Questions about Inflation/ Deflation Debate
This is a message that Jay sent me to answer. I have posted it as it may be interesting for some to read. This pertains to the Inflation/ Deflation debate.
Thanks for your interest Jay,
I need to answer this by item as you have asked a lot of question and made several arguments.
Issue #1
“Thanks a lot for your detailed explanation. One thing you did not explain is: What happens if people quit their job and take loans and default on it? Currently, people are taking loans AND also assuming the RISK associated with asset depreciation. The risk they are taking is that - they will have to pay later!!! And so far, Fed has not taken bad loans!!! So, if FED does it, ONLY THEN, we can see this problem happen. And I can bet you, lot of people today are not buying homes because they think it is risky, some think they can not afford etc. If FED is willing to take as much bad loans banks can create, What will stop banks from issuing tons of more loans? And what will stop people from taking these NO RISK loans (because fed is willing to take this back). If this happens, I am extremely convinced, even a 1 month old baby will apply for loans and pass the bad loan to FED. In such a NO RISK environment, you will not find any other job existing in the market/economy!!! You dont need interest or knowledge to do it!!! It is a guaranteed MILLION dollar winning lottery ticket!!! Dont you agree? Do you think, if people become aware of GUARANTEED million dollar lottery, dont you think everyone will play it whether they have interest or economic knowledge? I believe this is why BoJ did not take the bad loans!!!! It is not that BoJ is afraid of foreigners dumping yen - but it is the Japanese who will quit their jobs!!! Dont you agree?? “
Answer #1
What happens when people quit their job and take loans and default on it?
This has happened throughout US history. In the last 100 years the most famous time periods are the 1920’s with the resulting depression and the 1980’s with the S&L scandal. As many whom could understand, dream, followed the money, and willing to take risk move out of productive industry into the financial economy. As always a few lucky people get very rich and get out of the ascending market in time. The rest become bankrupt or wiped out and are worse off then when the asset bubble started.
Why do people become bankrupt, this is because even though the government creates some kind of corporation which assumes the loans, refinances them, and then liquidates them if necessary, like the RTC or HOLC, the borrower is still responsible for the balance of the loan, not the bank. So if the home goes underwater, the borrower is still on the hook to pay the difference. This leads to people losing all of their money.
This was the birth of Freddie Mac was through the programs generated in the Great Depression.
At this time some people have home owners insurance, protecting the borrower from owing on an underwater mortgage. Other borrowers have borrowed against the appreciation of the home and have nothing left to cushion the fall in value. Normally banks do not pursue the borrower for the underwater portion of the money due to past bankruptcy rules, however with the change in the bankruptcy laws they will. Banks always went after you if you could pay the underwater part of the mortgage, especially if you had money in the bank.
Therefore home loans are risky to the borrower, not the lender.
What prevents the banks from just giving out loans without abandon?
The government, as always, bails out the bad loans during a mass banking crisis. This does not bail out the borrowers, but in fact only bails out the lender. Creating a system which rewards banks for overextending credit. This is a very well documented phenomenon in US banking.
The BoJ did not assume the bad loans, they already had them, they just kept them on the books without getting rid of them, then borrowed heavily as many of these loans were not serviced (non-performing loans) to keep the banks from insolvency and bankruptcy.
The difference to which people compare the BoJ to US bailouts is that in America we buy the loans from the banks and either refinance them, upon further failure the US liquidates the loans. Japan kept the loans and kept the banks alive by providing them money to make up for the missed payments.
A country must be able to borrow effetely to accomplish this tactic that Japan used. It provided crushing debt to the Japanese and they still have never recovered from this cataclysm. As I stated before I am still open to further review of the Japanese banking crisis upon further information.
Therefore current US policy is to provide for expanding the money supply through lending for as long as can be accomplished.
Are governments worried about people not working in conventional jobs?
I don’t think the US or Japan has any policy about asset bubbles making jobs, in fact both the US and Japan had policies otherwise and encouraged it. “Ownership Society” is the common US mantra. Therefore governments see GDP growth through asset bubbles as providing jobs, they do not care if it is speculative in nature.
The US definitely does not have a policy about what type of jobs America’s have as we have lost most of our manufacturing base and real jobs to other countries. A disproportioned amount of US jobs are now either tied to the government or to the financial sector. Production of real goods has almost died in the US.
Will the government assume the distressed or non-performing loans?
The government has assumed distressed loans many times in our history. They have not recently, but with hyperinflation in housing, why would they need too. When housing really starts to decline you shall see massive government intervention in the form of a RTC or HOLC. Their have been many more of these corporations the US has set up to deal with distressed businesses and loans.
Since we are in a bubble not very many banks have gone bankrupt either for the same reason that massive appreciation protects banks from defaulting on their financial commitments.
Issue #2
“Also, in 1929, not just commodities, even food prices and essentials fell a lot ( greater than 50%) in price. I believe the reason is that: All though huge amount of reserves were maintained by the FED, the banks were not FULLY loaned. In murray rothbard's AGD, you will see that, the excessive reserves about 30Billion or some 30% (I dont know which one) was held as reserves!! In other words, all though reserves were high, money supply into the financial/real economy was curtailed by more than 30%!! That is why there was deflation in food and essential items!! This is exactly what Keynes called as "Liquidity trap". i.e there was tonnes of liquidity in reserve - but NO ONE borrowing!!!! This is what causes deflation!!!! “
Answer #2
I have always indicated that there might be some initial deflation in absolute monetary terms and I have stated this many times. It should be as no surprise that after a bubble prices fall in some areas, and some prices fall more than others. Even in our Depression we started inflating only after 3 years of mild deflation after many years of high inflation. Therefore the banks do in fact loan money out again.
The Story of Agricultural Goods, the WFC, and the RFC
Food prices in the Depression fell due to collecting a huge amount of agriculture goods through subsidizing farming not to deliver to market, then the enviable dumping of product. Murray Rothbard goes into this into great extend in his book called “America’s Great Depression” in his section of “The New Deal Farm Program”. Goods and services otherwise were really not effected much at all. Housing fell some, but never went down to its pre asset bubble values.
The story of food prices during the depression start with the War Finance Corporation (WFC) and a man by the name of Meyer who ran the WFC starting in 1918 at the end of the WW1. In the aftermath of the war WFC with capital of $500 million and the ability to borrow $3 billion was set on the task to subsidize and bail out companies in distress. WFC was used after the war to provide $1 billion in credit to finance American exports. WFC provided $150 million to finance the exports of various commodities and food goods including cotton and tobacco.
In 1919 Hoover’s European food relief program transported surplus US food to Europe and increased food prices
After the depression of 1921 Meyer who had left the WFC in 1920 started to lobby for the restoration of the WFC in order to subsidize agricultural exports. Meyer returned in 1921 with a directive to lend $1 billion to farmers’ cooperatives, exporters, and foreign importers. By 1923 WFC had loaned out $172 million to farm co-ops and $182 to rural banks. This money was used to increase food prices. In 1927 Meyer left the WFC and was now in charge of the Federal Farm Loan Board (FFLB), an institution he helped form.
In 1929 the Federal Farm Board (FFB) was given $500 million for the purpose of making loans and to establish stabilization corporations to control farm surpluses and increase farm prices. The first act was to increase wheat prices by giving loans to the coops to withhold wheat from the market, however prices continued to decline.
After the crash the FFB was able to hold wheat prices up for a time, but in response the farmer grew more wheat in order to get a bigger subsidy by growing wheat that would be held off the market. In the 1930’s saw the fall in wheat prices further as wheat in supply was increasing at a rapid rate. The surpluses continued to grow and prices continued to fall. Other countries began to increase production of wheat and this further drove prices down. Finally the FFB dumped its surplus wheat on the world and prices collapsed.
This story is basically the same for most of agricultural products in the Depression.
In 1931 Hoover tried to reform the old WFC in order to bail out distressed businesses, this became the Reconstruction Finance Corporation (RFC) and was formed in 1932 with Meyer as its head. RFC started with $500 million in capital and could issue $1.5 billion in securities.
So the farming and WFC philosophies were the basic financial structures used during the depression.
Back to the Answer
An interesting note is that if you were able to kept employed, due to Hoover’s directive to keep wages high, the working population actually gained in buying power as general goods and services only fell about 10%.
The banking system. I totally agree in a depression that banks tighten lending as banking defaults occurs, however, the game has changed since the 1930’s. The US, and the rest of the world for the most part has had a policy of bailing out troubles and distressed banks most of the time, and for the US this means every single time since the 1930’s.
The effect of the banks receiving this bail out money and not lending does in fact lead to an increase in the percentage of reserves. No question about this as this is well documented. The story does not end there however.
As I stated before in all countries that go through hyperinflation the banks die as the loans they made are either not paid, then bailed out, then the money coming in through existing good loans is so deflated in purchasing power that the bank cannot even pay the electric bill with the money and the banks go bankrupt again. So as inflation continues the banking reserves collected are depleted, lost to inflation.
This of course just one step on the road to hyperinflation. Banks must continue to lend or they will die through inflation. If they refuse, unlike the depression, the government can now dictate that they lend.
Now the next situation is borrowers. I would expect lending to fall initially, and then increase as home prices versus income become attractive. Businesses are really in a jam as they constantly need to borrow in order to survive. Not many large businesses can survive long without the ability to borrow. Not only that but many businesses will fail if they can not pay employees or buy materials with debt. This kind of debt is used to push money owed in the future to the present to accomplish goals. I do not mean debt used for sole purpose of expansion.
How about the US in the Depression?
