outstanding meanwhile shows that at no time during the recent bust was there a 'natural decline' in fiduciary media such as we would have observed without the backstopping of the banking system by the Fed and FDIC. In fact, it is quite clear that beginning with the demise of the Nasdaq bubble in 2000, money supply growth has  exploded – soon total TMS-2 will be about three times its level of 2000 – click for higher resolution.



How 'It' Could Happen Anyway

Having acknowledged Boyapati's contention regarding the banking establishment's likely views and even conceding that a preponderance of political control of the Fed still does not mean that anyone is pining for an inflationary conflagration down the road, it behooves us to ponder how and why it could happen anyway – eventually.

At the moment we have a situation where numerous market signals are confirming that an inflationary policy is pursued with great vigor all around the world. Just as Austrian theory would predict, we observe how capital is drawn toward higher order goods or durable consumer goods that due to their longevity can be analytically treated as akin to capital goods (this goes especially for housing  –  for more on why housing should be viewed through this lens, review Doug French's article 'Is Housing a Higher Order Good?', to which we would add J.H. de Soto's observation, made in 'Money, Bank Credit and Economic Cycles', p. 316, that 'durable consumer goods are ultimately comparable to capital goods maintained over a number of consecutive stages of production, while the durable consumer good’s capacity to provide services to its owner lasts'.).

Which prices precisely reflect the effects of monetary inflation most egregiously partly differs from country to country (China, Australia and Canada e.g. suffer from vastly extended real estate bubbles), while internationally traded and fungible commodities are of course rising in price everywhere with little local variation (here the 'inflationary effects' as visible in official statistics are largely a function of how exactly a country calculates its price indexes).

To remain with the US, we observe a palpable increase in inflation expectations, as evidenced by inter alia a persistent rise in so-called inflation break-evens. Note here that these expectations should be better named 'expectations regarding the annual increase of the official government-calculated and sanctioned consumer price index over the time period observed'. The inflation itself (i.e. the preceding increase in the supply of money) has already occurred and keeps occurring.



US 10-year inflation break-evens – as Bloomberg explains: They are calculated by subtracting the real yield of the inflation linked maturity curve from the yield of the closest nominal Treasury maturity. The result is the implied inflation rate for the term of the stated maturity – click for higher resolution.



Furthermore we observe a growing spread between short and long term yields, such as depicted below via the record high spread between the 2 year and 10 year maturities of US government notes:



The US 2 year to 10 year yield spread has reached a new high – click for higher resolution.



What this signifies in this case is a combination of an extremely loose Fed policy – which on account of its low administered interest rate is keeping a leash on the yields of shorter term maturities – with growing inflation expectations that are concurrently pulling longer term note yields up. 

Moreover, in addition to large increases in raw materials prices, reports from diffusion indexes such as PMI also show steadily increasing price pressures. The ECRI's future inflation gauge has even occasioned the institute to issue a warning about the current path of monetary policy.

In short, the Fed has indeed achieved one of its stated goals, namely to create widespread inflationary effects with its policy of inflating the money supply further via 'quantitative easing', or money creation from thin air as it is less euphemistically referred to.

As further proof that this is indeed a global phenomenon, German inflation break-evens currently look just as 'enthusiastic' as US ones. We already commented extensively on the persistent increase in prices in the U.K. economy , which happens even as said economy's growth rate is faltering once again.



German 10 year inflation break-evens. This is another remarkable uptrend, proving that inflation expectations are increasingly becoming unhinged worldwide – click for higher resolution.



It can certainly be said that there is more and more evidence of a growing inflation problem that is beginning to color perceptions of economic actors everywhere. There is at the same time proof that it is not yet perceived as being 'out of control' or even coming close to such an 'out of control' state – indirect proof that faith in the competence of central banks, or in this case, faith in the efficacy of Ben Bernanke's famed 'tools' still remains strong. This indirect proof is furnished by the gold price presently hovering at a low and well behaved level of $1,350/oz.

Rest assured that once there is an acute perception of inflation getting out of hand, gold will trade at a more exalted price level; not only that, it will also tend to vastly outperform non-monetary commodities at that stage of the process.

It is amazing that not only a certified monetary crank like Bernanke (and his retinue of supporters at the FOMC) fails to see the potential dangers, but that a plethora of financial journalists and economists (with a few notable exceptions such as Allan Meltzer), all evidently steeped in Keynesian opium, are egging this irresponsible policy on. Here are two recent pieces of evidence that came to our attention via a Bill Fleckenstein commentary. The  first is a Lex column in the FT, entitled 'Inflation' (we could at first not find it, because apparently, the title was retroactively changed from the original 'Learning to Love Inflation'. Why the FT would retroactively swap this far more descriptive title for a more bland one we leave for you to guess).

