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Austrians are divided on the long-term outlook for prices. In the present article I want to reiterate why I view rising prices as the real threat. I also want to point out some problems for the deflation camp.
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46 Responses
why has japan had falling cpi for a decade, when their discount rate has been less than 1% for 15 years? presumably that means it can’t be as simple as monetary base increase = hyperinflation. a more apt characterization of japan seems to be that the 1% discount rate merely froze the economy in stasis, not allowing high personal savings to reignite growth, and not allowing malinvestments to liquidate. possibly we can expect a similar trajectory in america, with persistent asset bubbles in stocks and treasuries instead of rampant cpi increases.
I’d be interested to hear comments on liklihood of biflation possibilities, especially with respect to commodity investment.
If only the global warming scientists were as up-front and honest about their internal disagreements as are the Austrians! Mr. Murphy makes a good case I think, but with so many variables in play, predictions become difficult. Bernanke is taking this country into uncharted waters to be sure. But I think all Austrians can agree that without letting the market correct the unsustainable asset bubbles the government and Fed continues to prop up, the long-term prospects are dire. It’s only in which direction the consequences manifest that seems to be in dispute.
to rafael garcia:
the carry trade. borrow yen and invest in foreign assets. paid for for many traders’ children’s college education.
What do you think of a prominent deflationist’s claim that “the Fed has shown no willingness to self-destruct”?
Who does Bernanke really work for? Is he ready to drop his “precious” into the abyss?
Aren’t those the real questions we should be asking ourselves? Don’t we Austrians believe in Human Action, including action of individual central bankers?
You can’t compare Japan to the United States. Japan is an exporter of goods AND capital; they are not a global empire issuing a reserve currency; their consumers were somewhat responsible and always held large cash balances. Their actions also exacerbated the rate differentials between the yen and other currencies, creating an incentive for speculators to borrow and export (carry) capital rather than bid up Japanese asset prices. Most importantly they were late in addressing their collapse and left short rates too high for too long and did not follow an immediate, aggressive counter-cyclical policy.
Granted there are similarities – huge “zombified” banks on life support, over-leveraged balance sheets, attempts at quantitative easing etc. – but it’s still a much different situation.
The reason why we don’t see massive deflation or inflation yet is because the central planners have done a pretty good job so far. They have balanced the drop in demand, increased resource slack, downward wage pressures, and increased demand to hoard cash with an artificial drop in the cost of capital, an increase in the supply of money, the salvaging of untold billions in bank credit-money through bailouts, fiscal policies to buoy demand, and an attack on the “deflation psychology” of the market.
They have followed the new anti-great depression playbook of aggressive monetary easing, counter-cyclical fiscal policy, and financial sector bailouts. This works great in the short-term; but as we all know central planners/cartel managers either don’t believe in or don’t care enough about the long-term. Eventually the market will either overcome the authorities desire to re-expand credit, boost consumption, and artificially devalue the USD (leading to deflation) or the authorities, being so determined to avoid that, will push the market to a point where money-demand starts dropping in something of a self-reinforcing spiral and the currency collapses (massive inflation). For an example of the former look to the second down leg of the GD starting in 1937 after the massive fiscal and monetary intervention during the first FDR term (price floors, deficit spending, USD devaluation etc.)
If the currency collapses it will be from a drop in money-demand, both foreign and domestic. It will be from a loss of confidence in the USD, treasuries, and the government – not necessarily how much money is printed. Most of the money printed so far has been sterilized by banks holding excess reserves at the fed. (Price) Inflation expectations will have to rise before you see this money start to bid up money prices. At that point things can get out of control very quickly in an environment where raising rates is politically and economically unpalatable.
Look at things like commodity prices, TIPS spreads, the steepness of the yield curve, ISM prices paid index, UofM inflation expectation data to see what inflation expectations are doing. (All those point to reflation, some more than others)
“I’d be interested to hear comments on liklihood of biflation possibilities, especially with respect to commodity investment.”
Increase in the money supply of bankers. Decrease in the money supply of everyone else.
“Who does Bernanke really work for?”
The owners of the Federal Reserve (i.e., the Rothschilds).
The primary arguments in favour of deflation look less at consumer prices and more at asset prices, bank lending, debt/income or debt servicing ratios, demographics and social revulsion of excesses.
Many things can contribute to consumer price changes. This year we had a very large drop in inventories and capacity utilization which eased downward pricing pressures significantly in spite of falling consumer demand and reduced credit availability. We also had commodity prices rising from leveraged speculative bets by hedge funds.