Hoover did try and did hyperinflate the currency by having the Federal Reserve create $1.1 billion US dollars through monetizing the debt and borrowing, then pushed this money into the banks. Hoover, frustrated that banks were taking this money and using it to increase reserve instead of lending the money out stopped creating money in this way
I believe in 1934 the banks started creating money through lending in the US again at a great enough level in order to grow the money supply.
Here is the kicker, a government never has to use commercial banks to loan money or even loan money at all to expand the money supply. All they must do is create money. This certainly leads to hyperinflation. This money is then used on various social programs and such.
Why didn’t the US go into hyperinflation during and after the depression. The US government never embraced creating money to print its way out of the depression after Hoover gave it up. The banks started loans out money again and the money supply increased again through fractional reserve banking. The US was also in much better shape than the rest of the world as the US entered WW1 much later than Europe, this gave the US a stronger starting point than the European countries devastated by WW1. The European powers all went through massive inflation. The US at this time was still the biggest creditor nation at the start of the Depression.
Therefore an increase in bank reserves does not in any way prevent inflation. The US did certainly inflate the money supply after the 1934.
It would be more accurate to say that in the Depression that America experienced some mild deflation as the banking system started to disintegrate from lack of faith in it, then started to re-inflate as the banking system recovered.
Issue #3
“In other words, banks will not loan new money to any one (because people are defaulting). Why does this matter to banks? Today, banks are making huge profits in these loans. So they are reporting lot of earnings per share and hence the ceo and the top guys are getting lot of money. Once defaulting happens, the profits reported by banks will take a huge dive!! So will the CEO and the top guys bonus/salary!! Now, the CEO and others being selfish, they will start cleaning up their balancesheet - in other words "liquidity trap"!!! So what has happened now is that, banks have pulled their future profits into their current year - so they will show loss or no profit in the future!!! If FED is willing to take the bad loans from the banks - you are not understanding one important aspect: The bank ceo - just one guy - will take a TRILLION dollar loan to buy some hedge fund etc - and then declare that loan as bad loan and pass it to FED. Do you think, Congress will allow ONE guy to take a TRILLION dollar loan that easily just to protect the economy? How about other CEOs? Even if you assume the general populace is ignorant - do you think the CEOs will be content with JUST 1 TRILLION? Why wont they go all the way to 100 TRILLION?? Why are you saying this is exactly what is happening today? (when you say, today real estate agents are doing it currently!!). It is not happening today. It will happen ONLY if FED is willing to take the bad loans. This will not happen for the simple reason, CEOs of banks, the knowledgeable people will take 100 TRILLION dollars loan and pass it to fed as bad loan!!! Are you defending this is what FED will allow to happen? Ofcourse, you might argue, fed will put a cap for 300K per person - Then the CEO will create 0.25 TRILLION fake bad loans equivalent to 299K and then pass it to FED!!!! Are you defending that FED will still take the bad loan - and create ZERO RISK for taking loan?”
Answer #3
One of the most misunderstood parts about the Federal Reserve is that it was formed between the political alliance between two very power groups. One lead by J.P. Morgan and the other lead by J.D. Rockefeller. The Federal Reserve started out as a private bank with special ability to create a national currency. A banking cartel was formed in the form of a central bank. Regulation has brought it closer to Washington DC, but is still not a public agency. More like a GSE. Its private bank past is why the Federal Reserve used to be headquartered in New York City and this is why the New York Fed is still the most important of all the Fed branches.
Why is this fact so important to answering your question about loading the balance sheets, using derivatives to hide losses, and white collar crime in general?
The banks make the rules. The largest banks are here for one reason alone, to stay in business and power. If you make the currency, set the rules, then as a large bank you have no real need to steal the money outright because you can just adjust the rules in their own favor. This defeats the need to steal. You already have the buying power the dollar provides. At this point in the game you are trying to manage it.
The largest banks jealously guard their buying power. It is very hard to steal from these banks as they will go after you if you do. Most of the time they will never do business with you again and they can and will go after you. The largest banks either control the smaller banks or have a huge amount of influence in them so the system polices itself.
Why bother stealing when you can just adjust the rules. Selfish greed keeps the banks in line.
Thus when viewed under this light it is easy to see why Thomas Jefferson made his past comments that I posted earlier.
This is not to say that stealing doesn’t happen on a grand scale in the US. It does and is very well documented. During the S&L scandal for example the stealing was biblical, and then most of it was covered up by the bailout. William K. Black wrote a book called “The Best Way to Rob a Bank is to Own One”.
Does stealing happen in smaller banks, investment firms, and business?
Yes, Often.
Mr. Black was the Deputy Director of the Federal Savings and Loan Insurance Company among other jobs in the service of banking and banking crime and is a noted expert in the Saving and Loan Scandal which he was heavily involved in. His book goes into detail on how banks steal money, cook the books, and get away with it. The main focus of the book is the 1980’s S&L scandal. Very good book. I highly recommend reading it.
The Federal Reserve just doesn’t bail out any loan, only in a crisis or to hide the weaknesses from the public. They have silently forced many, and I mean many banks, investment funds, and hedge funds to merge with each other upon taking losses that jeopardize to bankrupt them. This is very well documented.
Many CEO’s steal and loot their companies. Many get away with it, but only in an emergency does the government start buying loans wholesale. You can steal a little money, but steal too much and the banks will want their money back.
So why does the government bail out banks, companies, and citizens?
Remember, almost the entire world is on fractional reserve banking. Therefore it doesn’t take that many losses to jeopardize the whole system and start cascading defaults. At this point the government has two choices, let the monetary system fail, or inflate. It is a shame they always choose to inflate, but is the politically easiest thing for them to do.
It is also interesting to note that the power of the largest banks, financially and politically has not suffered. They are very influential in American elections to this day.
Will the fed bail out these loans, remember, the Federal Reserve is the one who asked that these crazy loans be carried out to re-inflate the world banking system after the 1998 banking crisis.
Martin Mayer writes in The Fed “It turned out to be a weekend of pure terror”. “Lumping together the five nations devastated by the Asian financial crisis, the Deutsche Bank researchers concluded that “While it is difficult to argue that governments are insolvent … under most scenarios, the ability of the government to service its debt in the short run is questionable.” Turning attention to Russia, the German bank’s expert argue that “there is a very high risk that Russia will not be able or willing to repay its foreign debt.” – ever.”“One of the last speakers at the Group of Thirty conference was William McDonough, president of the Federal Reserve Bank of New York… Everyone here, he said, is a banker or a bank supervisor. If you’re a banker, go out and lend – you don’t have to dot every I and cross every T. If you’re a bank supervisor, don’t criticize your banks for making loans even if they’re loans you might not have approved just a little while ago. Get the money out; the word needs the money.”Then later that week at the Chicago Board of Trade Martin Mayer writes “And then the roar stopped, the men stopped waving their arms in the pit, and they all just stood, arms at their sides. At 11:45 in the morning, the price of the T-bond futures contract had dropped $3,000, which was the maximum move in a single day. The market has closed “lock limit down” for the first time since Saddam Hussein invaded Kuwait.”“We returned to the Federal Reserve Bank of Chicago, and in the anteroom ran into Michael Moscow, president of the bank, a tolerant economist who does one thing at a time. We told him what we had seen across the street, and he nodded soberly. “Yes,” he said. “There are no bids for anything. There is no money.”
So my answer is yes, they will bail them out. They already have started as you can clearly see.
We are now living with aftermath of the last major crisis in 1998, which of course was the result of the crisis before that. Many view this as just a continuation of the Depression from the 1930’s. Remember, 1913 was the start of a national paper currency in the United States and of course this coincides with the birth of the Federal Reserve
Issue #4
“Finally, the only way the fed can help is reduce the interest rate (as opposed to taking bad loan) - Ofcourse, I can post the consequences in a separate section. So, in short deflation is in the cards - AS LONG AS FED CAN NOT CREATE ANOTHER ASSET BUBBLE!! I'm not sure if there are anymore assets going forward!!”
Answer #4
I personally think we are out of any more asset bubbles. Real estate is generally the last one you see because of its ubiquities nature and magnitude of money involved.
As a financial mechanic, the federal funds rate is just not that important. Think about it, they are just setting the interest rate for an overnight loan. If a business or bank needs a cheaper loan they can always get it on the international market. So if the federal funds rate is 3.75% and a thirty year bond is 4%, why not just buy the bond or borrow from a foreign bank. The federal funds rate is smoke and mirrors to distract the uninformed.
The Federal Reserve has many tools beyond adjusting the federal funds rate, which is not all that important beyond a political signal to the other countries. The Federal Reserve can and in the past has received all kinds of powers well beyond adjusting the short term rate. This is proven by Fed policy during the Depression and the S&L scandal. The power of the government over the banking system has really grown in the 70 years since the Depression.
Here is a list of just some of the powers of the government as it relates to our banking and currency many are not aware of.
The government can and has continued a policy of inflating the currency supply, a job for which the Federal Reserve was specifically invented to fulfill.
The government can and has forced banks to loan money. They do it all the time. This is a subject which is very, very well documented. Loans to minorities is a good example.
The government can and has taken the property rights away from the creditors of banks in order to keep insolvent banks from bankruptcy. This means a bank does not have to pay depositors or other creditors, but borrowers must still service their loans.
The government can and has changed the accounting rules of banks to hide massive insolvency. RAP is a perfect example.
The government can and has bailed out insolvent banks which are on the verge of bankruptcy, assuming the loans and obligations of the distressed bank, then liquidating or refinancing troubled loans.
The government can and has taken the property rights away from creditors from borrowers and allowed borrowers to hold loans without servicing the debt.
