Tuesday, May 26, 2009

Liquidity Drowning the Meaning of Inflation?


On Monday, Sheldon Filger wrote an article in the London Telegraph stating that the U.S. economy risks the dire prospect of hyperinflation:

... though not downgrading the danger of deflation, I believe policymakers are ignoring other factors regarding this economic and financial condition. Furthermore, the U.S. government and Federal Reserve in particular, are taking steps to "cure" deflation that will inevitably lead to hyperinflation, which in the long-term may prove far more destructive to the long-term health of the U.S. economy.

History demonstrates that deflation is not a permanent condition. Market forces, unencumbered by fiscal and monetary intervention, eventually restore pricing equilibrium. At a certain point prices of major durables such as homes are low enough to encourage new categories of consumers to enter the marketplace. As demand is restored, prices stabilize and then resume their upward ascent. It is all a question of time. However, key decision-makers in the United States are not paragons of patience. They want deflation cured immediately, which explains why the U.S. Treasury and Federal Reserve are hell-bent on policies that are guaranteed to be inflationary. The question is how bad will inflation ultimately be.

Massive quantitative easing by the Fed is pouring trillions of U.S. dollars into the money supply, essentially conjured out of thin air. This is being done without transparency, the rationale being that frozen credit markets require a vast expansion of the money supply in an attempt to get the arteries of commerce flowing again. Similarly, the U.S. government is spending vast amounts of money it does not have, with the Treasury Department selling unprecedented levels of government debt in a frantic effort to fund the wildly expanding U.S. deficit. These two forces, quantitative easing and multi-trillion dollar deficits, are the core ingredients of an explosive fiscal cocktail that I believe will ultimately lead to hyperinflation.

What exactly is hyperinflation? Economists disagree on a common definition, so I will offer one myself. Double-digit inflation extending over a period of at least two years would arguably be a hyperinflationary period. It can get much worse, witness Weimar Germany in the early 1920's and Zimbabwe at present. The most recent experience the United States had with this unstable economic condition was in 1981, when the annual CPI rate exceeded 13%. The cure was draconian; Federal Reserve Chairman Paul Volcker engineered a severe economic recession that created the highest level of U.S. unemployment since the Great Depression -- until now. The federal funds rate, currently near zero, rose to above 20% under Volcker's harsh discipline. Eventually high inflation was purged out of the system and economic growth was restored, however the monetary regimen was punitive for several years.

The current monetary and fiscal policies being enacted by the key economic decision-makers in the United States are laying the groundwork for a far more dangerous inflationary environment than anything encountered by Paul Volcker.

The explosive growth in the money supply and government debt is simply unsustainable without severe inflation. It must be kept in mind that the Federal government is not the only public authority engaged in massive deficit spending.

Throughout America, state, county and municipal governments are faced with imploding tax revenues and lack the ability or political flexibility to cut services to a level commensurate with revenue flows. Both the Fed and the public sector are engaging in a reckless gamble; borrow like crazy in the hope that this overdose of economic stimulation will restore growth to the economy and normal tax revenues, leading to a decreased and sustainable level of public sector indebtedness.

If one believes that the policymakers running the Federal Reserve, Treasury and Federal government, the same architects of the Global Economic Crisis, are smart enough to now get everything right, perhaps we may escape the worst consequences of their turbo-charged fiscal and monetary policies. However, there are growing indications that global investors and the broader market are beginning to reach a far more sobering assessment.

In an interview with Bloomberg News, Bill Gross, co-chief investment officer of PIMCO (Pacific Investment Management Company) suggested that the coveted AAA credit rating U.S. government debt now benefits from will eventually be downgraded. "The markets are beginning to anticipate the possibility of a downgrade," Gross said.

China, the major purchaser of Treasuries and holder of $1 trillion of U.S. government debt, is already on record as expressing concern for the integrity of its American investments, and has begun actively exploring alternatives to the U.S. dollar as the primary global reserve currency. These moves by China are not based on fears of expropriation of its U.S. assets, but focuses on the specter of hyperinflation destroying much of the value of assets denominated in U.S. dollars. No doubt China's economic experts are well aware of the growing number of economists who are convinced that the U.S. will be unable to service its rapidly expanding debt burden without significant inflation. Inflation in monetary terms means the erosion of the intrinsic value of the American dollar.

What is most frightening about the policy moves being enacted by the Fed and Treasury is that their actions may not be a reckless gamble after all. They may have come to the conclusion that only hyperinflation will enable the United Sates to avoid national insolvency. In effect, they may be pursuing the exact opposite course undertaken by Paul Volcker in the early 1980's. If that is their prescription for the dire economic crisis confronting the U.S., then one must conclude that Ben Bernanke, Timothy Geithner and Larry Summers have learned nothing from history. Once the spigot of hyperinflation is tuned on, it becomes a cascading torrent that is almost impossible to switch off, and which in its wake inflicts inconceivable levels of economic, political and social devastation. Before it is too late, President Obama should put the brakes on his economic team's dangerous gamble with the haunting specter of hyperinflation. If he fails to act in time, a hellish prospect may be his economic and political legacy.