The first two are like bullets in a six shooter. They can only be used once. I suppose the commodity speculation could be considered the very early beginnings of a “crack-up-boom,” but other than gold, there seems to be little panic buying in the more “emotional” of these commodities (grains, energy). And it is precisely this fear (OMG, I might not be able to feed my family, “I’ll take 10 sacks of rice!”) that characterizes the CuB.
Until I see that kind of fear and still no willingness to quash it from central bankers, speculation of runaway inflation is premature.
One thing we can likely all agree on is that deflation “should” happen. We have too much debt and asset prices are too high to be supported by our incomes. And the easiest solution to this problem for those without access to a printing press (small businesses and consumers) is deleveraging. Considering they are the largest sectors of the economy, their actions will determine the overall outcome.
Richard Russell has a commentary over on 321gold, but it seems kind of muddled.
On the one hand he says that China will continue to become very productive and flood the world with cheap goods, and this will be deflationary (I assume price deflation, but this is the good kind, in the sense that more is available for purchase.) But this will put downward pressure on wages in the developed world.
So central banks will continue quantitative easing and there will be competitive devaluation of everyone’s currencies (monetary inflation) but somehow this will all be in the midst of continuing deflation, and China’s greatly increased output will lead to overall slower output. Huh?
Ultimately it’s an argument for gold, which I don’t necessarily disagree with, but how he arrived at his conclusion seems a little flawed.
@ JonO “If the currency collapses it will be…from a loss of confidence in the USD, treasuries, and the government – not necessarily how much money is printed. ”
I like this analysis. The Chinese have publicly worried about their huge investment in toxic UST securities, but like the toxic assets of those banks too big to fail, they can’t sell because there are no buyers. Of course Treasury and the Fed could bail China out as they did the banks by printing USDs, but the last things China wants or needs are more dollars. The reason China has so many Ts is because they had too many Ds, and nothing else they could buy with so many of them. Talk about being trapped between a rock and a hard place with your investments!!
Austrians and few others–maybe by now the Chinese–know that the USD and USTs are intrinsically worthless. I think the price of gold is indicating a gradual loss of confidence in the dollar and treasuries, but where is the tipping point in worldwide public confidence, after which the fall could be so rapid that getting out of Ds and Ts will be like trying to sell a Lost Wages macmansion in the summer of 2007–to who?, or is it to whom?
Robert Murphy is one of my favorite writers and we do agree on the thrust of this article. But imprecise language can lead to confusion.
We are in an inflationary time. We do have a growing money supply that is causing the dollar to lose value. But we are also in a government induced CONTRACTION.
Contraction is different from inflation or deflation. You can have contraction manifest in falling prices within an inflation. This was what happened in large part during the Great Depression after FDR debased the currency from $20/oz gold to $35/oz gold. There can be no doubt that this was inflationary in the sense of the debasement of the quality of money but prices did not manifest the inflation until after WWII.
Murphy has identified the reasons that the inflation is bottled up and at some point it will be relaeased but will this be a catastrophic event?
That remains to be seen.
My take is that contraction will dominate in 2010. Prices generally will fall within the inflation.
I’m predicting inflation, but I don’t have a solid analysis to back that up. I like what Robert Murphy has said here because it focuses more on value, demand, and production as opposed to financial accounting. I think it strikes more at the heart of the economic theory and has a little more long-term flavor to it.
But after having read the comments posted thus far, it seems like we’re headed one of two ways: constant global Y with rapid inflation (I guess the tyrants would prefer this), or little to no inflation with a massive decrease in global Y.
And the more I think about it, the more I think we’re headed for a tough and inevitable decrease in global Y. I really hope I’m wrong.
“Even though many people think that the Fed is spewing gushers of new money into the economy daily, that’s not really accurate. It’s true that the monetary base continues to reach new highs, but most of that new money is bottled up in the banks’ own checking accounts (as it were) on deposit with the Fed.”
the same article shows a chart where the amb went from 800 billion to over 2 trillion in a few months….is this true? if so , what particular principle motivated the federal reserse to more than double the amb?
again, if true…is it the rapid increase in the amb that some here say will enter the economy rising prices – further?
@scott t
The Federal Reserve publishes these charts, so you can confirm that it is true. As long as the money sits as excess reserves, it doesn’t do too much to prices. When the banks decide to start lending all this extra money out and the money multiplier takes effect, that’s when we need to worry.
“When the banks decide to start lending all this extra money out and the money multiplier takes effect, that’s when we need to worry.”
