Confessions of a 'Flationary Agnostic

I have no particular allegiance to either the hyperinflation or the deflationary camps. Both outcomes are possible, but not yet probable. Rather than being a benefit, occupying the middle ground too often just puts one in the middle, being able to see the merits in both arguments and possibilities, and being unwilling to ignore the flaws in each argument. But this is where reason takes me.

In a purely fiat regime, where a monetary authority has the ability and the willingness to monetize debt, there is NO mandated, no predetermined outcome for hyperinflation or deflation in the event of a credit crisis, unless that money is pegged to an external standard, which is ruled out by definition in a purely fiat regime.

In a credit crisis there is often a 'credit crunch' which is what was seen in the financial system when short term credit transactions seized up out of fear. This is not the same as a true monetary deflation which is a real contraction in the money supply, at the least. So far we have not seen this. And we may never.

Also, I would have to agree that the eventual fate of all fiat currency is failure and reissuance of a 'new' currency, due to the sustained erosion of a seemingly incessant, if gradual, inflation. This does not HAVE to be, but it is, as an outcome of human nature. Men will always and everywhere eventually succumb to the temptation of currency debasement, a free lunch, and so they cannot be trusted to manage a nation's affairs with the unrestrained keys to the Treasury.

And at the end of a currency's lifespan, there is quite often a bout of serious inflation that precipitates the reissuance and restructuring. How long this period of time can be no one can say.
That is the simple fact of it. The only limitation on the Fed's ability to inflate is the value of the dollar and the bonds; that is, their acceptability to 'creditors' who are willing to exchange goods and services with real value for paper.

And it should be perfectly clear that to choose a monetary deflation as a fiat policy decision for a country that is a net debtor would be bizarre to say the least.

Everything else is noise and generally ad hominem attacks. And the louder the noise, the less likely the person speaking knows anything about monetary systems.

I read that the Fed has taken on (a euphemism for 'monetized') roughly half of the Treasury debt issued in the second quarter of 2009. And it is quite likely that this is only a part of it, that a good portion of the rest of the debt was arranged for with other central banks, including those who are engaged in large scale currency manipulation of their own which is a de facto monetization on the road to default as China will be finding out most likely some day.

There is quite a bit of misunderstanding on the issue of deflation. As we have discussed before, deflation driven by slack demand is not uniform across product and service classes as it would be during a true monetary deflation. That is because goods and services vary in the elasticity of their demand.

Yes some prices will decrease, as one would expect, especially in those assets whose value has been inflated during a preceding bubble and discretionary items with a significant elasticity of demand.

But other items will remain stable or even increase in price, particularly essential items, and those provided from a sector with an oligopolistic framework.

Why? Because those who control access to essentials will seek to increase prices and 'rents' even during severe recessions to make up for lost revenue streams and profits in other areas of their business. Barring government intervention, every crisis has its profiteers.

So we have the phenomenon of banks being bailed out by the government, with public funds, not lending as they had promised, and greatly increasing fees and cutting services whenever and wherever they can on certain instruments such as credit cards, for example. Or other financial firms taking advantage systemic flaws and leverage and loopholes to game the markets, extracting what amounts to increased rents, a tax, on the nation's transactions, further dragging down the real economy.

Credit is not money. Debt is not money per se. These are things that are instrumental to the process of money creation and destruction.

If I 'owe you' ten dollars, are you ten dollars richer? Not unless you hold some sort of legally enforceable piece of paper to back it up, and even then there is a discount on the value of that paper which is repayment risk, the possibility that I might default on that arrangement.

Money is the sanction of the monetary authority on a particular debt arrangement. It is limited to only that which has been sanctioned, that which passes through the hands of the creditor "into" the money system. This may occur at the point of origin, the central bank, or one of its officially designated representatives, sanctioned by executive order or under the law created by the Congress.

One does not count a private debt obligation held by the creditor as money, in addition to the actual currency that was delivered to the debtor. That would be double counting, a misunderstanding of the accounting system. The debt held by the creditor is an asset, of varying liquidity and risk.