On Tuesday, the Telegraph's Ambrose Evans-Pritchard reports that China has warned a top member of the US Federal Reserve that it is increasingly disturbed by the Fed's direct purchase of US Treasury bonds:

Richard Fisher, president of the Dallas Federal Reserve Bank, said: "Senior officials of the Chinese government grilled me about whether or not we are going to monetise the actions of our legislature."

"I must have been asked about that a hundred times in China. I was asked at every single meeting about our purchases of Treasuries. That seemed to be the principal preoccupation of those that were invested with their surpluses mostly in the United States," he told the Wall Street Journal.

His recent trip to the Far East appears to have been a stark reminder that Asia's "Confucian" culture of right action does not look kindly on the insouciant policy of printing money by Anglo-Saxons.

Mr Fisher, the Fed's leading hawk, was a fierce opponent of the original decision to buy Treasury debt, fearing that it would lead to a blurring of the line between fiscal and monetary policy – and could all too easily degenerate into Argentine-style financing of uncontrolled spending.

However, he agreed that the Fed was forced to take emergency action after the financial system "literally fell apart".

Nor, he added was there much risk of inflation taking off yet. The Dallas Fed uses a "trim mean" method based on 180 prices that excludes extreme moves and is widely admired for accuracy.

"You've got some mild deflation here," he said.

The Oxford-educated Mr Fisher, an outspoken free-marketer and believer in the Schumpeterian process of "creative destruction", has been running a fervent campaign to alert Americans to the "very big hole" in unfunded pension and health-care liabilities built up by a careless political class over the years.

"We at the Dallas Fed believe the total is over $99 trillion," he said in February.

"This situation is of your own creation. When you berate your representatives or senators or presidents for the mess we are in, you are really berating yourself. You elect them," he said.

His warning comes amid growing fears that America could lose its AAA sovereign rating.

I doubt America will lose its AAA sovereign rating, but $99 trillion of unfunded liabilities can bring the world's biggest economy closer to that day of reckoning.

But not all Fed presidents fear inflation. Last Thursday, Boston Federal Reserve Bank President Eric Rosengren said the risk of deflation is currently more of a concern than inflation:

Between inflation and deflation, my concerns are currently more weighted toward deflation," Rosengren said in response to audience questions after giving a speech to the Worcester Economic Club.

He added that the size of the Fed's balance sheet -- which has more than doubled in the financial crisis -- was "not a situation we want to be in, it's a situation we need to be in" given the severity of the crisis.

Answering a separate question, Rosengren said that due to the global nature of the crisis "in the short-run it will be hard to have export-led growth."

Rosengren is not a voter in 2009 on the Federal Open Market Committee, the Fed's policy-setting panel.

Indeed, if you look around the world, you see that Japan, the U.K. , and other countries are grappling with deflation.

So why is the U.S. bond market on edge? Isn't all this talk of hyperinflation absurd? The Financial Ninja is back and he writes that with each interest ticker higher, another "green shoot" dies:

"There isn't enough capital in the world to buy the new sovereign issuance required to finance the giant fiscal deficits that countries are so intent on running. There is simply not enough money out there," -Kyle Bass

FN: Giddy talk of "green shoots" has completely drowned out a more sober and rational assessment of the global situation. Random statistical noise in various minor economic indicators have over the past two months resulted in wild exclamations of "the worst is definitely over".

It most certainly is not.

With every major economy in the world attempting to solve this economic crisis with both loose monetary and fiscal policy, it was only a matter of time before the global credit markets would reach their limits.

These limits have almost been reached.

The long end of every curve of every major economy has been steadily climbing. The rate of change has now accelerated and interest rates on these important benchmarks have now reached "pre-crisis" levels. In a ZIRP world this is definitely a bad sign. Formerly respectable governments from the US to the UK have gone the "banana republic" route and started monetizing their debts in a desperate attempt to prevent long rates from rising, to no avail. A veritable tsunami of debit issuance now sits just over the horizon, waiting to dumped on a crippled and saturated global debt market.

The UK will eventually lose it's coveted triple 'AAA' rating and the US cannot be far behind. Rising rates will drag everything from mortgage rates to credit card rates higher. Everything from residential and commercial real estate to businesses will feel the pain of higher borrowing costs. The central banks of the world have no more real options left. They've lowered the rates they control to zero and have flooded the financial system with liquidity. Their balance sheets are now swollen with toxic assets and outright debt monetization won't bring rates down.
The ECONOMPICDATA blog asks, Can we inflate ourselves out of this mess?, and concludes

Thus, the concern I have is that inflation won't be driven through via wage increases (where at least workers salaries are keeping up), but by a spike in the price of commodities. If inflation concerns = dollar concerns = commodity spike, then that impossible stagflation may be possible once again.

We may be in the early stages of asset inflation in stocks and commodities. It's too early to tell, but it is worth keeping in mind that asset inflation can transpire as liquidity makes its way through the financial system.