This assumes that banks can lend out the money profitably. But this is not the case now, and how can it become the case? Currently, these reserves are “unbankable”, insofar as banking spreads are insufficient to cover default risk. Spreads can only increase with higher interest rates, but those higher rates would also increase default risk. The monetary base cannot fuel asset bubbles or CPI increases until it is monetized by bank lending, and bank lending is impossible in this environment. Currently, the banking system is in stasis, and all the monetary stimulus is doing is preventing the collapse of an insolvent banking sector.
Banks will never be able to lend again, until debt markets clear. All markets clear eventually, working around government obstacles, and the debt market is no exception. Real interest rates will rise to begin the slow and painful debt-clearing process. These will manifest in collapsing prices in particular sectors. Possibly CPI decreases, but more likely falling stock prices, property prices, and treasury prices. The asset-specific price decreases can be added to nominal rates to determine real interest rates.
All of this suggests to me that we will see a Japan-style stagnation as economies de-leverage.
Bloomberg must have been reading Murphy:
“Fastest Food Inflation Since Riots Means Milk Up 39%â€
http://www.bloomberg.com/apps/news?pid=20601109&sid=aBYSp0.XfXZs&pos=14
“Rice may surge 63 percent to $1,038 a metric ton from $638 on Philippine imports and a shortage in India, a Bloomberg survey of importers, exporters and analysts showed. The U.S. government says nonfat dry milk may jump 39 percent next year, and JPMorgan Chase & Co. forecasts a 25 percent gain for sugar. Global food costs jumped 7 percent in November, the most since February 2008, four months before reaching a record, according to the United Nations Food and Agriculture Organization.â€
My own thoughts: Deflationists forget that the state can borrow the money and spend it. That’s typically how cpi inflation happens. The Fed’s monetary pump has resulted in the huge run up in the stock market.
@Jon O, nice analysis
@Matt Stiles, yes deleveraging is the cure. The question is whether the Fed will allow interest rates to rise, which will accelerate the process. The longer they hold down interest rates, the longer this misery will last.
@Rafael G, right on brother
Ok, I am reading Milton Friedman’s A Monetary History of the U.S. and you can bet that Bernanke has read this book too. Excess reserves leads to a loss of control by the Fed. When banks are holding reserves, then FOMC buying has no effect on money stock, since banks already won’t create the Fed’s desired credit expansion. Lowering the discount rate is meaningless. What to do? Twice in history the Fed has raised reserve requirements to sop up excess reserves, in 1936 and 1946. If history repeats, we should expect this in 2010 as inflation starts to show.
Mr. Murphy, could you take a look at reserve requirements and what would be required to soak up 1 trillion in excess reserves? Before crises High Powered Money was at 100 billion, now it is 1.1 trillion. What would the reserve ratio have to be to fix this? Does the Fed have a balance of Treasuries they could sell to conteract the increase in money stock?
If the bank’s balance at the Fed is an asset to them, and this asset value is needed to balance with their liabilities, would they ever loan them out? Do banks really loan out reserves? Or do they use them as legal base requirement for bank credit expansion? Is the paying of interest by the Fed on bank reserves really just a controlled expansion of the monetary base?
Anadotal evidence: I bought a gallon of milk last night for at Moto-mart for 3.09. Just last month is was 2.59. Have you seen the price of candy? My favorite Cadbury Fruit & Nut was 1.18, now 1.50 at Walmart.
[quote]The reader may recall that at the end of 2008 and early 2009, major politicians were calling on the banks to expand loans and hence justify the huge bailouts they received. After all, the ostensible purpose of the bailout, Paulson told us, was to allow small businesses to have access to credit. I foolishly believed that the growth we saw in M1 and M2 at the end of 2008 would continue, and that’s why I was warning of large price inflation in 2009.[/quote]
After Paulson made the ‘bait-and-switch’ move against Congress for TARP, it seemed obvious that destruction of credit (bank capital) was the issue. First the FED increased liquidity in the system at the end of 2008 to restore the interbank lending markets. So M1 and M2 were going up because of this FED liquidity injection in that particular market.
Then banks needed capital to shore up holes in their balance sheets and lay the foundation for the effort of lending (in the future). So far, inflation is nowhere to be seen as bank lending (credit) is contracting and toxic assets were bought out from balance sheets. (credit is the initial driver for inflation, followed by a 6-12 month delay in the increase in base money supply M0).
Regarding your expectation of food and energy price inflation I would agree. Commodity prices are rising as a direct result of the secular bull trend in commodities and an investor urge for a return on capital in a highly liquid environment, with investors chasing eachother to Emerging Markets and a dollar carry trade. These are min. two (2) inflationary environments which are a potential treat for future inflation in food and energy.