The government can and has made loans without any respect to the commercial interest rate in order to induce borrowing. This means that the government just arbitrarily chooses the interest rate of the loan. This happens every day.
The government can and has the right to confiscate your property and pay you at a value it feels is fair. This power was just radically expanded. This is a fairly common action. The most radical confiscation was during the depression with the confiscation of gold, and the immediate revaluation of gold verses the US dollar.
The government can and has the right to create any ability it seems necessary, limited only by sporadic voter uprisings.
By the trend in inflation and government intervention, inflation and hyperinflation are not only in the future, but the only outcome that can happen at this point.
Thanks for your responses
Chromatic Dispersion
Thanks for your interest Jay,
I need to answer this by item as you have asked a lot of question and made several arguments.
Issue #1
“Thanks a lot for your detailed explanation. One thing you did not explain is: What happens if people quit their job and take loans and default on it? Currently, people are taking loans AND also assuming the RISK associated with asset depreciation. The risk they are taking is that - they will have to pay later!!! And so far, Fed has not taken bad loans!!! So, if FED does it, ONLY THEN, we can see this problem happen. And I can bet you, lot of people today are not buying homes because they think it is risky, some think they can not afford etc. If FED is willing to take as much bad loans banks can create, What will stop banks from issuing tons of more loans? And what will stop people from taking these NO RISK loans (because fed is willing to take this back). If this happens, I am extremely convinced, even a 1 month old baby will apply for loans and pass the bad loan to FED. In such a NO RISK environment, you will not find any other job existing in the market/economy!!! You dont need interest or knowledge to do it!!! It is a guaranteed MILLION dollar winning lottery ticket!!! Dont you agree? Do you think, if people become aware of GUARANTEED million dollar lottery, dont you think everyone will play it whether they have interest or economic knowledge? I believe this is why BoJ did not take the bad loans!!!! It is not that BoJ is afraid of foreigners dumping yen - but it is the Japanese who will quit their jobs!!! Dont you agree?? “
Answer #1
What happens when people quit their job and take loans and default on it?
This has happened throughout US history. In the last 100 years the most famous time periods are the 1920’s with the resulting depression and the 1980’s with the S&L scandal. As many whom could understand, dream, followed the money, and willing to take risk move out of productive industry into the financial economy. As always a few lucky people get very rich and get out of the ascending market in time. The rest become bankrupt or wiped out and are worse off then when the asset bubble started.
Why do people become bankrupt, this is because even though the government creates some kind of corporation which assumes the loans, refinances them, and then liquidates them if necessary, like the RTC or HOLC, the borrower is still responsible for the balance of the loan, not the bank. So if the home goes underwater, the borrower is still on the hook to pay the difference. This leads to people losing all of their money.
This was the birth of Freddie Mac was through the programs generated in the Great Depression.
At this time some people have home owners insurance, protecting the borrower from owing on an underwater mortgage. Other borrowers have borrowed against the appreciation of the home and have nothing left to cushion the fall in value. Normally banks do not pursue the borrower for the underwater portion of the money due to past bankruptcy rules, however with the change in the bankruptcy laws they will. Banks always went after you if you could pay the underwater part of the mortgage, especially if you had money in the bank.
Therefore home loans are risky to the borrower, not the lender.
What prevents the banks from just giving out loans without abandon?
The government, as always, bails out the bad loans during a mass banking crisis. This does not bail out the borrowers, but in fact only bails out the lender. Creating a system which rewards banks for overextending credit. This is a very well documented phenomenon in US banking.
The BoJ did not assume the bad loans, they already had them, they just kept them on the books without getting rid of them, then borrowed heavily as many of these loans were not serviced (non-performing loans) to keep the banks from insolvency and bankruptcy.
The difference to which people compare the BoJ to US bailouts is that in America we buy the loans from the banks and either refinance them, upon further failure the US liquidates the loans. Japan kept the loans and kept the banks alive by providing them money to make up for the missed payments.
A country must be able to borrow effetely to accomplish this tactic that Japan used. It provided crushing debt to the Japanese and they still have never recovered from this cataclysm. As I stated before I am still open to further review of the Japanese banking crisis upon further information.
Therefore current US policy is to provide for expanding the money supply through lending for as long as can be accomplished.
Are governments worried about people not working in conventional jobs?
I don’t think the US or Japan has any policy about asset bubbles making jobs, in fact both the US and Japan had policies otherwise and encouraged it. “Ownership Society” is the common US mantra. Therefore governments see GDP growth through asset bubbles as providing jobs, they do not care if it is speculative in nature.
The US definitely does not have a policy about what type of jobs America’s have as we have lost most of our manufacturing base and real jobs to other countries. A disproportioned amount of US jobs are now either tied to the government or to the financial sector. Production of real goods has almost died in the US.
Will the government assume the distressed or non-performing loans?
The government has assumed distressed loans many times in our history. They have not recently, but with hyperinflation in housing, why would they need too. When housing really starts to decline you shall see massive government intervention in the form of a RTC or HOLC. Their have been many more of these corporations the US has set up to deal with distressed businesses and loans.
Since we are in a bubble not very many banks have gone bankrupt either for the same reason that massive appreciation protects banks from defaulting on their financial commitments.
Issue #2
“Also, in 1929, not just commodities, even food prices and essentials fell a lot ( greater than 50%) in price. I believe the reason is that: All though huge amount of reserves were maintained by the FED, the banks were not FULLY loaned. In murray rothbard's AGD, you will see that, the excessive reserves about 30Billion or some 30% (I dont know which one) was held as reserves!! In other words, all though reserves were high, money supply into the financial/real economy was curtailed by more than 30%!! That is why there was deflation in food and essential items!! This is exactly what Keynes called as "Liquidity trap". i.e there was tonnes of liquidity in reserve - but NO ONE borrowing!!!! This is what causes deflation!!!! “
Answer #2
I have always indicated that there might be some initial deflation in absolute monetary terms and I have stated this many times. It should be as no surprise that after a bubble prices fall in some areas, and some prices fall more than others. Even in our Depression we started inflating only after 3 years of mild deflation after many years of high inflation. Therefore the banks do in fact loan money out again.
The Story of Agricultural Goods, the WFC, and the RFC
Food prices in the Depression fell due to collecting a huge amount of agriculture goods through subsidizing farming not to deliver to market, then the enviable dumping of product. Murray Rothbard goes into this into great extend in his book called “America’s Great Depression” in his section of “The New Deal Farm Program”. Goods and services otherwise were really not effected much at all. Housing fell some, but never went down to its pre asset bubble values.
The story of food prices during the depression start with the War Finance Corporation (WFC) and a man by the name of Meyer who ran the WFC starting in 1918 at the end of the WW1. In the aftermath of the war WFC with capital of $500 million and the ability to borrow $3 billion was set on the task to subsidize and bail out companies in distress. WFC was used after the war to provide $1 billion in credit to finance American exports. WFC provided $150 million to finance the exports of various commodities and food goods including cotton and tobacco.
In 1919 Hoover’s European food relief program transported surplus US food to Europe and increased food prices
After the depression of 1921 Meyer who had left the WFC in 1920 started to lobby for the restoration of the WFC in order to subsidize agricultural exports. Meyer returned in 1921 with a directive to lend $1 billion to farmers’ cooperatives, exporters, and foreign importers. By 1923 WFC had loaned out $172 million to farm co-ops and $182 to rural banks. This money was used to increase food prices. In 1927 Meyer left the WFC and was now in charge of the Federal Farm Loan Board (FFLB), an institution he helped form.
In 1929 the Federal Farm Board (FFB) was given $500 million for the purpose of making loans and to establish stabilization corporations to control farm surpluses and increase farm prices. The first act was to increase wheat prices by giving loans to the coops to withhold wheat from the market, however prices continued to decline.
After the crash the FFB was able to hold wheat prices up for a time, but in response the farmer grew more wheat in order to get a bigger subsidy by growing wheat that would be held off the market. In the 1930’s saw the fall in wheat prices further as wheat in supply was increasing at a rapid rate. The surpluses continued to grow and prices continued to fall. Other countries began to increase production of wheat and this further drove prices down. Finally the FFB dumped its surplus wheat on the world and prices collapsed.
This story is basically the same for most of agricultural products in the Depression.
In 1931 Hoover tried to reform the old WFC in order to bail out distressed businesses, this became the Reconstruction Finance Corporation (RFC) and was formed in 1932 with Meyer as its head. RFC started with $500 million in capital and could issue $1.5 billion in securities.
So the farming and WFC philosophies were the basic financial structures used during the depression.
Back to the Answer
An interesting note is that if you were able to kept employed, due to Hoover’s directive to keep wages high, the working population actually gained in buying power as general goods and services only fell about 10%.
The banking system. I totally agree in a depression that banks tighten lending as banking defaults occurs, however, the game has changed since the 1930’s. The US, and the rest of the world for the most part has had a policy of bailing out troubles and distressed banks most of the time, and for the US this means every single time since the 1930’s.
The effect of the banks receiving this bail out money and not lending does in fact lead to an increase in the percentage of reserves. No question about this as this is well documented. The story does not end there however.
As I stated before in all countries that go through hyperinflation the banks die as the loans they made are either not paid, then bailed out, then the money coming in through existing good loans is so deflated in purchasing power that the bank cannot even pay the electric bill with the money and the banks go bankrupt again. So as inflation continues the banking reserves collected are depleted, lost to inflation.
This of course just one step on the road to hyperinflation. Banks must continue to lend or they will die through inflation. If they refuse, unlike the depression, the government can now dictate that they lend.