To quote from said editorial:


“Inflation has become a fact of life in much of the world. Higher food prices (wheat is up 95 per cent since last June) helped trigger regime-changing discontent in north Africa and the Middle East. Manufacturing surveys show record pricing pressure everywhere. And if strong manufacturing performance really prefigures higher employment, wage pressure can be expected to rise in developed economies. What is to be done?

The answer, eventually, is tighter monetary, fiscal and regulatory policy, which would take away the monetary fuel that makes price and wage hikes possible. But post-crisis, overleveraged parts of the world have some good reasons for delay.

Most important, unexpected inflation detoxifies over-leveraged financial systems by eroding the value of fixed debts – without going through disruptive defaults.”


Welcome to the conceit that the 'debt can be harmlessly inflated away'. The truth is of course that 'inflating away' debt is tantamount to default by other means. In fact, since it is in undeclared default, it should rather be termed 'theft' – plain and simple. The difference lies only in who is going to pay for the default, bondholders or the great mass of people forced to use the underlying currency, including and most importantly, savers and all those dependent on fixed income (retirees, widows, orphans, etc.). The editorial continues by asserting that


“Also, below-inflation wage increases are generally more palatable than actual cuts in the pay packet. This “money illusion” could help push Spanish or Greek wages down to competitive levels, as long as the workers do not wake up too fast to what is happening to them.”


In other words, it actually advocates the fraudulent dispossession of workers in the hope that they will prove too stupid to realize it! In spite of the cynicism,  this actually contains a kernel of truth – an inflationary policy is always more popular than a policy of tight money, even if it is economically more sensible (this is beside the fact that all attempts at centrally planning the economy in this manner are doomed to failure, no matter how 'sensible' they may look).  Alas, how can a serious economic/financial periodical serve up such 'pearls of wisdom' without even once stopping to question them? It gets even better …


Looking further ahead, Olivier Blanchard, chief economist of the International Monetary Fund, argued last year that an increase in the targeted inflation rate would give central bankers more freedom to set negative real policy interest rates.” 


(our emphasis)

We already knew that Blanchard is dangerous, but just to make this point one more time: 'negative interest rates' are definitely not a natural market condition, given that present goods will always be worth more than future goods. They can thus only be imposed by 'fiat' and as such contribute to even more economic destruction on a structural level. This Blanchardian drivel is hardly worthy of further comment, but we have dealt with similar ideas in the past if readers want to brush up on details of our critique (specifically, we let loose a broadside against such monetary crankdom in 'A Dose of Buiternomics', after the nice, but utterly misguided chief economist of Citi went so far as to attempt a revival of Silvio Gesell – evidently the worse an idea is the more likely it will be seriously considered by today's mainstream economists).

The editorial then states further that


“There is a case for allowing higher inflation in the developed world, and an honest admission of this would help the debate. The problem lies in the developing world, where rising commodity prices have created the wrong kind of inflation.” 


An 'honest admission that we need higher inflation would help the debate?' Good grief. Oh, and there really is a 'wrong' and a 'right' kind of inflation? You simply couldn't make this up.

In the meantime, yet another FT article has been published in the very same vein, this time entitled 'Getting caught on a commodity spike'. This article is a truly appalling example of circular reasoning. It starts off by lauding central bankers for not letting soaring prices intimidate them into adopting tighter monetary policy. 


To date, central bankers have sensibly resisted the temptation to respond to increases in food and raw material costs by tightening monetary policy. In a speech this week, the Fed chairman, Ben Bernanke, gave short shrift to the idea that commodity price rises presented any problem that would require a response from the Fed. Of course, US inflation remains below target so it was perhaps easier for him to say this. But a day later, the European Central Bank took a similar line.

Such dovishness is surely warranted by the incomplete nature of the recovery in the developed world, as this week’s feeble US employment figures attest. While growth has picked up, this has yet to stub out persistent fears about a double-dip recession. The output gap is still estimated to be significant.”



We have discussed the phantom/chimera of the so-called 'output gap' and its non-significance regarding the issue of inflation previously. The circular reasoning in the FT article comes next:


“It makes no sense for central bankers to respond to rising prices for commodities by depressing their economies until demand for those items is checked. Not only would this threaten a recession; it would be counter-productive. High prices are the best incentive for investment to remove supply bottlenecks. Damping them slows the self-correcting mechanism.”