If you have an unused credit card with a $1000 credit limit, do you have $1000 dollars? Does that $1000 dollars exist anywhere? No, clearly not. You may act differently in having it, it may influence your behaviour, but it is not money.

Once you use that card, and 'borrow' $1000 on that credit line, then it does exist as money, and a corresponding liability of $1000 is created and is held by the bank as an asset.

Is that $1000 debt obligation being held by the bank the same as the $1000 in money that was created when you borrowed it and spent it, putting it into motion within the real economy? No. If anything we might have learned from this credit crisis should sink in, the value of collateralized debt obligations, a collection of assets on a variety of instruments, is deeply affected by risk.

This is why a private debt obligation cannot be money, because it is not significantly riskless and is more an asset. Anything that bears a significant risk of default that is not tied to the full faith and credit of the central monetary authority is not money. It is a product, some proxy for money.

Is the savings deposit in excess of FDIC at my local bank 'money?' Yes, but not of the same quality as cash in my pocket. That is why there are a variety of money supply figures.

Is the reduction of debt directly correlated to the levels of money in the nation's monetary supply? It depends on how it is accounted. The debt can be written off, and no 'money' is destroyed per se but the bank will take a writedown on assets. We are seeing this in action today, as vast amounts of CDS and MBS are devalued on the books of the banks.

We make a distinction obviously between the existence of the money itself, and the means or ability to create money through a particular process, which can itself be impaired, without a reduction in the aggregate supply of 'money' depending on how you account for it.

Here is an interesting chart. It clearly shows the precipitous dropoff in commercial lending, and the actions of the monetary authority and the government to step in and support lending, primarily in the programs of the Fed.



This lack of productive economic vigor is impairing the ability of the Fed to maintain an organic growth in the money supply. But it does not stop it. They have some limitation or impairment in their ability to manage the money supply, because of the slack demand in the economy and the loss of the aid of the 'money multiplier' and the moribund velocity of money. The money that is created by the Fed without a corresponding increase in economic activity is 'hot money' that is particularly dangerous from an inflationary perspective.

Here is an interesting paradox. At a time of slower growth rate of money supply, many might think that this is 'good' for the dollar, because less dollars means more value for each dollar, right? In essence, this is one of the major tenets of those called 'deflationists.'

First, there are not less dollars. The growth rate of dollars is slowing but as one can see, this is a relative thing historically.









But here is the key point.

The growth rate of dollars is slowing at the same time that the 'demand' for dollars, the velocity of money and the creation of new commercial credit, is slowing. GDP is negative, and the growth rate of money supply is still positive, and rather healthy. This is not a monetary deflation, but rather the signs of an emerging stagflation fueled by slow real economic activity and monetization, or hot money, from the Fed. The monetary authority is trying to lead the economic recovery through unusual monetary growth. All they are doing is creating more malinvestment, risk addiction, and asset bubbles.

Money supply and the rate of money supply growth is a confusing topic, primarily because lots of commentators twist it and split hairs about it to make points, without really caring to explain what is actually happening to those who are not specialists. 'Experts' hide behind terminology to obfuscate the situation to support particular policy initiatives under a cloud of fear, uncertainty and doubt. Despicable.

We have not written it out and worked the details yet, and the lags and expectations are always a significant issue, but generally the growth in the broad money supply should bear a positive relationship to the growth rate of real economic activity, with the appropriate lags. It ought not to lead it or lag it artificially except in extreme circumstances. Using money as a 'tool' to stimulate or retard economic activity is a dangerous game indeed, fraught with unintended consequences and unexpected bubbles and imbalances, with a spiral of increasingly destabilizing crises and busts. The Obama Administration bears a heavy responsibility for this because of their failure to reform the system and restore balance to the economy in any meaningful way. Whether it is cowardice, ignorance, or corruption is difficult to judge, but it is a failure without regard to motives.