Core-CPI remains stable, slightly rising. It is very hard to say where this comes from, but my sensible guess would be towards the misallocation of capital expenditure in the economy (e.g. cash for clunkers program – destroying cars resulting in secondary market price hikes).
The CPI increase could be influenced by social security checks (e.g. food stamps) and other government stimulus efforts. Something tells me that this is a factor in inflation for food in the CPI in a deflationary environment as clearly visible in the private sector. Debt-destruction is the primary force.
The only reason why monetary deflation (like Japan) hasn’t kicked in yet, is due to the fast injection of massive stimulus by the US government. Japan stimulus efforst were continously behind the deflationary curve. Too slow and too small…hence the 2 decade stagnation.
If the above expectation is right, then 2010-2011 will be the year of more deflationary pressures since government (and states) is already stretched to the limit. Another 1.5 trillion in stimulus for 0.8 percent QoQ growth will be unsustainable. If CPI increases endure…be sure to see a currency crisis in the near future…unless the interest rate goes towards double digits. But then again, the economy will tank either way.
Debt-deflation is the key driver in this market environment. Keynesians are on the wrong side of this game.
Both Mr. Murphy and Mish seem right, but are misaligned on the timing. And we all know that timing is something we can’t control. Its a dynamic process remember? Just like our climate problem…
regards, my 2 cents
[quote]The reader may recall that at the end of 2008 and early 2009, major politicians were calling on the banks to expand loans and hence justify the huge bailouts they received. After all, the ostensible purpose of the bailout, Paulson told us, was to allow small businesses to have access to credit. I foolishly believed that the growth we saw in M1 and M2 at the end of 2008 would continue, and that’s why I was warning of large price inflation in 2009.[/quote]
After Paulson made the ‘bait-and-switch’ move against Congress for TARP, it seemed obvious that destruction of credit (bank capital) was the issue. First the FED increased liquidity in the system at the end of 2008 to restore the interbank lending markets. So M1 and M2 were going up because of this FED liquidity injection in that particular market.
Then banks needed capital to shore up holes in their balance sheets and lay the foundation for the effort of lending (in the future). So far, inflation is nowhere to be seen as bank lending (credit) is contracting and toxic assets were bought out from balance sheets. (credit is the initial driver for inflation, followed by a 6-12 month delay in the increase in base money supply M0).
Regarding your expectation of food and energy price inflation I would agree. Commodity prices are rising as a direct result of the secular bull trend in commodities and an investor urge for a return on capital in a highly liquid environment, with investors chasing eachother to Emerging Markets and a dollar carry trade. These are min. two (2) inflationary environments which are a potential treat for future inflation in food and energy.
Core-CPI remains stable, slightly rising. It is very hard to say where this comes from, but my sensible guess would be towards the misallocation of capital expenditure in the economy (e.g. cash for clunkers program – destroying cars resulting in secondary market price hikes).
The CPI increase could be influenced by social security checks (e.g. food stamps) and other government stimulus efforts. Something tells me that this is a factor in inflation for food in the CPI in a deflationary environment as clearly visible in the private sector. Debt-destruction is the primary force.
The only reason why monetary deflation (like Japan) hasn’t kicked in yet, is due to the fast injection of massive stimulus by the US government. Japan stimulus efforst were continously behind the deflationary curve. Too slow and too small…hence the 2 decade stagnation.
If the above expectation is right, then 2010-2011 will be the year of more deflationary pressures since government (and states) is already stretched to the limit. Another 1.5 trillion in stimulus for 0.8 percent QoQ growth will be unsustainable. If CPI increases endure…be sure to see a currency crisis in the near future…unless the interest rate goes towards double digits. But then again, the economy will tank either way.
Debt-deflation is the key driver in this market environment. Keynesians are on the wrong side of this game.
Both Mr. Murphy and Mish seem right, but are misaligned on the timing. And we all know that timing is something we can’t control. Its a dynamic process remember? Just like our climate problem…
regards, my 2 cents
The banks have been making more loans, at least on housing. The federal tax credit did help “stimulate” lending on housing if you get a mortgage through the FHA.
The banks have been making more loans, at least on housing. The federal tax credit did help “stimulate” lending on housing if you get a mortgage through the FHA.
Maybe the CPI is wrong.
Possible evidence: the plummet in sales tax collections nearly everywhere in the U.S.
Does the CPI follow the price of a box of cornflakes, or what people are paying for their breakfast?
“the same article shows a chart where the amb went from 800 billion to over 2 trillion in a few months….”