Is it really necessary to point out that in the history of free market capitalism, commodity prices, especially real commodity prices, have been falling with unwavering consistency? Do we  really have to point out that therefore, whenever we have seen a broad swathe of real commodity prices increase sharply, it was due to one thing and one thing only, namely inflation of the money supply? How can it be 'sensible' for the self-anointed 'inflation fighters' at the central banks to ignore this? The article then notes that the rise in commodity prices harbors certain dangers – only to blow them off one paragraph later. It is worth quoting this as well:


“That does not mean that rising commodity prices do not pose a threat to price stability.” (duh, ed.) […]

“But this surely is an argument for continuing vigilance rather than overhasty action. The biggest threat that commodity prices pose to the recovery is that central bankers lose their nerve and raise interest rates prematurely. This would risk simply fulfilling the market’s fearful prophecies.”


'Vigilance' is henceforth to replace 'action'. Clearly, taking away the punchbowl is on nobody's agenda anymore.

The reason why we are spending so much time with detailing these editorials/articles is that they are fully reflective of the current establishment view as enunciated by Ben Bernanke since at least 2002 – the Japanese experience must be averted at all costs. They show how the conviction has grown that somehow, we will find a painless way out of our economic predicament without incurring any cost whatsoever, and if there is a cost, then it will  mainly be borne by clueless laborers and other defenseless members of society (who presumably deserve no better, since  it is likely assumed that few of them even read the FT). Presto, problem solved.

This narrative is a variation of Keynes' idea that by lowering the interest rate as close to zero as possible, central economic planners could achieve a kind of 'eternal boom' and in the process so to speak kill two birds with one stone by achieving both the 'euthanasia of the rentier' while concurrently abolishing the scarcity of capital. This cavalier attitude toward inflation and its increasingly visible effects is what will at some point make an uncontrollable inflation possible.


A Possible Scenario

As noted above, in addition to the actual, already perpetrated deed of vastly inflating the  money supply, we have growing evidence of inflation's effects in the form of rising prices and the increase in so-called inflation expectations. However, there is no guarantee that we are already directly on the path toward an uncontrollable inflationary episode. In fact, if we were to guess , there is probably at least one more iteration (and perhaps more than one) of the 'deflation scare followed by even more inflationary policy' yo-yo ahead of us. Maybe even directly ahead.

As we noted in a previous article on the phenomenon of hyperinflation, no-one has ever set out to deliberately  go down the path to hyperinflation. One weakness in Boyapati's argumentation is in fact that he simply assumes  that politicians would 'go for it' while bankers would not. We would submit that given a clear choice informed by well-reasoned economic arguments beforehand, no-one would ever chose such a path on purpose. In reality, a currency collapse tends to happen more by mistake than by design. We also noted in said article that the resilience and strength of the real economy underlying a given currency system – even the fiat confetti system of modern times – plays an important role in whether such a currency system collapse will happen or how easily it can be averted. Most historical cases of hyperinflation were marked by a confluence of events, including the size of the government's  debt getting too big (this is to say, growing beyond a certain threshold relative to economic output and relative to the remaining wealth left for the government to confiscate), the economy weakening on a structural level and lastly often an additional unexpected economic shock (such as e.g. the confiscation of farmland by Robert Mugabe), all 'accommodated' by the central bank's printing of money. In the final phase, economic actors will simply lose their faith that the purchasing power of the currency concerned will do anything but decline further, at which point the 'self-fulfilling prophecy effect' does the rest.  In Bernanke-speak, at that point, 'inflation expectations would become 'unanchored' – terminally so.  The frog would no longer be boiled slowly, but instead reject the state-issued money as a viable medium of exchange at lightning speed.

Let us reflect for a moment on the fact how much inflation there is already in the system from the policies implemented to date. Here we note that the growth in the supply of money has clearly outstripped the growth in underlying economic activity by multiples. As noted above, soon the true money supply will be three times as large as it was in the year 2000. Obviously, the same can not be said of economic output. Furthermore, we have not one, but at least four major central banks in the world pursuing a way too easy monetary policy (the Fed, the BoE, the ECB and the PBoC). Lastly, we have financial media and numerous economists lined up greeting these policies with approval, even while their inflationary effects have become clearly visible. At the same time, another ingredient – vast growth in government indebtedness – is also clearly present.

And yet, we must always bring this into relation with the countervailing deflationary undertow from market forces, unleashed since the 2008 bust. This is evident by the fact that lending to the private sector remains subdued (except in China, where the authorities can order the banks to lend) , by an incipient decline on total credit market debt and by the fact that banks are still hanging on to large excess reserve balances. Furthermore, the resilience and adaptability of the underlying economic system can not be doubted – yet.