What makes matters worse is that given the cumulative years of government 'tinkering' some of the key economic measures are hopelessly spoiled. The Consumer Price Index is probably the best example as is shown at Shadowstats. Consumer inflation is a key problem because it is used, as the chain deflator, in calculating real GDP, the basic measure of economic activity in a nation.

And so after the cumulative years of financial engineering by the government and the Federal Reserve, here we are today, caught in an ugly cycle of boom and bust, with an outsized financial sector, a government controlled by the money interests, and a productive economy in a systemic decline.

And this is why we say:

The banks must be restrained, and the financial system reformed, and the economy brought back into a balance between the productive and administrative sectors, before there can be any sustained recovery.

How the Economy Was Lost

Paul Craig Roberts was Assistant Secretary of the Treasury in the Reagan administration.

"How long can the US government protect the dollar’s value by leasing its gold to bullion dealers who sell it, thereby holding down the gold price? Given the incompetence in Washington and on Wall Street, our best hope is that the rest of the world is even less competent and even in deeper trouble. In this event, the US dollar might survive as the least valueless of the world’s fiat currencies."

Counterpunch
Doomed by the Myths of Free Trade
How the Economy was Lost
By PAUL CRAIG ROBERTS

The American economy has gone away. It is not coming back until free trade myths are buried six feet under.

America’s 20th century economic success was based on two things. Free trade was not one of them. America’s economic success was based on protectionism, which was ensured by the union victory in the Civil War, and on British indebtedness, which destroyed the British pound as world reserve currency. Following World War II, the US dollar took the role as reserve currency, a privilege that allows the US to pay its international bills in its own currency.

World War II and socialism together ensured that the US economy dominated the world at the mid 20th century. The economies of the rest of the world had been destroyed by war or were stifled by socialism [in terms of the priorities of the capitalist growth model. Editors.]

The ascendant position of the US economy caused the US government to be relaxed about giving away American industries, such as textiles, as bribes to other countries for cooperating with America’s cold war and foreign policies. For example, Turkey’s US textile quotas were increased in exchange for over-flight rights in the Gulf War, making lost US textile jobs an off-budget war expense.

In contrast, countries such as Japan and Germany used industrial policy to plot their comebacks. By the late 1970s, Japanese auto makers had the once dominant American auto industry on the ropes. The first economic act of the “free market” Reagan administration in 1981 was to put quotas on the import of Japanese cars in order to protect Detroit and the United Auto Workers.

Eamonn Fingleton, Pat Choate, and others have described how negligence in Washington DC aided and abetted the erosion of America’s economic position. What we didn’t give away, the United States let be taken away while preaching a “free trade” doctrine at which the rest of the world scoffed.

Fortunately, the U.S.’s adversaries at the time, the Soviet Union and China, had unworkable economic systems that posed no threat to America’s diminishing economic prowess.

This furlough from reality ended when Soviet, Chinese, and Indian socialism surrendered around 1990, to be followed shortly thereafter by the rise of the high speed Internet. Suddenly, American and other first world corporations discovered that a massive supply of foreign labor was available at practically free wages.

To get Wall Street analysts and shareholder advocacy groups off their backs, and to boost shareholder returns and management bonuses, American corporations began moving their production for American markets offshore. Products that were made in Peoria are now made in China.

As offshoring spread, American cities and states lost tax base, and families and communities lost jobs. The replacement jobs, such as selling the offshored products at Wal-Mart, brought home less pay.

“Free market economists” covered up the damage done to the US economy by preaching a New Economy based on services and innovation. But it wasn’t long before corporations discovered that the high speed Internet let them offshore a wide range of professional service jobs. In America, the hardest hit have been software engineers and information technology (IT) workers.

The American corporations quickly learned that by declaring “shortages” of skilled Americans, they could get from Congress H-1b work visas for lower paid foreigners with whom to replace their American work force. Many US corporations are known for forcing their US employees to train their foreign replacements in exchange for severance pay.