Now the next situation is borrowers. I would expect lending to fall initially, and then increase as home prices versus income become attractive. Businesses are really in a jam as they constantly need to borrow in order to survive. Not many large businesses can survive long without the ability to borrow. Not only that but many businesses will fail if they can not pay employees or buy materials with debt. This kind of debt is used to push money owed in the future to the present to accomplish goals. I do not mean debt used for sole purpose of expansion.
How about the US in the Depression?
Hoover did try and did hyperinflate the currency by having the Federal Reserve create $1.1 billion US dollars through monetizing the debt and borrowing, then pushed this money into the banks. Hoover, frustrated that banks were taking this money and using it to increase reserve instead of lending the money out stopped creating money in this way
I believe in 1934 the banks started creating money through lending in the US again at a great enough level in order to grow the money supply.
Here is the kicker, a government never has to use commercial banks to loan money or even loan money at all to expand the money supply. All they must do is create money. This certainly leads to hyperinflation. This money is then used on various social programs and such.
Why didn’t the US go into hyperinflation during and after the depression. The US government never embraced creating money to print its way out of the depression after Hoover gave it up. The banks started loans out money again and the money supply increased again through fractional reserve banking. The US was also in much better shape than the rest of the world as the US entered WW1 much later than Europe, this gave the US a stronger starting point than the European countries devastated by WW1. The European powers all went through massive inflation. The US at this time was still the biggest creditor nation at the start of the Depression.
Therefore an increase in bank reserves does not in any way prevent inflation. The US did certainly inflate the money supply after the 1934.
It would be more accurate to say that in the Depression that America experienced some mild deflation as the banking system started to disintegrate from lack of faith in it, then started to re-inflate as the banking system recovered.
Issue #3
“In other words, banks will not loan new money to any one (because people are defaulting). Why does this matter to banks? Today, banks are making huge profits in these loans. So they are reporting lot of earnings per share and hence the ceo and the top guys are getting lot of money. Once defaulting happens, the profits reported by banks will take a huge dive!! So will the CEO and the top guys bonus/salary!! Now, the CEO and others being selfish, they will start cleaning up their balancesheet - in other words "liquidity trap"!!! So what has happened now is that, banks have pulled their future profits into their current year - so they will show loss or no profit in the future!!! If FED is willing to take the bad loans from the banks - you are not understanding one important aspect: The bank ceo - just one guy - will take a TRILLION dollar loan to buy some hedge fund etc - and then declare that loan as bad loan and pass it to FED. Do you think, Congress will allow ONE guy to take a TRILLION dollar loan that easily just to protect the economy? How about other CEOs? Even if you assume the general populace is ignorant - do you think the CEOs will be content with JUST 1 TRILLION? Why wont they go all the way to 100 TRILLION?? Why are you saying this is exactly what is happening today? (when you say, today real estate agents are doing it currently!!). It is not happening today. It will happen ONLY if FED is willing to take the bad loans. This will not happen for the simple reason, CEOs of banks, the knowledgeable people will take 100 TRILLION dollars loan and pass it to fed as bad loan!!! Are you defending this is what FED will allow to happen? Ofcourse, you might argue, fed will put a cap for 300K per person - Then the CEO will create 0.25 TRILLION fake bad loans equivalent to 299K and then pass it to FED!!!! Are you defending that FED will still take the bad loan - and create ZERO RISK for taking loan?”
Answer #3
One of the most misunderstood parts about the Federal Reserve is that it was formed between the political alliance between two very power groups. One lead by J.P. Morgan and the other lead by J.D. Rockefeller. The Federal Reserve started out as a private bank with special ability to create a national currency. A banking cartel was formed in the form of a central bank. Regulation has brought it closer to Washington DC, but is still not a public agency. More like a GSE. Its private bank past is why the Federal Reserve used to be headquartered in New York City and this is why the New York Fed is still the most important of all the Fed branches.
Why is this fact so important to answering your question about loading the balance sheets, using derivatives to hide losses, and white collar crime in general?
The banks make the rules. The largest banks are here for one reason alone, to stay in business and power. If you make the currency, set the rules, then as a large bank you have no real need to steal the money outright because you can just adjust the rules in their own favor. This defeats the need to steal. You already have the buying power the dollar provides. At this point in the game you are trying to manage it.
The largest banks jealously guard their buying power. It is very hard to steal from these banks as they will go after you if you do. Most of the time they will never do business with you again and they can and will go after you. The largest banks either control the smaller banks or have a huge amount of influence in them so the system polices itself.
Why bother stealing when you can just adjust the rules. Selfish greed keeps the banks in line.
Thus when viewed under this light it is easy to see why Thomas Jefferson made his past comments that I posted earlier.
This is not to say that stealing doesn’t happen on a grand scale in the US. It does and is very well documented. During the S&L scandal for example the stealing was biblical, and then most of it was covered up by the bailout. William K. Black wrote a book called “The Best Way to Rob a Bank is to Own One”.
Does stealing happen in smaller banks, investment firms, and business?
Yes, Often.
Mr. Black was the Deputy Director of the Federal Savings and Loan Insurance Company among other jobs in the service of banking and banking crime and is a noted expert in the Saving and Loan Scandal which he was heavily involved in. His book goes into detail on how banks steal money, cook the books, and get away with it. The main focus of the book is the 1980’s S&L scandal. Very good book. I highly recommend reading it.
The Federal Reserve just doesn’t bail out any loan, only in a crisis or to hide the weaknesses from the public. They have silently forced many, and I mean many banks, investment funds, and hedge funds to merge with each other upon taking losses that jeopardize to bankrupt them. This is very well documented.
Many CEO’s steal and loot their companies. Many get away with it, but only in an emergency does the government start buying loans wholesale. You can steal a little money, but steal too much and the banks will want their money back.
So why does the government bail out banks, companies, and citizens?
Remember, almost the entire world is on fractional reserve banking. Therefore it doesn’t take that many losses to jeopardize the whole system and start cascading defaults. At this point the government has two choices, let the monetary system fail, or inflate. It is a shame they always choose to inflate, but is the politically easiest thing for them to do.
It is also interesting to note that the power of the largest banks, financially and politically has not suffered. They are very influential in American elections to this day.
Will the fed bail out these loans, remember, the Federal Reserve is the one who asked that these crazy loans be carried out to re-inflate the world banking system after the 1998 banking crisis.
Martin Mayer writes in The Fed “It turned out to be a weekend of pure terror”. “Lumping together the five nations devastated by the Asian financial crisis, the Deutsche Bank researchers concluded that “While it is difficult to argue that governments are insolvent … under most scenarios, the ability of the government to service its debt in the short run is questionable.” Turning attention to Russia, the German bank’s expert argue that “there is a very high risk that Russia will not be able or willing to repay its foreign debt.” – ever.”“One of the last speakers at the Group of Thirty conference was William McDonough, president of the Federal Reserve Bank of New York… Everyone here, he said, is a banker or a bank supervisor. If you’re a banker, go out and lend – you don’t have to dot every I and cross every T. If you’re a bank supervisor, don’t criticize your banks for making loans even if they’re loans you might not have approved just a little while ago. Get the money out; the word needs the money.”Then later that week at the Chicago Board of Trade Martin Mayer writes “And then the roar stopped, the men stopped waving their arms in the pit, and they all just stood, arms at their sides. At 11:45 in the morning, the price of the T-bond futures contract had dropped $3,000, which was the maximum move in a single day. The market has closed “lock limit down” for the first time since Saddam Hussein invaded Kuwait.”“We returned to the Federal Reserve Bank of Chicago, and in the anteroom ran into Michael Moscow, president of the bank, a tolerant economist who does one thing at a time. We told him what we had seen across the street, and he nodded soberly. “Yes,” he said. “There are no bids for anything. There is no money.”
So my answer is yes, they will bail them out. They already have started as you can clearly see.
We are now living with aftermath of the last major crisis in 1998, which of course was the result of the crisis before that. Many view this as just a continuation of the Depression from the 1930’s. Remember, 1913 was the start of a national paper currency in the United States and of course this coincides with the birth of the Federal Reserve
Issue #4
“Finally, the only way the fed can help is reduce the interest rate (as opposed to taking bad loan) - Ofcourse, I can post the consequences in a separate section. So, in short deflation is in the cards - AS LONG AS FED CAN NOT CREATE ANOTHER ASSET BUBBLE!! I'm not sure if there are anymore assets going forward!!”
Answer #4
I personally think we are out of any more asset bubbles. Real estate is generally the last one you see because of its ubiquities nature and magnitude of money involved.
As a financial mechanic, the federal funds rate is just not that important. Think about it, they are just setting the interest rate for an overnight loan. If a business or bank needs a cheaper loan they can always get it on the international market. So if the federal funds rate is 3.75% and a thirty year bond is 4%, why not just buy the bond or borrow from a foreign bank. The federal funds rate is smoke and mirrors to distract the uninformed.
The Federal Reserve has many tools beyond adjusting the federal funds rate, which is not all that important beyond a political signal to the other countries. The Federal Reserve can and in the past has received all kinds of powers well beyond adjusting the short term rate. This is proven by Fed policy during the Depression and the S&L scandal. The power of the government over the banking system has really grown in the 70 years since the Depression.
Here is a list of just some of the powers of the government as it relates to our banking and currency many are not aware of.
The government can and has continued a policy of inflating the currency supply, a job for which the Federal Reserve was specifically invented to fulfill.
The government can and has forced banks to loan money. They do it all the time. This is a subject which is very, very well documented. Loans to minorities is a good example.