“First the FED increased liquidity in the system at the end of 2008 to restore the interbank lending markets. So M1 and M2 were going up because of this FED liquidity injection in that particular market.”
“Then banks needed capital to shore up holes in their balance sheets and lay the foundation for the effort of lending (in the future).”
1. so the chart in the article indicating a rapid rise in the amb was a policy (federal reserve??) to help commercial banks shore up there (wrecked) balance sheets, so they can only go back to lending (in a similar way) in the future?
is this true…and is that what is being said?
2. what exactly does the massive increase in the amb permit the commercial banks to do now?
3. does that truly count as ‘money out of thin air’ – only it hasnt made its way into the broader economy?
4. the rapid increases in the amb….was it money that purchased various goods from the commercial banks?
it seems like such a waste or a deliberate lie.
Do we really need to see asset prices “catching a bid” to see inflation?
I think many analysts are looking for asset inflation in the markets and yes it does look like its going to be hard to push assets higher but Bernanke seems determined to push the pedal to the metal until the dollar literally collapses.
Dollar collapses and there is our inflation strictly from a severe loss of purchasing power
This has been a great discussion! Here’s my two cents’ worth:
1. As for how to sop up excess reserves, George Reisman recommends that the Fed require a dollar reserves for a dollar of demand money. This was the crux of his recommendation in his speech at the Mises Circle in Long Beach last month. You can read it on http://www.georgereisman.com., too.
2. The trillion dollars in excess reserves are a ticking timebomb and President Obama wants to light the fuse. Banks can’t lend because they are trying to rid themselves of toxic loans and there are no good loans out there. Sooooo…our Nobel Laureate president may just nationalize the banks and direct lending the way Soviet era commissars did in the old Warsaw Pact nations. It might happen. Of course, that would trigger hyperinflation and make the 1930s look like the good old days.
“Austrians are divided on the long-term outlook for prices.”
I think Mish is thinking short, not long term.
I was talking about inflation eventually skyrocketing back in 2003 but I was expecting deflation first. My time frame was 15 to 20 years. I had predicted gold/silver going up immediately however.
The banks generate the fractional reserve monetary inflation first. Then as this bubble pops the Fed comes in and tries to back fill with fiat inflation. Thus under our current system you would expect monetary inflation to correlate with private bank leveraging up the money supply.
Right now we are in a fractional reserve monetary deflation, with fiat monetary inflation. Prior to now we were in a productivity/import driven consumer price deflation, and that will continue. But it was countered before by the prior fractional reserve monetary inflation. We were also experiencing price deflation because of a trade imbalance.
What happens to prices from here is not simply related to interest rates. Low rates don’t mean inflation if the carry trade moves the money overseas.
I don’t think anyone can predict exactly how much fiat inflation would be sufficient to counter these other deflationary forces. Plus I think any such fiat inflation would be injected in the wrong locations in the economy (because you can tell the correct places to inject). If it was predictable then central planning would work.
What actually happens is highly dependent on what the Fed does. Which could change at any time. Do they pump enough liquidity in to counter the fractional reserve deflation or not.
There are other factors like the government debt that can lead to problems as it becomes obvious that we cannot pay, and as interest rates rise, which they eventually will. I think the government will lose control of the interest rates, and that will cause them grave problems with the budget which will further aggravate the debt.
My take is we will get weak price deflation/low inflation until we don’t anymore and inflation will rise very high very fast, and the dollar will go further into the toilet.
Gold/Silver will swing wildly, but will continue on an uptrend until the government had devalued the dollar to the point where it can “pay” it’s debts.
Then hopefully we will have a new Paul Volker and again precious metals will drop, and be a poor investment. This however is not going to happen for 20-25 years or so.
Or so I guess. That’s the general plan, if they don’t screw things up even worse.
Why does the deflation camp want to ignore rising commodity prices? They’re rising precisely because of monetary expansion.
Either way, Murphy’s analysis seems indubitable; there’s a reason why the FED is paying banks not to lend, while Obama is criticizing them for not lending–they realize what they’ve done. If the banks start lending, the money supply will grow exponentially. And if the FED tries to pull back, they will burst the bond bubble and interest rates will soar through the roof–something they simply wont allow.
The reason why both camps (inflationist/deflationists) have it wrong is because both are psychological phenomenon. Most monetary analysis is flawed regarding this. For example, if you are unemployed and have little or no money, does it matter if McDonald’s charges $4 dollars for a burger or $2 for the same burger? Chances are you will not purchase the burger at either price. In this circumstance, businesses lower their prices in a competitive deflationary price war.