Finally, writing in the Asia Times, Henry C K Liu writes that liquidity is drowning the meaning of 'inflation':

The conventional terms of inflation and deflation are no longer adequate for describing the overall monetary effect of excess liquidity recently released by the US Federal Reserve, the nation's central bank, to deal with the year-long credit crunch.

This is because the approach adopted by the Treasury and the Fed to deal with a financial crisis of unsustainable debt created by excess liquidity is to inject more liquidity in the form of both new public debt and newly created money into the economy and to channel it to debt-laden institutions to reflate a burst debt-driven asset price bubble.

The Treasury does not have any power to create new money. It has to borrow from the credit market, thus shifting private debt into public debt. The Fed has the authority to create new money. Unfortunately, the Fed's new money has not been going to consumers in the form of full employment with rising wages to restore fallen demand, but instead is going only to debt-infested distressed institutions to allow them to deleverage from toxic debt. Thus deflation in the equity market (falling share prices) has been cushioned by newly issued money, while aggregate wage income continues to fall to further reduce aggregate demand.

Falling demand deflates commodity prices, but not enough to restore demand because aggregate wages are falling faster. When financial institutions deleverage with free money from the central bank, the creditors receive the money while the Fed assumes the toxic liability by expanding its balance sheet. Deleverage reduces financial costs while increasing cash flow to allow zombie financial institutions to return to nominal profitability with unearned income and while laying off workers to cut operational cost. Thus we have financial profit inflation with price deflation in a shrinking economy.

What we will have going forward is not Weimar Republic-type price hyperinflation, but a financial profit inflation in which zombie financial institutions turn nominally profitable in a collapsing economy. The danger is that this unearned nominal financial profit is mistaken as a sign of economic recovery, inducing the public to invest what remaining wealth they still hold, only to lose more of it at the next market meltdown, which will come when the profit bubble bursts.

Hyperinflation is fatal because hedging against it causes market failures to destroy wealth. Normally, when markets are functioning, unhedged inflation favors debtors by reducing the value of liabilities they owe to creditors. Instead of destroying wealth, unhedged inflation merely transfers wealth from creditors to debtors. But with government intervention in the financial market, both debtors and creditors are the taxpayers. In such circumstances, even moderate inflation destroys wealth because there are no winning parties.

Debt denominated in fiat currency is borrowed wealth to be repaid later with wealth stored in money protected by monetary policy. Bank deleveraging with Fed new money cancels private debt at full face value with money that has not been earned by anyone, that is with no stored wealth. That kind of money is toxic in that the more valuable it is (with increased purchasing power to buy more as prices deflate), the more it degrades wealth because no wealth has been put into the money to be stored, thus negating the fundamental prerequisite of money as a storer of value.

This is not demand destruction because decline in demand is temporarily slowed by the new money. Rather, it is money destruction as a restorer of value while it produces a misleading and confusing effect on aggregate demand.

Thinking about the value of any real asset (gold, oil, and so forth) in money (dollar) terms is misleading. The correct way is to think about the value of the money (dollars) in asset (gold, oil) terms, because assets (gold, oil, and so on) are wealth. The Fed can create money, but it cannot create wealth.

Central bankers are savvy enough to know that while they can create money, they cannot create wealth. To bind money to wealth, central bankers must fight inflation as if it were a financial plague. But the first law of growth economics states that to create wealth through growth, some inflation needs to be tolerated.

The solution then is to make the working poor pay for the pain of inflation by giving the rich a bigger share of the monetized wealth created via inflation, so that the loss of purchasing power from inflation is mostly borne by the low-wage working poor and not by the owners of capital, the monetary value of which is protected from inflation through low wages. Thus the working poor loses in both boom times and bust times.

Inflation is deemed benign by monetarism as long as wages rise at a slower pace than asset prices. The monetarist iron law of wages worked in the industrial age, with the resultant excess capacity absorbed by conspicuous consumption of the moneyed class, although it eventually heralded in the age of revolutions. But the iron law of wages no longer works in the post-industrial age in which growth can only come from mass demand management because overcapacity has grown beyond the ability of conspicuous consumption of a few to absorb in an economic democracy.

That has been the basic problem of the global economy for the past three decades. Low wages even in boom times have landed the world in its current sorry state of overcapacity masked by unsustainable demand created by a debt bubble that finally imploded in July 2007. The whole world is now producing goods and services made by low-wage workers who cannot afford to buy what they make except by taking on debt on which they eventually will default because their low income cannot service it.

All the stimulus spending by all governments perpetuates this dysfunctionality. There will be no recovery from this dysfunctional financial system. Only reform toward full employment with rising wages will save this severely impaired economy.

How can that be done? Simple. Make the cost of wage increases deductible from corporate income tax and make the savings from layoffs taxable as corporate income.
I agree with Henry Liu, unless we get wage increases across all OECD nations, I wouldn't count on a sustained global economic recovery, or on the hyperinflation we've seen in the past.

But asset bubbles and another market meltdown look inevitable as excess liquidity finds its way into the global financial system. When this happens, don't say nobody predicted it. You've been warned.