The government can and has taken the property rights away from the creditors of banks in order to keep insolvent banks from bankruptcy. This means a bank does not have to pay depositors or other creditors, but borrowers must still service their loans.
The government can and has changed the accounting rules of banks to hide massive insolvency. RAP is a perfect example.
The government can and has bailed out insolvent banks which are on the verge of bankruptcy, assuming the loans and obligations of the distressed bank, then liquidating or refinancing troubled loans.
The government can and has taken the property rights away from creditors from borrowers and allowed borrowers to hold loans without servicing the debt.
The government can and has made loans without any respect to the commercial interest rate in order to induce borrowing. This means that the government just arbitrarily chooses the interest rate of the loan. This happens every day.
The government can and has the right to confiscate your property and pay you at a value it feels is fair. This power was just radically expanded. This is a fairly common action. The most radical confiscation was during the depression with the confiscation of gold, and the immediate revaluation of gold verses the US dollar.
The government can and has the right to create any ability it seems necessary, limited only by sporadic voter uprisings.
By the trend in inflation and government intervention, inflation and hyperinflation are not only in the future, but the only outcome that can happen at this point.
Thanks for your responses
Chromatic Dispersion
posted by Chromatic Dispersion at 10/14/2005 05:36:00 PM
33 Comments:
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Chromatic,
Thanks again for your quick response. I understand and agree with most of your response. However, there are few areas, where I would appreciate if you can throw more light.
Answer 1#: I perfectly agree with you that banks would be bailed but not the debtors. For this reason, a bank ceo can not create a trillion dollar loan and pass it as bad loan to the Fed. I agree 100% with you on this. However, currently most of the population has taken huge loans and these debtors are going to default. And the banks are going to hold them responsible with the new bankruptcy rule. This bankruptcy rule is similar to 1929s where French and US govt did not allow the Germans to default on their loan and is criticized to be a main policy error. Isnt this deflationary? Why would it be inflationary? Also, why would these debtors go for new loan (and why would they be given a new loan) if they have defaulted and banks are after them? Dont you agree this is deflationary? Also, what asset would these guys buy to cause inflationary response? So, you are also expecting liquidity trap initially. Correct?
Answer #2:
I agree with you when you say the inflation started cranking up soon - there are very few people who understands that from 1934 onwards the CPI was positive!! However, I disagree with you that deflation was mild (monetary deflation was mild, but CPI fell atleast 50% in aggregate till pre-1934). Also, the key fact Murray Rothbard mentions in AGD is that - these inflationary policies prolonged the depression!! So RTC, HLOC etc will push to create inflation - but this inflation will only prolong the recession/depression!!! I'll post another comment based on this!!! Also, Murray Rothbard clearly agrees Deflation is only secondary and it need not be a necessity. What is guaranteed is recession/depression!!! What I dont agree with you is that hyperinflation is possible. Hyper inflation is not possible because, the job losses will be so severe if Fed takes this path!!! Just to preserve jobs, they will have to attempt to contain inflation (see the next comment).
Answer #4: One of the thing about a recession is the PPI (lower order goods) has to fall below the CPI (higher order goods). i.e the cost of making products (PPI) should fall below the price consumers are willing to pay (cpi). If this doesnt happen, business will take the only alternative to reduce PPI - i.e cut wages or layoff people to support the reduced customer base!! This is the reason, inflationary effect takes the recession deeper than it should go!! This is what Murray Rothbard articulates in AGD (also see my next comment). Keynes calls this as sticky prices - because industry was not able to lower prices so that consumers could buy!! Instead, they expected higher price - and hence less people could afford - and hence they had to layoff massively and not rehire!!
Answer #4: I agree with you that the Fed has bailed banks. But I dont agree that all banks have been bailed since 1945. No. After the Texas oil boom, few banks that had over-lended home loans went bankrupt. Many of S&L banks went bankrupt as well. The remaining were merged with larger banks. So, you might be asking what was the taxpayer money used for in the S&L crisis? I've not read any report - but correct me if I'm wrong - I would assume the FDIC paid all the depositors upto 100K with their money!!! Isnt this what happened? Why would they bail the depositors? So that there are no more future bank runs - and the Fed (as FDIC is supposed to cover its promise) bailed the depositors. This is what was paid by taxpayers money!! Also, when LTCM went down the fed did not give even $1 to LTCM depositors (as it is not guaranteed by FDIC). However, the banks that had invested in LTCM were bailed by guaranteed FedFundsRate reduction (hence they could profit from the carry trade)!! i.e Fed will ONLY give money to cover FDIC insurance to depositors - nothing more!!! (there was no FDIC in 1929 - so bank holidays had to be declared!! I assume Argentina doesnt have FDIC policy and hence they had to declare bank holidays as well). However, if there is bank run today (unlikely from depositors because FDIC will cover all the deposit upto 100K) because of derivatives collapse, bad banks will be closed - just like some of the S&L banks and texas housing bust banks!! Why? Because of the moral hazard. Tell me if JPM is bailed what will stop Wellsfargo or other small time community banks to overbid derivatives - lend free money to 3rd world countries - and grow to overtake JPM?? If there is no risk - banks will just lend without taking documents - because all they care is earnings which gives bigger bonus to CEOs!!! So, there will be some reward for taking risk - but absolutely no reward with zero risk!!! Today, the derivative players are taking the risk that USTreas will rise in price once there is distress in the private bond market. Hence lot of the derivatives must have been hedged against USTreasuries (refer to Doug Noland's article). And I believe, like Doug, that this time it is different!! Fedrate is going to go up and bond market is going to be in distress. The derivatives is going to collapse massively!! Bank runs are going to happen because of this!!! Not because of depositors bailing out!!! But because of investors bailing out!!! I dont think Fed has insurance to protect investors - nor is there a need to protect investors!! Can you tell me with absolute guarantee that there has not been even a single bank closure since 1945 AND in the S&L crisis, all the taxpayer's money was not used to protect depositors but someone else?
However, I agree that agencies like RTC, HLOC etc will be created today - most likely to create national health insurance (to bail GM, ford etc) and national pension schemes etc. But these will be inflationary and prolong the recession!!!
Chromatic,
Look at the oil price in 1931 at the below link!!
http://angrybear.blogspot.com/20...- revisited.html
Also, Do you know what is most common complaint people say about BankOfJapan for this deflation? BoJ did not lower the interest rates as soon as the markets were crashing - they waited longer. That is right. Now look at the CPI in Japan for 1991 - Jan!!
http://www.stat.go.jp/english/data/cpi/
Tell me were they morons for not reducing the rate? No way. Inflation was accelerating before that and they had no option but to hold on to the high interest rate!!
Also, in 1931, in the middle of deflation, UK was having commodity inflation (PPI positive and CPI negative) - because pound was depreciating faster than commodity prices!!!
http://www.futurecasts.com/Depre...nt-end-' 31.html
From the above link:
"Expectations were that the pound would lose a substantial proportion of its purchasing power in foreign markets. With foreign raw materials and goods costing more in terms of pounds, a significant price rise within England would exist for a couple of months side by side with the great unemployment caused by the Great Depression.
This is an occurrence that John Maynard Keynes and his followers have always since conveniently ignored. By the end of the year, the British price index would be up almost 10% - it would still be up more than 4% a year after the devaluation.
?
If the devaluation had not been accompanied by harsh austerity measures - if it had been "accommodated" by monetary expansion - the inflation of prices could have continued indefinitely, even with Great Depression unemployment."
Now, the above is exactly what Greenspan is afraid of!! In the face of deflation fear - Greenspan is thinking that he can allow the inflation to grow and allow it to fight against the deflation. And now it is becoming obvious, the inflation will be sustained in PPI. It will be sustained longer, longer the interest rates remains accomodative. Why? As oil prices stay high for longer - all the enterprises will start entering into contracts at higher oil prices, higher transportation prices etc. And when the deflation hits - the industries will be forced to pay this price and hence their cost can not come down. (this is what Keynes referred as Sticky prices - which is likely to more sticky today where there are more contracts and fed's extensive accomodative policy). Fortunately, consumers dont sign contracts!! If electricity price is high, they will just live with candle. But will a consumer go to a grocery shop that operates in candle light??? No.
So, there you go. Monetary inflation does ALWAYS cause inflation. Only thing is that - at turning point recessions (if there is no more asset to inflate) - PPI will continue to be higher than CPI!! CPI will fail to raise because there are no asset price raise to support this CPI rise!! This is true both in inflationary recession and deflationary recession. That is why govt support programs, anti-immigration programs, higher taxes, high monetary growth - all were causing the deflationary recession even worse (in 1930s). They all make it worse by making the cost of production (PPI) higher than the cost of selling price (CPI).
I believe, this is Doug Noland's prediction. He says, Hyman Minsky was even becoming doubtful deflation can no more happen because fed can always reduce the interest rates and keep avoiding it. However, Doug Noland now predicts that the inflation manifestation is going to be so entrenched that Fed will not have a chance to reduce the interest rates and act against deflation!!! The interest rate reduction will depreciate the currency faster than commodity price fall in the rest of world's currency!!!
I believe all the nations that will be running into deflation will want to spend and "save" the economy. How can these economies "spend" without causing higher PPI in their country? How can govt build roads, buy steel, cement etc without causing PPI increases (or PPI not decreasing faster than CPI)? The ONLY way is to spend it in "some other countries' currency" - for example USD!!! So, the asian countries will be releasing the dollars madly to save their economy. That itself will cause humongous PPI in US. Do you think US Fed can add more USD in the world market on top of it and not cause PPI inflation in US? No way.
So, the current inflation is going to stay squarely on industries and when the deflation hits, all the adjustments are going to be in standard of living for consumers.