Take note that the 1970s had high inflation but it’s unemployment level never came close to the levels of the 1930s depression ( http://www.answers.com/topic/unemployment ). Take a look at table 1. So if employment continues higher, it is more likely to be a deflationary crash.
with communication now vastly imporved would banks begin lending over a trillion dollars of amb (the 1.something trillion increase shown in the chart, if true) only send prices, as many here claim, skyrocketing?
would an infusion of approx 1/15th+ of the gdp in bank loans create havoc??
what was the federal reserve policy in increasing the amb to such an amount (again, if true)? is it in physical cash to cover dollar claims at banks?
an effect on prices similar to this when prices are adjusted for inflation, Americans today spend ’40% less on clothes, 20% less on food, more than 50% less on appliances, about 25% less on owning and maintaining a car’than they did during the early 1970s.”
http://blog.mises.org/archives/010741.asp
I would like to offer what I think is a significant reason for CPI increasing in the past year. It seems that companies of all types have managed to dramatically reduce inventories to the point where pricing power has returned slightly, but sales volume has fallen dramatically. For example, the auto industry was selling about 16M cars a year and now that’s down to 10M cars per year.Revenue is down, profits are down, but the price per transaction is going up. The price is only up because the factories cut back too far and the supply is temporarily constrained. There’s a lot of excess capacity that can fill the pipeline very quickly. I think there’s a good chance that CPI will bounce around zero until factory utilization maxes out. This logic can apply to virtually any industry in the productive economy.
“There’s a lot of excess capacity”
What do you mean by excess capacity? I think what you’re trying to say is that there were bubbles within certain sectors which are deflating, and rightfully so.
I guess I will have to stick to the simple definitions for inflation and deflation being somewhat of a novice.
From what I have read these terms refer to the money supply and it’s increase or decrease.
To me, it appears the money supply is in limbo in the banks reserves and we are in a period of price adjustment entirely based upon supply and demand for now.
Frankly, I believe you are not talking much about inflation or deflation but trying to predict where the market will go and you are thus talking about “price symptoms” of inflation and deflation as though it is the disease itself.
Is this too simplistic?
I don’t know what the official CPI stats are the the Japanese government wants people to believe, but my personal CPI of groceries shows an increase of between 60% and 200%+ on goods from 1998-2009 in Kyoto and Tokyo.
The CPI inflation of USD will come from China, not from within the US.
Currently USD and Yuan are pegged, which actually means China is using USD’s and there are actually two central banks regarding USD.
One is the FED and the other is the Chinese central bank.
And the balance sheet of the Chinese CB is actually stronger than the FED. Chinese CB has more US Treasuries (it doesn’t matter who actually hold the USTs because in China the CB isn’t independent) than the FED and the FED has all kinds of worthless toxic mortgage backed agency debt. Maybe China can not create additional USD’s like the FED but at this point they really need to.
Many countries tried to peg their currencies to the dollar and the euro before, for stability, but most of them failed because they didn’t have enough reserves, and they couldn’t keep current account deficit down which is a must when you peg your currency.
But China is just the exact opposite. It both has tremendous reserves, and account surplus as of now.
Also one must not forget that, China is still a command economy and when they get into the stimulus business money travels faster down the chain, unlike the US where governments involvement in the economy is relatively small. If China wants to inject money in the economy, they really inject the money. No bottlenecks and no delays.
So I am expecting, China to keep its own stimulus going and do this by the aid (backing) of nearly 1 trillion dollars worth of UST’s. This will both put upwards pressure on commodity prices and also Chinese manufactured goods. And of course this will firstly effect the US since the Yuan is pegged to the dollar, and China has the ammunition to keep the peg going.
Other countries with floating exchange rates against the dollar, thus yuan, may avoid the Chinese inflation but only if they have the nerve to stick to a tight monetary policy and not inflate with tandem.
And only countries that seem to be able to do is, countries that export commodities, like Australia, New Zealand, Canada and Russia. Of course they might not want to, but at least they have a chance unlike the US.
To add two more points.
Many people think of China being between a rock and hard place because of all the dollar reserves.
It is true that they just can not give up on the US treasuries thus dollar. They also can not diversify enough without damaging the value of their reserves.
The only scenario where they can get the most out of the the dollar reserves is the above scenario, where they inflate their own currency (much more than the past).
Also the effect of this Chinese policy discussed above will cause inflation with real growth (much more in nominal terms but still a little bit in real terms) in China, but stagflation in the US.
During stagflation it looks to the observer as if the costs are increasing without any demand from the consumer. There is high unemployment, lots of people with no money but cost of production somehow increases.
