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Source link: http://archive.mises.org/10125/the-fed-might-have-painted-itself-into-a-corner/

The Fed Might Have Painted Itself into a Corner

June 11, 2009 by

Most Fed officials and various economic commentators are of the view that the US economy might be rapidly approaching a stage where it is possible to take out a large chunk of the recently pumped money without causing any harmful side effects. What they don’t tell us is that monetary pumping has given rise to various bubble activities. Hence, contrary to popular thinking, the massive money pumping has actually weakened the economy’s bottom line. If the Fed were to start taking some of the newly pumped money from the economy, it would set in motion an economic bust.

FULL ARTICLE

{ 11 comments }

Geoffrey S. June 11, 2009 at 11:07 pm

What a huge mess.

Marc Faber thinks that the Fed will not pull the money out because of the government’s massive debt that will have to be paid back. Faber, like Mises, thinks deflation is too unpopular a policy to sustain.

Rick June 12, 2009 at 1:11 am

As Schiff said, but in a slightly different manner: If the cure to Heroin withdrawals is shooting up more Heroin, eventually you’re going to overdose. I guess this is the part where you need to shoot up some more stimulus just to feel “normal”.

Bogart June 12, 2009 at 9:05 am

The divestiture of US dollar related securities is already under way. There were two Japanese folks arrested in Italy smuggling US bonds into Switzerland. And the Fed that answers to no one is buying massive amounts of long term debt that investors do not want to bid on.

George June 12, 2009 at 10:11 am

I saw this a long time ago:

imho, the Fed is walking a balancing act between keeping the dollar afloat by raising rates, and keeping the economy going by not raising rates.

And parallel lines never meet — what makes everyone assume these lines are parallel? I keep feeling that somewhere in the future we will all find out that they cross…

Ben Ranson June 12, 2009 at 10:12 am

On the whole, I like Mr. Shostak’s assesment.

Because there is no fixed period of production in the economy in general, there is no non-arbitrary period against which growth in the money supply can be measured. When economists and statisticians talk about growth in the money supply, they talk about growth over periods of years or quarters. It is possible, and no less arbitrary (in a praxeological sense), to use milliseconds or centuries.

This situation stands in contrast with the growth and diminution of the supply of wheat, which is seasonal. Analysis of the supply of wheat over periods which do not correspond to whole numbers of wheat harvests is clearly absurd.

I agree that even “if the Fed were to decide to tighten its stance just slightly, given the current strengthening in the growth momentum of economic activity, this could visibly weaken the growth momentum of monetary liquidity, thus posing a threat to the stock market.”

The difficulty is predicting what sized change will have what degree of effect on what lines of business over what period of time.

Ryan June 12, 2009 at 10:45 am

I really wish one of the Mises Daily authors would write up a post on the actual magnitude of Treasuries that the US Government has to float this year alone. The only person I see anywhere talking about concrete numbers is Michael Pento who regularly appears on CNBC and Bloomberg, but even he fails to state all the figures for the coming supply. Not only does the US Govt have to finance this most recent spending binge, but they also must rollover other debts that are coming to maturity, and it’s unclear really where the source of demand to sop up this incredible supply is going to originate. The US economy is running smaller trade imbalances with China, so it’s not like they can buy as much of this paper as people seem to imply. I really hope someone will take up the task of identifying: 1) The absolute level of Federal debt that must be financed this yr; and 2) Potential sources of demand for that debt. I would love to take up the work but I have no clue where to find this information.

And as a brief aside: the most alarming thing I find of this whole predicament is not necessarily the awesome level of debt that must be financed, but instead the concern for how private companies will gain financing with this extreme level of competition from the treasury. I fear we are going through a period of the most immense squandering of capital in the history of the world. The US govt will get their funding–at the expense of the productive members of our economy.

BioTube June 12, 2009 at 4:47 pm

Here’s a scary thought: what does the Fed do if it decides the dollar’s done for?

George June 12, 2009 at 10:51 pm

How much debt the US Treasury has to sell in 2009?

This is approxmate and ignores debt issued in 2009 which also matures in 2009. First there’s the existing debt:

http://www.treasurydirect.gov/govt/reports/pd/mspd/mspd.htm

Before this mess, the total debt was about 10T. About half is intergovernmental issue (owed to Social security etc), the other half is (5T) is owned by the public (including China). Of that about 2.5T is due in 2009.

Then there are the additions. The original US deficit estimate was about .5T. The bailout/stimulus packages could be something like 2T. So that’s 2.5T of “new” money to raise.

In total the treasury needs to sell 5T of debt in 2009.

This is about 100B/week, hence the 100B auctions in recent weeks.

Some of that non-public owned debt is owned by other US State and local government entities which are having their budgets squeezed — they will need the money and won’t roll it.

ralph h June 13, 2009 at 9:48 am

Financial Profit Inflation from Price Deflation

By
Henry C.K. Liu

This article appeared in AToL on May 27, 2008 as Liquidity drowns meaning of ‘inflation’.
An edicted excerpt of this article appeared in New Deal 2.0, a project of the Franklin and Eleanor Roosevelt Institute.

The conventional terms – inflation, deflation – are no longer adequate for describing the overall monetary effect of excess liquidity recently released by the 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 liguidity 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 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 increases cash flow to allow zombie financial institutions to return to nominal profitability with unearned income 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 turning 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 melt down 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, i.e. 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 tmeproarily slowed down 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, etc.) in money (dollars) terms is misleading. The correct way is to think about the value of the money (dollars) in asset (gold. oil, etc.) terms, because asset (gold, oil,etc.) is 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 empolyment 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.