Thus in 1930s, Fed build lot of roads where they dont need one. This raised cement and steel prices for industries!! Car companies had to build cars with steel (they could not use card board for instance). Hence their prices of car stayed high - no buyers - and hence massive layoffs!! How about consumers? Would they use steel grills? No - it is expensive. Their stomach and mouth will accept any food, that is cooked on top of "clean stone" vessel!!! THere you go - that is why CPI will fall badly and until industries can sell at that price - they will be continously laying off!! So, Fed's reflationary effect WILL cause inflation - but in PPI. So hold on - you are going to see even more higher inflation before you see the deflation!! You will not go to hyper-inflation - dont worry! Do you disagree with this? Isnt this what happened in 1930s - and isnt this what Murray Rothbard describes in AGD?
in 1934 Roosevelt had been in power for 2 years.
I don't understand how you can possibly believe in hyper inflation. Of course it is the best option, the only way to erase debts and erase the financial power of the lenders. Yet as you've said, lenders are in power now, they most probably will resist any pro inflation move.
Here's how I see things
1
Present debt grows faster than present GDP. This is true world wide.
It has been true in the USA in the last 50 years.
2
It is impossible to stockpile infinite amounts of debts in a new kind of babel tower.
Therefore sooner or later, debt growth has to peak and fall, faster than GDP.
3
US household citizens is below zero, US fed deficit is heading for free fall in 2006 (spec thanks Iraq, Katrina, end of housing boom and reduction of economic growth)
Bankrupcy law pushes for less careless lending. Same with end of housing boom.
Saving rates are poised to move up. A credit crunch is just at hand.
4
if credit crunch is at hand and labor power is so weak that it can't get wage increases to match productivity, deflation is guaranteed in the oncoming recession.
Conclusion :
The best thing for the FED to do would be to monetise agressively the US fed deficit in order to organise a fall of the dollar against asian currencies a long postponed stock market and housing crash and hand out cash to battered consumers to allow them to erase their debts.
High inflation would help also to reduce debt levels.
Alas, those in power don't care about the welfare of the USA at large, but about giving more money to those who already have too much, this is the only explanation of all the pseudo stagflation talk.
Inflation is a threat for asset holders, is is a benediction for debt holders. Stangely the managers of the economy have forgotten the second part of the equation. They have built this faith that asset prices always go up, and piling debt is not dangerous because asset prices go up.
I bet it's now a simple choice. Santa Klaus believers in the asset economy (supply side, deregulation, fear of inflation ... )
And realist defending the revenue based economy.
NB
Every body knows this equation
PY = MV
This stands for the price of all things produced*those things equals the mass of money in circulation * its speed of circulation
"Strangely" P has been wrongly taken has the same thing has the general price level of consuming goods. The asset price variations of production goods have been forgotten.
Monetarism has lost all explanatory power post 1985 because asset prices have skyrocked, in direct relation with the explosion in the money emitted, while the general price level stayed flat, despite the explosion in the money supply.
For a given increase of the money supply, the main factor explaining the choice between an increase in production goods or in consuming goods is of course the rise in real wages. If real wage growth does not match productivity growth, asset prices skyrocket.
When wages do not match productivity, of course wage earners can not buy all the stuff produced WITHOUT BORROWING.
In such a situation stock holders win twice : they make higher profit by paying low wages.
They make higher profits through their lending activities.
Of course it's impossible has explained above to pile on debt forever. So sooner or later the all thing crashes.
This has occured repeatedly.
It is nothing more than the optimism-pessimism scenario inherent to human nature.
So hyperinflation, may be, hopefully, but alas given the prolending attitude of present bankers, deflation is 100% sure to happen first.
or if I can phrase all this in one sentence :
the ratio of publicly emitted money to privately emitted money (through debt creation) has fallen continuously for the last 50 years, it now needs to rise, the fed needs to crowd out private banks of money creation.
Will they dare do it ?
Why haven't they done it already ?
Epimethee,
Interesting observations in your post, the one issue I am interested in now is the big one
Is The Fed Lying about the Money Supply and Debt in its reports
This is not an uncommon activity in countries which are in economic trouble to cloud the facts of their currency creation and buy their own debt through the auspices of other countries.
I am trying to answer as many people as possible today so forgive me for my short post. I am just running out of time today.
Chromatic Dispersion
Chromatic,
Have you seen this yet?
http://biz.yahoo.com/ap/051017/fannie_mae_lobbying.html?.v=2
Do you think you can get a hand on the report since it is being withheld from the public. Do you think this is significant news?
-Ben Green
Its starting.........Refco declares bankruptcy.....and systemic risk is reintroduced into the system:
http://biz.yahoo.com/ap/051018/refco.html?.v=2
Regards,
Ben Green
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Jay,
Here is the answer to the following question you asked. Lots of work on my part so it took me some time. I shall try to break them down when I post them.
Chromatic Dispersion
“jay said...
Chromatic,
Thanks again for your quick response. I understand and agree with most of your response. However, there are few areas, where I would appreciate if you can throw more light.
Answer 1#: I perfectly agree with you that banks would be bailed but not the debtors. For this reason, a bank ceo can not create a trillion dollar loan and pass it as bad loan to the Fed. I agree 100% with you on this. However, currently most of the population has taken huge loans and these debtors are going to default. And the banks are going to hold them responsible with the new bankruptcy rule. This bankruptcy rule is similar to 1929s where French and US govt did not allow the Germans to default on their loan and is criticized to be a main policy error. Isnt this deflationary? Why would it be inflationary? Also, why would these debtors go for new loan (and why would they be given a new loan) if they have defaulted and banks are after them? Dont you agree this is deflationary? Also, what asset would these guys buy to cause inflationary response? So, you are also expecting liquidity trap initially. Correct?”
Let me start out by saying that the mechanics of bankruptcy are deflationary, the government response is the process is what can causes inflation. Therefore based on past US policy since the 1930’s you will find that the deflationary pressures have been circumvented through US public policy.
In the 1930’s the US would have had much greater deflation had the government not stepped in with various socialist and planed economy measures (i.e. the New Deal). In the 1980’s the US started a similar program to HOLC called the Resolution Trust Corporation (RTC) which not only bought up distressed loans, but either refinanced them or upon further failure liquidated them. Therefore based on past policy imitative formed through our government I would expect to see something similar.
Here is the next issue, does this action of bailing out loans cause general inflation. I would argue probably not on its own. It definitely causes deflation in the assets based on loans, but it this by itself would not do it to the general economy. The telecom bust is a good example as telecom prices went down, but the rest of the economy didn’t move that much.
The cause of general inflation would have to increase the amount of money in general circulation. This would be the amount of money floating around that people pay for groceries, gas, going to movies, and things people do every day. Therefore I break money in circulation into two main groups. Money used for every day expanses and money used in some kind of saving vehicle. I consider investing savings as this money in my opinion is just another form of savings. However I recognize lots of gray in the distinction between the two. Housing is a good example.
Countries also tend to increase deficits by putting the potentially unemployed population to work by creating military projects, public works projects, and other employment. This injects currency directly into the economy and acts just like newly created money as if created by the Federal Reserve. This money may enter general circulation if the money is used to buy everyday things. If the money is used for some kind of savings then the money gets trapped in an asset class of some sort.
Next consider a negative trade balance. The mechanics of a negative trade balance is that it takes money spent on everyday things and transports it out of the country, getting it out of general circulation in the US.
The next thing to consider is that the US is the world’s reserve currency. Having the US dollar replace gold as the medium for international exchange has caused an enormous amount of US dollar based assets to be held by foreign banks. This means of course that most of the total amount of US currency is outside of the United States in the form of bonds, cash, or other assets denominated in US currency.
Therefore the case I would make would entail that as the housing bubble falls and public policy kicks into high gear you will see deflation in highly over inflated asset classes initially. This may be a falling stock market and housing prices.
Then the government shall take over the bad loans and start bailing out defaulting banks just like in the S&L crisis (bank bailouts in the US means that the depositors are bailed out, however the banks are still dissolved. This is different than other industries in the US whereas banks can cease to exist, but bailed out businesses are still in business).
The next phase begins whereas the government starts making military or other public works in order to keep the people employed. This will insert money directly into the economy.
Here is the Danger Zone. If the absolute magnitude of the money being used to bail out housing and the unemployed people is too high, then the world starts losing confidence in the stability in the US dollar. This will cause the US dollar not to be used as medium for international exchange. Resulting is a process in which US dollars held oversees in one form or another starts coming back into the US, flooding the money in circulation.
Now it gets interesting as the US is pumping money through military and public works or what ever else they can come up with while money comes back into the country in the form of MBS, treasuries, or whatever. This will sink the buying power of the dollar internationally while raising prices domestically as it will be much harder for this newly created money to leave the country through a negative trade deficit.
Therefore as people make the decision between savings and expenses, a greater percentage of their income will have to go to expenses. As investment and savings vehicles start to become unstable I would expect investment to also reduce.
However I also recognize that due to the amount of assets denominated in US currency in foreign central banks that as soon as the US dollar starts to devalue this will have major negative effects on all currencies. These countries also have housing and asset bubbles of their own. Therefore their currencies are also in jeopardy as they try to print money to get out of their economic crisis.
Therefore I would expect the world to go through massive hyper inflation until a new monetary order is established.