Our contention is that the current 'reflation' episode (that is already producing truly bizarre extremes in price behavior, primarily in commodities and stocks) will weaken the underlying real economy further. This is unavoidable, as fresh malinvestments are ladled atop the previous, still unresolved malinvestments remaining from the preceding boom.  In turn it appears to us that any prospective tightening of monetary conditions could immediately bring this inflationary echo boom to a standstill and initiate a resumption of the temporarily arrested liquidation processes. This was clearly the case when the Fed ended 'QE1' in March and the ECB tried to withdraw its 'unlimited liquidity facilities' shortly thereafter. It took exactly two months from that point in time for  the next major financial crisis to break out, this time centered on the euro area.

The result? Central banks immediately proceeded to engage in 'reflation step two'. The Fed announced 'QE2', while the ECB restored its unlimited liquidity facility and began buying up bonds of insolvent peripheral nations in the euro area.

From the point of view of the 'cavalier inflationists' populating the establishment these days, the economic retrenchment that is sure to follow any signs of tightening will be taken as proof that even more inflation is needed. And this is how we may eventually get from 'A' to 'B' – by a series of 'deflation scares' (marked by falling asset prices and declining economic activity as measured by official statistics) that bring forth fresh efforts to alleviate the perceived economic ills with even more easy money. Contrary to the mainstream view we believe that it is precisely during these seemingly 'better times' when the inflationary policy produces rising asset prices and an illusion of profitability due to mispricing of capital that the greatest economic damage occurs. The only thing that policy makers achieve thereby is a postponement of the necessary retrenchment, while ensuring that every new iteration of the boom-bust cycle will be worse than the one preceding it.

At some point then we may conceivably arrive at the unknowable threshold where the combination of rising government debt, a structurally severely weakened economy and the cumulative amount of money that has been created in the vain attempt to keep the deflation bogey at bay create the necessary conditions for an 'out of control' death spiral of the underlying currency system. When that  time comes, few people will realize that it took a long time and many iterations of the boom-bust cycle to get to that particular point, which may partially obscure the chain of causality if/when it happens.

The alternative in the form of a 'controlled deflation' as proposed by Boyapati can of course not be ruled out a priori.  It just seems not terribly likely considering the mindset of the people currently in charge , their analysis of the situation and their preferred decision making processes (since they misconceive the causes of the bust, they can not possibly conceive of the wrongheadedness of their policies in fighting it).

However, we must be alive to the possibility of a political backlash creating different conditions than the ones we are observing at present. For instance, Bernanke and others in his camp may no longer hold sway after the current 'reflation' experiment fails.

We will certainly keep our eyes peeled for any signs that such a change in official attitudes may be in store. The essential preconditions for a deflationary era are just as easily discernible after all – in the main we are here referring to  the fact that the size of the extant systemic debt far exceeds the total money supply and that the private sector clearly wants to deleverage.  In the end, which way the cookie crumbles will come down to a political decision.

Alas, the desire to go the route promising the least short term pain is deeply ingrained, as is the Keynesian economic orthodoxy. The cultural and historical inhibitions that have hitherto guided the Bank of Japan's policies may not apply to the central banks of the West. Furthermore, even the BoJ may eventually yield to the temptations of an outright inflationary policy once the Japanese government's fiscal predicament becomes untenable.

Arguably, if Japan should ever 'tip over' from its current low money supply growth regime  to a clearly inflationary regime , it could have a devastating psychological effect on other regions of the world as well. At the moment this is still idle speculation of course, but since every passing day brings a resolution closer, it is still worth considering.

In conclusion, the current approach of the planners is akin to a doctor refusing to prescribe a life-saving medicine with the argument that its taste may be too bitter. Even though the eventual demise of our untenable tower of paper money and debt will likely involve a great deal of upheaval, it would be better for all concerned if the attempt to delay the inevitable were cut short – before the planners succeed in sowing even more chaos. Whether or not their intentions are merely misguided but well-meaning is irrelevant in this particular context.  It is high time to introduce the only type of monetary system that can be considered viable – a fully free market based one. Governments can not be entrusted with this responsibility, simply because it is not possible to plan the economy. It is preposterous to hold on to the archaic notion that something as central to the division of labor and the modern economy as money should be excepted from this universally valid economic law.