This will happen because since the dollar will still be pegged to the US, when the Chinese inflation hits, the cheapest option for the US consumer (regarding imports) will be still China, because USD will devalue against other producers much more.
It will be like, the price of Chinese products are rising (along with commodities) but the prices of German, Korean and Japanese manufactured products will be rising even more.
Agree with a lot of the comments above and just wanted to give a UK perspective. The Bank of England has followed every move the Fed has made. The increase in monetary base as a result of QE is now at £200 billion – implying potential extra lending into the economy of £2 trillion and guess what – it’s starting to happen! You know the saying ‘ an Englishman’s home is his castle’ – well, give an Englishman a mortgage priced at 2-3% and he will buy a house, or two or three. The government owned bank ( one of many!) Northern Rock, is offering a ‘teaser’ rate of 2.79% fixed for two years before the mortgage reverts to their standard variable rate which is currently 4.79%. They are not alone in trying to tempt people into debt that they ultimately will not be able to afford and surprise, surprise today December 15th 2009, we hear that house prices are rising at their fastest rate in three years! On top of that we had CPI out today showing a month on month increase of 0.3% or an annual equivalent rate of 3.6% – much higher than the Bank of England’s 2% target rate. Help!!
Banks are lending to the state. The banks are buying US treasuries, keeping rates low in the bond market and financing the growing gigantic US deficit. This new money is then transferred from the state to the general population. That’s why prices haven’t fallen. Also, banks have created an enormous asset bubble in US treasuries, which may trap them if rates were to rise quickly, and force the Federal Reserve to buy US treasuries to save them.
The bottom line to all this is that total bank reserves (fed deposits + vault cash) have soared since August of 2008, rising from $63 billion at that time to $1,161 billion as of November of 2009. Meanwhile, the Consumer Price Index, as John Williams of shadowstats.com has documented, has been fudged in recent years to underreport the rate of dollar depreciation by about 3% from the pre-Clinton era methodology. While there is always an element of arbitrariness to any price index, the unmanipulated version of the year-over-year CPI shows that the dollar hasn’t risen in value at any point in time over the past year, not even when factoring in the late 2008 drop in the index.
Obviously, there has been a strong deflationary present present in terms of the banks being unwilling to lend because of the combination of low interest rates and high default rates. This hasn’t resulted in actual deflation, however, as the total money stock is still increasing and the purchasing power of the dollar has continued on its downward course.
As Murphy correctly points out, in the long run there is little the Fed can do to sterilize that trillion dollar plus mountain of new bank reserves, so short of a radical monetary reform, the inflation situation can only grow worse–and just analyzing the money stock doesn’t even begin to capture the full inflationary potential of the situation. A new carbon tax and new healthcare mandates will surely further cripple whatever’s left of U.S. manufacturing and deliever a devastating blow to small businesses. Given all the socialistic measures that are currently threatening the U.S. economy, the value of the dollar is also at risk due to a falling demand for dollars.
http://research.stlouisfed.org/fred2/data/MULT_Max_630_378.png
At the above link you will find a chart of the “money multiplier”, which is the primary indicator for ‘monetary’ inflation. Please note that, aside from a couple of bounces to par, it is dropping like a rock. The chart also indicates the velocity of ‘money’, which is a primary facilitator of the inflationary process; the chart indicates that it too is bouncing along the terminal line. And this is after Ben flushed an additional, what, $14 Trillion(?) through the global bankster system!
Two things to keep in mind;
1) If it don’t circulate, it can’t inflate.
2) Without inflation greater than previous inflation, people can’t pay their debts and if people can’t pay their debts, the whole fractionalized debt based ‘monetary’ system collapses.
On the subject of ‘money’ let me leave you with this to ponder:
http://jengafinance.blogspot.com/2009/12/fractional-naked-shorting.html
Regards
Adam Smith’s Real Bills Doctrine states that a bank can create all the money it wants so long as the money created is backed by an assett of immediate utility to human beings that can be sold into the market in the amount of the new money created within 90 days of the creation of the new money.
In our central bank backed fractional banking system money is created in two ways. The first is central bank created money. The second is commercial bank created money through loans or so called credit money.
The total money supply is the sum of central bank created money + commercial bank created money.
All money needs to be backed with sufficient collateral as per Adam Smith’s Real Bills Doctrine. If I go to a store to buy a toaster on my credit card then money is created by the bank which issued me that credit card in the amount of the sale price of the toaster. If that toaster lasts only two months and I throw it away and it ends up in a land fill then the money created by the bank to lend me to buy that toaster is now backed by garbage literally. Say I lose my job. I still owe the bank for the toaster loan. I have no toaster to sell into the market to repay the loan. I default on the loan. What happens to the credit money created? It dissapears is what happens. It gets written off. Commercial bank created money dissapears anytime a loan is defaulted on or is paid off.