Chromatic Dispersion
“Answer #2:
I agree with you when you say the inflation started cranking up soon - there are very few people who understands that from 1934 onwards the CPI was positive!! However, I disagree with you that deflation was mild (monetary deflation was mild, but CPI fell atleast 50% in aggregate till pre-1934). Also, the key fact Murray Rothbard mentions in AGD is that - these inflationary policies prolonged the depression!! So RTC, HLOC etc will push to create inflation - but this inflation will only prolong the recession/depression!!! I'll post another comment based on this!!! Also, Murray Rothbard clearly agrees Deflation is only secondary and it need not be a necessity. What is guaranteed is recession/depression!!! What I dont agree with you is that hyperinflation is possible. Hyper inflation is not possible because, the job losses will be so severe if Fed takes this path!!! Just to preserve jobs, they will have to attempt to contain inflation (see the next comment).
Answer #4: One of the thing about a recession is the PPI (lower order goods) has to fall below the CPI (higher order goods). i.e the cost of making products (PPI) should fall below the price consumers are willing to pay (cpi). If this doesnt happen, business will take the only alternative to reduce PPI - i.e cut wages or layoff people to support the reduced customer base!! This is the reason, inflationary effect takes the recession deeper than it should go!! This is what Murray Rothbard articulates in AGD (also see my next comment). Keynes calls this as sticky prices - because industry was not able to lower prices so that consumers could buy!! Instead, they expected higher price - and hence less people could afford - and hence they had to layoff massively and not rehire!!”
A would like to point out that hyperinflation is almost never, and I do think never is a better word here, chosen by a political system cognitively. Hyperinflation is something that is forced upon a country through international pressures. Hyperinflation means the end of the politician’s jobs, so I really don’t think they want to that direction by design.
Therefore I would argue that governments make choices leading up to hyperinflation, like Argentina, by trying to “have their cake and eat it too” mentality. They have just got too many fiscal commitments to keep their party in power verses the amount of money their country can actually pay. These countries just keep on piling on more debt, manipulate their GPD with military and public works projects, until the rest of the world divulges themselves of the bad money.
“Answer #4: I agree with you that the Fed has bailed banks. But I dont agree that all banks have been bailed since 1945. No. After the Texas oil boom, few banks that had over-lended home loans went bankrupt. Many of S&L banks went bankrupt as well. The remaining were merged with larger banks. So, you might be asking what was the taxpayer money used for in the S&L crisis? I've not read any report - but correct me if I'm wrong - I would assume the FDIC paid all the depositors upto 100K with their money!!! Isnt this what happened? Why would they bail the depositors? So that there are no more future bank runs - and the Fed (as FDIC is supposed to cover its promise) bailed the depositors. This is what was paid by taxpayers money!! Also, when LTCM went down the fed did not give even $1 to LTCM depositors (as it is not guaranteed by FDIC). However, the banks that had invested in LTCM were bailed by guaranteed FedFundsRate reduction (hence they could profit from the carry trade)!! i.e Fed will ONLY give money to cover FDIC insurance to depositors - nothing more!!! (there was no FDIC in 1929 - so bank holidays had to be declared!! I assume Argentina doesnt have FDIC policy and hence they had to declare bank holidays as well). However, if there is bank run today (unlikely from depositors because FDIC will cover all the deposit upto 100K) because of derivatives collapse, bad banks will be closed - just like some of the S&L banks and texas housing bust banks!! Why? Because of the moral hazard. Tell me if JPM is bailed what will stop Wellsfargo or other small time community banks to overbid derivatives - lend free money to 3rd world countries - and grow to overtake JPM?? If there is no risk - banks will just lend without taking documents - because all they care is earnings which gives bigger bonus to CEOs!!! So, there will be some reward for taking risk - but absolutely no reward with zero risk!!! Today, the derivative players are taking the risk that USTreas will rise in price once there is distress in the private bond market. Hence lot of the derivatives must have been hedged against USTreasuries (refer to Doug Noland's article). And I believe, like Doug, that this time it is different!! Fedrate is going to go up and bond market is going to be in distress. The derivatives is going to collapse massively!! Bank runs are going to happen because of this!!! Not because of depositors bailing out!!! But because of investors bailing out!!! I dont think Fed has insurance to protect investors - nor is there a need to protect investors!! Can you tell me with absolute guarantee that there has not been even a single bank closure since 1945 AND in the S&L crisis, all the taxpayer's money was not used to protect depositors but someone else?
However, I agree that agencies like RTC, HLOC etc will be created today - most likely to create national health insurance (to bail GM, ford etc) and national pension schemes etc. But these will be inflationary and prolong the recession!!!
1:40 PM, October 16, 2005 “
I have written quite a lot about bank bailouts in the past and the S&L scandal in particular. I have often pointed out that in US bank bailouts for smaller banks that the bank creditors are paid, but the bank itself is dissolved. This technique is not used in all countries. Other countries may very well bail out their banks as a whole and the bank continuous to operate as before with the same owners.
Many businesses go through bankruptcy and operate even after liquidation, just with different owners. I have been personally involved in a few of these.
If a large US bank were to get into trouble, like J.P. Morgan, then the government would probably bail them out and keep the same owners as they did in 1998 during the Russian Banking Crisis/ US bond market crisis.
Another interesting historical note that Martin Meyer (famous financial historian and writer) has written about is that the government through the Federal Reserve, FDIC, and any other government program, bail out the creditors as a whole. This means that FDIC actually pays back everything, regardless of the monetary amount. They bail out depositors well above FDIC limits, and any other creditor with a provable claim.
I don’t know for sure if every bank has been bailed out in such generous manor as all depositors have been bailed out in full, even above FDIC limits. However the US has a very serious reason for doing so. The reason is to keep the US dollar standard and to keep confidence in the dollar.
It is believed they do to keep international faith in the strength of the US dollar. If confidence were to fail the US monetary system would be a wreck as the US dollars held by international banks came back into the money supply.
I would also like to point out that FDIC doesn’t have that much money for bailouts, only a few billion, so they really get money from the government through the Fed in order to accomplish a major bailout.
Generally there is some kind of program like FDIC in most countries, no matter if they are in the third world or not. Japan just got rid of their equivalent FDIC bank protection this year.
LTCM, this is what I meant when I was referring too the silent hand of the Fed in forcing distressed financial companies to merge with each other. You are quit correct that the Fed didn’t spend money on this one. However William McDonough is the one who really organized the bailout of LTCM. LTCM was bailed out and failed like a year or two latter.
The Moral Hazard, the US really has no policy to discourage the moral hazard as the US has a policy in my opinion of encouraging the moral hazard. I believe the basis of this policy is the power of the financial economy over the real economy. As the financial economy grew they gained more influence over our political system. Therefore they have instituted policies which link them very close to the political system as a world power. Therefore the government, in order to protect this economic and financial power, is very incentives to keep the present state of uncontrolled lending going for as long as possible.
I like this quote from Dr. Marc Faber “never overestimate the intelligence of central bankers”. The business of central banking is very political, so what seems to be bad policy is really good politically for those in power.
I also believe the US taxpayer, or really international bond holders of US debt are being the brunt of our past banking crisis.
As for the derivatives market I believe that these will accelerate the collapse, for as Doug Noland and various others points out that with excessive leverage, the cross defaults would happen much faster than in a time before modern derivatives.
I also think Doug Noland is right about the collapse. I just believe the currency will not survive the collapse because public policy and international pressure will lead to hyperinflation of the currency.
Here is part of a research paper I am writing and this part is about the S&L Scandal.
The Savings and Loan Scandal
The Savings and Loan Scandal encompasses the time in the 1980’s when the Savings and Loan industry went through over 10 years of deregulation ending in the mass bankruptcy and insolvency of hundreds of S&L’s across the country.
During this deregulation process the net worth requirement for insured S&Ls was reduced from 5 to 4 percent of total deposits in 1980 and again lowered to 3 percent in 1982. In 1983 newly chartered S&Ls net worth requirement was raised to 7 percent. After the crisis started in 1985 the net worth requirements are raised slowly to 6 percent in 1986.
The first attempt to save the S&L’s was in September of 1981 when the Federal Home Loan Bank Board permitted the Federal Savings and Loan Insurance Corporation (FSLIC) to buy Income Capital Certificates from insolvent S&L’s. This allows the S&L’s to appear solvent on their balance sheets when they are in fact insolvent.
GAAP requirement are dropped and replaced with Regulatory Accounting Principles (RAP) in January of 1982. This effetely avoids accounting which would indicate that the S&L’s are insolvent and liberalizes financial accounting. Further steps are taken to deregulate the S&L’s by expanding their powers through 1985. In 1985 the collapse of the S&L’s starts in March in Ohio and in May in Maryland.
In 1985 the Federal Asset Disposition Association (FADA) is created to dispose of the Income Capital Certificates and other assets owned and held by the FSLIC. FADA was able to dispose of approx. $1.5 billion of $4 billion assets before being turned over by the Resolution Trust Corporation (RTC) in 1990 per the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA).
In 1990 the RTC took over the job the FADA had started. The RTC directive was to dispose of the deposits, branches, and assets of insolvent S&Ls and to sell assets that the acquirers of the S&Ls didn’t want to purchase.
Per the FDIC 1,043 S&L’s with total assets of over $500 billion failed. The cost to the US taxpayer was approx. $124 billion and the thrift industry $29 billion. Per the treasury department the national deficit was approx. $2.1 trillion in 1986 to $4.9 trillion in 1995. The number of federally insured thrifts dropped to 1,645 in 1995 from 3,234 in 1986.