Fed chairman Ben Bernanke: “We only do 'good' inflation”

(Photo credit: AP)


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10 Responses to “The Road to Perdition”

  • White eagle:

    Excellent post!Nice description of the Great Fall predicted by Albert Jay Nock in 1935 after Fuhrer FDR took power.
    The game will continue until there is nothing left to confiscate and masses stop getting their bread and circuses.
    Politicians are aware that they are riding a wild mustang and don’t know how to get off without breaking their necks.
    Prudent people are looking for physical gold bars,that saved well-to-do Roman families(latifundi) from utter ruin and Jewish people during 2000 years of homelessness and prosecution.
    Anybody hoping for some reform and U-turn should ponder the wise words of F.A.Hayek:˝In democracy (as practiced in modern times) scum rises to the top.˝

    • Unfortunately Hayek’s pessimism seems entirely justified. Nock’s writings are hereby strongly recommended. Here is a pertinent excerpt from “Our Enemy, the State” – ‘The Progressive Conversion of Social Power into State Power’:

      • Floyd:

        Equilibrium between various competing parties is unstable.
        Pretty quickly the one party that grows on the expense of the other is getting so powerful that the weakening party must adjust or disappear.
        This explanation is simplistic, yet a good place to start grasping the trends.

        Observe another factor, the asymmetry of the situation.
        “We the people” will always elect to have some administration, aka government, to manage long-term-broad interests using pooled resources. Think police, building a bridge, etc.
        Sooner or later the opportunity comes for this administration to grow a bit (consider this a fluctuation). Before long administration becomes government, the most powerful organization in the country.

        GAME OVER.

  • Kathleen4:

    Dear Pater, et al.,

    You speak of selective default. I have been wanting to make an inquiry into boom-bust cycles culminating in War as the “end-game” solution. War, as a means to morally and monetarily enrich the elite. War, as an ingenious and disingenuous way to veil the “other collapse.” Although Keynes decried the Treaty of Versailles, he is also quoted implying the ability to plan, “Thus the economic clauses of the treaty are comprehensive, and little has been overlooked which might impoverish Germany now or obstruct her development in future.” I am not making any predictions, but a blabbergast from Australia informed Hillary Clinton [from a Wikileaks’ cable] that troops would be ready if the “financial stuff with China did not work out.” I am wondering if selective default would be a way to make treaties for the “provisions for War.” I would very much appreciate if you wrote an economically oriented post on the Weimar Republic with an emphasis on the Treaty of Versailles.


    • You make a very fair point regarding boom-bust cycles and war. In fact, if we look at economic history, one thing that stands out is that secular economic contractions invariably bring forth war. I like your idea of writing a post on the Weimar Republic and the Versailles treaty (in fact, one can not write about Weimar and not mention the treaty). I will make this the next ‘history post’ once the series on communism is concluded (the final part of that one should be out soon).

  • Siggyboss:

    I consider the Federal Reserve a blind man driving a car. The man can easily accelerate or decelerate with the available levers. However, he is dangerous to society because he cannot possibly know when to use said levers. Likewise, the Federal Reserve can inflate or deflate the money supply, but cannot know when to do so and to what extent within a dynamic market. In addition, the Federal Reserve has no control over the demand to hold US dollars. This demand can also fall faster than any decrease in the supply of money, and make the central bank irrelevant. According to Nassim Taleb, it’s worth betting on the rare possibility of a central bank underestimating this demand risk because the gains would be substantial (e.g. gold). Lastly, the snippet on Steve Keen was very informative. After learning of Keen via Mish, I believed he was the first to make that observation regarding the consequence of sweeps.

    Thanks for the great read.

    • I absolutely agree with your characterization of the central bank. Indeed, the central bank faces a variation of the socialist calculation problem that makes it impossible for it to know when to do what and in what measure.
      Your point about the demand for money is quite important as well. Consider that e.g. in the final stages of a hyperinflation, the purchasing power of money always tends to fall faster than the concomitant increase in its supply would suggest it should. One way to know for certain that one has arrived at the point where a staggering fall in the demand for money makes its repudiation as a viable medium of exchange a near certainty is when someone from the monetary authority suddenly announces that ‘we must now print more money to alleviate cash shortages’.

  • Joe Bloggs:

    What of the ‘savings glut’ argument put forward by Greenspan (and Bernanke) as a cause of the increase in money supply during the 2000s? Also, Greenspan claims that there was a serious deflationary threat in 2003.

    Has anyone proven him wrong yet?

    • The so-called ‘savings glut’ argument has been debunked numerous times. I’m sure it was at one time discussed here as well (to be found somewhere in the 2008 archive), but just to clear up one misconception right away: foreign savings, no matter how big they are, can not possibly ‘increase the US money supply’. Only the Fed in conjunction with the commercial banks in the US can do that. Likewise can foreign savings not be held responsible for the Fed’s policy on interest rates. A very lucid and easy to understand rebuttal of this attempt to exonerate the Fed from the sorry results of its policies by inventing a mythical ‘savings glut’as Greenspan et al. have done, was provided by Frank Shostak here:

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