Chasing after shareholder return and “performance bonuses,” US corporations deserted their American workforce. The consequences can be seen everywhere. The loss of tax base has threatened the municipal bonds of cities and states and reduced the wealth of individuals who purchased the bonds. The lost jobs with good pay resulted in the expansion of consumer debt in order to maintain consumption. As the offshored goods and services are brought back to America to sell, the US trade deficit has exploded to unimaginable heights, calling into question the US dollar as reserve currency and America’s ability to finance its trade deficit.

As the American economy eroded away bit by bit, “free market” ideologues produced endless reassurances that America had pulled a fast one on China, sending China dirty and grimy manufacturing jobs. Free of these “old economy” jobs, Americans were lulled with promises of riches. In place of dirty fingernails, American efforts would flow into innovation and entrepreneurship. In the meantime, the “service economy” of software and communications would provide a leg up for the work force.

Education was the answer to all challenges. This appeased the academics, and they produced no studies that would contradict the propaganda and, thus, curtail the flow of federal government and corporate grants.

The “free market” economists, who provided the propaganda and disinformation to hide the act of destroying the US economy, were well paid. And as Business Week noted, “outsourcing’s inner circle has deep roots in GE (General Electric) and McKinsey,” a consulting firm. Indeed, one of McKinsey’s main apologists for offshoring of US jobs, Diana Farrell, is now a member of Obama’s White House National Economic Council.

The pressure of jobs offshoring, together with vast imports, has destroyed the economic prospects for all Americans, except the CEOs who receive “performance” bonuses for moving American jobs offshore or giving them to H-1b work visa holders. Lowly paid offshored employees, together with H-1b visas, have curtailed employment for older and more experienced American workers. Older workers traditionally receive higher pay. However, when the determining factor is minimizing labor costs for the sake of shareholder returns and management bonuses, older workers are unaffordable. Doing a good job, providing a good service, is no longer the corporation’s function. Instead, the goal is to minimize labor costs at all cost.

Thus, “free trade” has also destroyed the employment prospects of older workers. Forced out of their careers, they seek employment as shelf stockers for Wal-Mart.

I have read endless tributes to Wal-Mart from “libertarian economists,” who sing Wal-Mart’s praises for bringing low price goods, 70 per cent of which are made in China, to the American consumer. What these “economists” do not factor into their analysis is the diminution of American family incomes and government tax base from the loss of the goods producing jobs to China. Ladders of upward mobility are being dismantled by offshoring, while California issues IOUs to pay its bills. The shift of production offshore reduces US GDP. When the goods and services are brought back to America to be sold, they increase the trade deficit. As the trade deficit is financed by foreigners acquiring ownership of US assets, this means that profits, dividends, capital gains, interest, rents, and tolls leave American pockets for foreign ones.

The demise of America’s productive economy left the US economy dependent on finance, in which the US remained dominant because the dollar is the reserve currency. With the departure of factories, finance went in new directions. Mortgages, which were once held in the portfolios of the issuer, were securitized. Individual mortgage debts were combined into a “security.” The next step was to strip out the interest payments to the mortgages and sell them as derivatives, thus creating a third debt instrument based on the original mortgages.

In pursuit of ever more profits, financial institutions began betting on the success and failure of various debt instruments and by implication on firms. They bought and sold collateral debt swaps. A buyer pays a premium to a seller for a swap to guarantee an asset’s value. If an asset “insured” by a swap falls in value, the seller of the swap is supposed to make the owner of the swap whole. The purchaser of a swap is not required to own the asset in order to contract for a guarantee of its value. Therefore, as many people could purchase as many swaps as they wished on the same asset. Thus, the total value of the swaps greatly exceeds the value of the assets.

The next step is for holders of the swaps to short the asset in order to drive down its value and collect the guarantee. As the issuers of swaps were not required to reserve against them, and as there is no limit to the number of swaps, the payouts could easily exceed the net worth of the issuer.

This was the most shameful and most mindless form of speculation. Gamblers were betting hands that they could not cover. The US regulators fled their posts. The American financial institutions abandoned all integrity. As a consequence, American financial institutions and rating agencies are trusted nowhere on earth...