So the issue for me is not how large the money supply is or whether it is growing or declining. The issue is how well is that money backed by collateral immediately useful to human beings.
Starting with the subprime scare and the dissapearance of Bear Sterns in mid 2007 and peaking in late 2008 there was a huge bubble of credit money with insufficient collateral backing. It dissapeared in default causing a massive liquidity crisis. Most prices fell.
Price is just a ratio = money supply / supply of economic goods. As the money supply fell and the inventories and stockpiles of unsold goods ballooned upwards we saw deflation. The Fed stepped in to reflate the money supply and made up the loss in credit money with central bank money. Industries cut production and layed off workers to cut back on the supply of economic goods. The startegy was successful in stabilizing prices and easing the economy back from the edge of deflation.
But much of this central bank money is collaterilzed with already defaulted on mortgages bought from commercial banks at face value (56% of the dollar is backed by mortgage backed securities is the latest figure that I read).
In it’s Quarterly report issued December 7, 2009 The Bank for International Settlements reports a continuing contraction in international bank claims, a 45% decrease in new credit isuuance from the developing countries with the exception of the UK (up 174%) and Ireland (up 75%). It reports a loss of gross value of interest rate swaps and credit default swaps. But the rate of credit money destruction is slowing down.
So it appears that credit money is still in contraction and the money created by the central banks to offset the loss in credit money has increasingly shaky collateral foundations.
So what happens if interest rates go up? Defaults will immediately follow suit setting off another round of money supply contraction but this time it will attack the very foundation of the US dollar because the collateral foundation for the US dollar is mortgage backed securities.
What would cause interest rates to go up? A scarcer supply of money would.
My only point here is that too much capital has been obscenely wasted and that much of the current recovery is based on borrowed capital from the future which is also being wasted. We need to start using capital in all it’s forms in a much more efficient way so that it produces the real wealth, both present and future, to properly back the money created as a medium of exchange of goods and services of real immediate use to humans. Our present crisis has it’s roots in an obscene and criminal waste of capital which means that a lot of money out there still has insufficient collateral backing. I see long term deflation only because at the rate of uncollateralized money creation going on right now by the Treasury and Fed they are only postponing the write down that needs to happen and making the final reckoning even worse.
@Carl
The demand for cash holdings is not increasing, as demonstrated by the 6.3% rise in PPI and 2.3% rise in the CPI. Those reserves aren’t going to magically disappear, eventually the banks will lend them out and make some money. When that happens, assuming V remains constant, we’re looking at a 45 trillion dollar increase in the money supply. Debt default is what we need–the interest rate must rise towards the natural rate.
adam smith’s rbd. always bad, never dead.
Our area is quite affluent, and I see pervasive indicators of deflation–mostly various forms of discounting–to a degree I haven’t seen in 25 years. I agree that the potential for hyperinflation exists if the Fed decides to monetize federal debt to cover shortfalls, but it isn’t here yet.
by the way, I know a number of small businessmen, and none of them are interested in borrowing money; they are reducing debt, and sometimes eliminating employees, instead. Unless National Health care and Cap and Tax are derailed permanently, that is the way it will stay.
Any thoughts on Mish’s rebuttal?
http://globaleconomicanalysis.blogspot.com/2009/12/fictional-reserve-lending-and-myth-of.html
Here’s my interpretation of his post (which is a bit unclear and rather lengthy):
We’re well past the days when banks lent out excess reserves, now they just create credit on the fly (like printing notes redeemable for gold you don’t have). Same basic process, but much more brazen. When banks print, they don’t consider their reserve requirements, they consider their capital requirements: cash on hand plus performing assets. Since the latter is in the crapper, banks won’t lend, no matter how much funny money the Fed has in the vaults.
“Yes”, we have inflation, as defined by the Fed punching some numbers into a computer which state that banks have cash that probably doesn’t really exist.
“No”, we won’t see a direct causal link to CPI (whether you include asset prices or not) because prices aren’t based on the money supply, they are based on demand for cash holdings, which is a subjective valuation that is influenced by the money supply.
I really don’t know what’s going to happen, but I am increasingly convinced that human action is being driven by more than just some numbers typed in a computer.
When I think about the shear volume of transactions that take place without a single dollar bill ever changing hands, I shudder at the potential for further economic collapse.
These counterfeiters needs to be stopped.