May 25. 2009

ralph h June 13, 2009 at 9:56 am

Please scroll down to see a pasted article which conforms to the comments in this article

ralph h June 13, 2009 at 9:59 am

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The Fed Might Have Painted Itself into a Corner
June 11, 2009 9:52 PM by Frank Shostak | Other posts by Frank Shostak | Comments (10)

Most Fed officials and various economic commentators are of the view that the US economy might be rapidly approaching a stage where it is possible to take out a large chunk of the recently pumped money without causing any harmful side effects. What they don’t tell us is that monetary pumping has given rise to various bubble activities. Hence, contrary to popular thinking, the massive money pumping has actually weakened the economy’s bottom line. If the Fed were to start taking some of the newly pumped money from the economy, it would set in motion an economic bust.

FULL ARTICLE

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Comments (10)
Geoffrey S.
What a huge mess.

Marc Faber thinks that the Fed will not pull the money out because of the government’s massive debt that will have to be paid back. Faber, like Mises, thinks deflation is too unpopular a policy to sustain.

Published: June 11, 2009 11:07 PM

Rick
As Schiff said, but in a slightly different manner: If the cure to Heroin withdrawals is shooting up more Heroin, eventually you’re going to overdose. I guess this is the part where you need to shoot up some more stimulus just to feel “normal”.

Published: June 12, 2009 1:11 AM

Bogart
The divestiture of US dollar related securities is already under way. There were two Japanese folks arrested in Italy smuggling US bonds into Switzerland. And the Fed that answers to no one is buying massive amounts of long term debt that investors do not want to bid on.

Published: June 12, 2009 9:05 AM

George
I saw this a long time ago:

imho, the Fed is walking a balancing act between keeping the dollar afloat by raising rates, and keeping the economy going by not raising rates.

And parallel lines never meet — what makes everyone assume these lines are parallel? I keep feeling that somewhere in the future we will all find out that they cross…

Published: June 12, 2009 10:11 AM

Ben Ranson
On the whole, I like Mr. Shostak’s assesment.

Because there is no fixed period of production in the economy in general, there is no non-arbitrary period against which growth in the money supply can be measured. When economists and statisticians talk about growth in the money supply, they talk about growth over periods of years or quarters. It is possible, and no less arbitrary (in a praxeological sense), to use milliseconds or centuries.

This situation stands in contrast with the growth and diminution of the supply of wheat, which is seasonal. Analysis of the supply of wheat over periods which do not correspond to whole numbers of wheat harvests is clearly absurd.

I agree that even “if the Fed were to decide to tighten its stance just slightly, given the current strengthening in the growth momentum of economic activity, this could visibly weaken the growth momentum of monetary liquidity, thus posing a threat to the stock market.”

The difficulty is predicting what sized change will have what degree of effect on what lines of business over what period of time.

Published: June 12, 2009 10:12 AM

Ryan
I really wish one of the Mises Daily authors would write up a post on the actual magnitude of Treasuries that the US Government has to float this year alone. The only person I see anywhere talking about concrete numbers is Michael Pento who regularly appears on CNBC and Bloomberg, but even he fails to state all the figures for the coming supply. Not only does the US Govt have to finance this most recent spending binge, but they also must rollover other debts that are coming to maturity, and it’s unclear really where the source of demand to sop up this incredible supply is going to originate. The US economy is running smaller trade imbalances with China, so it’s not like they can buy as much of this paper as people seem to imply. I really hope someone will take up the task of identifying: 1) The absolute level of Federal debt that must be financed this yr; and 2) Potential sources of demand for that debt. I would love to take up the work but I have no clue where to find this information.

And as a brief aside: the most alarming thing I find of this whole predicament is not necessarily the awesome level of debt that must be financed, but instead the concern for how private companies will gain financing with this extreme level of competition from the treasury. I fear we are going through a period of the most immense squandering of capital in the history of the world. The US govt will get their funding–at the expense of the productive members of our economy.

Published: June 12, 2009 10:45 AM

BioTube
Here’s a scary thought: what does the Fed do if it decides the dollar’s done for?

Published: June 12, 2009 4:47 PM

George
How much debt the US Treasury has to sell in 2009?

This is approxmate and ignores debt issued in 2009 which also matures in 2009. First there’s the existing debt:

http://www.treasurydirect.gov/govt/reports/pd/mspd/mspd.htm

Before this mess, the total debt was about 10T. About half is intergovernmental issue (owed to Social security etc), the other half is (5T) is owned by the public (including China). Of that about 2.5T is due in 2009.

Then there are the additions. The original US deficit estimate was about .5T. The bailout/stimulus packages could be something like 2T. So that’s 2.5T of “new” money to raise.

In total the treasury needs to sell 5T of debt in 2009.

This is about 100B/week, hence the 100B auctions in recent weeks.

Some of that non-public owned debt is owned by other US State and local government entities which are having their budgets squeezed — they will need the money and won’t roll it.

Published: June 12, 2009 10:51 PM

ralph h

Financial Profit Inflation from Price Deflation

By
Henry C.K. Liu

This article appeared in AToL on May 27, 2008 as Liquidity drowns meaning of ‘inflation’.
An edicted excerpt of this article appeared in New Deal 2.0, a project of the Franklin and Eleanor Roosevelt Institute.

The conventional terms – inflation, deflation – are no longer adequate for describing the overall monetary effect of excess liquidity recently released by the 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 liguidity 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 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 increases cash flow to allow zombie financial institutions to return to nominal profitability with unearned income 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 turning 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 melt down 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, i.e. 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 tmeproarily slowed down 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, etc.) in money (dollars) terms is misleading. The correct way is to think about the value of the money (dollars) in asset (gold. oil, etc.) terms, because asset (gold, oil,etc.) is 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 empolyment 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.

May 25. 2009

Published: June 13, 2009 9:48 AM

ralph h
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