Source
http://www.fdic.gov/bank/historical/s&l/index.html
http://www.fanniemaefoundation.org/programs/hpd/pdf/hpd_0101_ely.pdf
http://www.fanniemaefoundation.org/programs/hpd/pdf/hpd_0201_kettl.pdf#search='Resolution%20Trust%20Corporation'
http://www.fdic.gov/bank/analytical/banking/2000dec/brv13n2_2.pdf#search='savings%20and%20loan%20scandal'
http://www.fdic.gov/bank/analytical/banking/2000dec/brv13n2_2.pdf
http://www.publicdebt.treas.gov/opd/opdpenny.htm
Chromatic,
Thanks again for your response. Now, I fully concur with you. Banks will be failed means - depositors will be saved and banks could cease to exist. And then the only inflationary action the govt can do is: Spend mad on projects, military build up etc. Individuals will not be able to spend (because of the recession, lot of people would have lost job, there would be uncertainity and hence the job holders will save instead of spending).
However, I've one final question for you. I've also posted another comment on why PPI will stay higher than CPI in a recession (whether it be inflationary or deflationary recession). Do you concur with it that - as govt spends, dollar falls, and fed eases interest rates - PPI could creep very high and CPI could still be high - but job loss from private sector will be extremely high!!! Do you envision this scenario - i.e inspite of job losses happening - govt will spend like mad resulting in more job losses - But people will want govt to spend even more!! Also, look at the Bank of England's action in 1931. Their currency fell and they had commodity inflation - even though commodity deflation was happening in USD!! Dont you think samething will be happening in US and hence they will need to hike the interest rate (even though job losses are mounting!!) - Also, another way to curb inflation is to tax - and hence the govt could hike the tax!! In short, any attempt to fight deflation with money will be possible - but it will be highly inflationary.
One more last question: Do you think 1970s was inflationary or hyper-inflationary recession? i.e Do you think hyperinflationary recession in US will be where inflation will be about 10-15%?
Thanks,
Jay
Jay and Chromatic, please continue the exchange. This is just a comment.
Argentina had (private) bank deposit insurance in 2001. But that did not prevent the crisis. The bank runs were caused by lack trust in the government's ability or desire to maintain the convertibility law. Depositors wanted to withdraw their dollar denominated deposits and convert their pesos to dollars, before the law was repealed.
The government had two options, full dollarization, or elimination of the convertibility law and devaluation of the peso. The government had enough dollar reserves for full dollarization at the one-to-one rate.
However, that would have left the government with no means, (except much higher taxes) to pay the interest on the external dollar denominated debt. Therefore, they decided to screw the depositors and rob the banks, rather than bankrupt the government.
Withdrawals from all accounts were restricted, the convertibility law was eliminated and depositors were eventually allowed to withdraw their money in devaluated pesos, instead of dollars.
In peso terms there was hyperinflation as in one year the peso fell from dollar parity to a 4-to-1 rate. However, in dollar terms, there was deflation.
Could bank runs happen in the US if confidence is lost in the government's ability or desire to prevent hyperinflation?
If hyperinflation was a possibility, wouldn't the public try to withdraw their funds and use them to purchase other currencies or assets?
Jay,
I had promised to write about the end of the British Pound Sterling standard during the late 1920’s through the 1930’s. I feel that this issue and the US in the 1970’s have many things in common.
I will have to do some research on the CPI issue as I do not know it off the top of my head, but I suspect it is related to Europe losing confidence in the British pound sterling and devulging themselves of this currency. This finally ended when England left the gold standard and currencies became just based on future taxes.
I feel that this impacted PPI and CPI, but I don’t know exactly how until I read some more about it.
I feel this is similar to the US in the 1970’s when the US went off the gold standard and foreigners started to get rid of the US dollar. This caused the amount of US currency to increase in the international market.
One important thing to keep in mind, this was in a time before modern derivatives. Therefore the amount of leverage this time will be much greater, leading to a much higher, by several orders of magnitude, velocity of money and insolvencies. The government will be key in determining of the insolvencies turn into bankruptcies.
Chromatic Dispersion
Serg,
Argentina is one of my favorite topics. The semi currency board that Argentina set up between the US dollar and the Peso in a one for one exchange is not what sent Argentina into hyperinflation. Argentina fell into the trap that all democracies fall into. In order to get and stay elected politicians promise more than their country can really deliver.
So let’s take a look at currency creation under the semi currency board. This would mean that the peso could be exchanged for the US dollar, and the US dollar could be used as legal tender in Argentina. This means that the Argentina central bank used the US dollar as the basis for creating pesos. Therefore the central bank had a supply of US dollars they could exchange pesos for.
However this supply was still limited. Meaning they had a default fractional reserve bank in respect to the peso. Therefore this limited supply of US dollars was not a problem as long as there was no run on US currency.
Argentina then started borrowing money from Wall Street. This money was used for various things (I would actually have to look it up again). Argentina started down the road of a bubble economy at this point.
Argentina then went through the bust cycle, which of course hurt its tax base. This of course lead to one of the biggest problems with currency in Argentina, the state governors could print their own money and obtain their own debt.
As debt and currency creation went out of control, US dollars started flowing out of the bank. Argentina borrowed money from the IMF to keep things going, but the damage had been done, too many promises had been made and needed to be kept. This happens in all democracies.
Argentina then took property rights away from the bank depositors by not allowing them to take more than a set amount of money out of the bank on a weekly basis. They also disallowed people to be paid in US dollars. This sent the peso into sharp decline.
Argentina could not maintain the semi currency board; there debt was in terms of the US dollar with money owed to the IMF and Wall Street. The Argentinean peso hyperinflated.
How does this compare to the US.
The US has debt in terms of its own currency.
The US, like Argentina, has made promises in the form of social security, welfare, military, that the US tax base cannot support without the assumption of debt.
The US is the world’s reserve currency, and a large portion of foreign central banks hold assets in terms of the US dollar. Therefore if the US dollar is devalued, this will directly impact all other currencies on the planet in a very negative way.
Therefore the US may go into hyperinflation either from paying for its programs or by the world losing confidence in the US dollar. Either one will send the US into hyperinflation very easily.
Also as the US dollar is present in so many foreign banks, if the US hyperinflates, so does everyone else.
Chromatic Dispersion
Chromatic,
If the inflation flares (before it hits hyper-inflation), wont the Fed increase the interest rates to stop the inflation flaring? How can rising interest rates cause inflation then? It will cause derivatives, housing crash (higher the interest rate, higher the crash) - hence it would only cause more monetary deflation!!!! The hyper inflation can not be sustained - dont you think? My opinion is that, there will be some inflation - mostly in PPI and "actual" CPI will be falling like rock thrown into a pond. How will the fed be able to raise asset prices and wages - when there is higher inflation (which precedes hyper-inflation) - and hence interest rates are rising? In the 1970s, wages were clamped down, Most of the assets were anyway less inflated than today. And labor arbitrage with China/India was not possible in 1970 and hence wages increased in 1970s (nominal wages). None of these scenarios exist today. That is why we will have deflation. In the 1929s, there was excess manufacturing capacity in US because capacity was built to support WWar I and export to Europe - And this prevented Wage increases then!!! There was lot of corporate debts then. Today is very close to 1929 than 1970s. And in 1929s also, Fed printed copious amount of dollars - all it did was prolong the depression - for the simple reason that inflation was in the PPI as explained above. There is no way hyperinflation is in the cards....I believe, USD is gong to fall to say 2$=1euro. This itself will be inflationary (in the PPI definetely) and fed will be fighting this by increasing interest rates and this will reinforce deflation!! This is what happened in UK in 1929!!!
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Jay,
I have been reading two research papers on stagflation in the 1970’s
http://www.fordschool.umich.edu/research/rsie/workingpapers/Papers451-475/r452.pdf
from Barsky and Kilian
Also I am reading
http://www.mises.org/asc/2002/asc8-barnett.pdf
from Barnett
I am not done with these two papers yet, time is tight lately, however when I get done with them I shall post something. The interesting thing I am finding is one group of researchers are convinced that oil supply shocks caused massive inflation while another group believes that an exponentially increasing money supply is really at fault.
I made an 18 mile hike on Sunday and was thinking about interest rates and inflation while in the depths of Rock Creek Park in DC. I really don’t have much to do during these hikes except think and walk.
The Low Interest Rate Question
I would agree that a rising interest rate doesn’t cause inflation as it is a symptom of inflation. As the purchasing power of money goes down as not only asset prices rise, but so do everyday goods, then the buyers of debt would need a higher interest rate as their bonds are losing value. Interestingly enough interest rates tend to shoot up quickly during a banking crisis.
Interest rates are generally set by supply and demand for credit. When credit is easy to generate then too much credit chases too few assets, causing low interest rates as credit competes for business.
In a democracy, it is a politically popular move to induce cheap credit through manipulating central bank policies on credit creation. As lending standards are lowered. Bank reserve requirements are lowered, old accounting rules are changes to favor expanding credit, and then a crushing amount of credit enters the marketplace, forcing interest rates low.
The case of low interest rates gets interesting when one considers that as credit is created, this action also creates money, expanding the money supply, driving asset prices upwards. As people use HELOC loans to take money out of their mortgages and use this money for everyday goods and services (i.e. gas, food, TV’s, living expanses, …) then this money is converted from money trapped within a loan to money unleashed onto general circulation, expanding the money in circulation.
Then a magical thing happens, the money just spent on everyday goods and services is transported out of the country via a huge negative trade balance. This is due to the fact that much of what American’s buy is made overseas, so when we spend money this money is transported to the production country of origin.
What happens to the money which stays in the country, as the people at Best Buy and the supermarket get their cut?
This money adds to the general money supply, which helps keeps prices from falling due to world wide deflation in prices. Fed policy to maintain price stability, therefore they add to the money supply in general circulation to keep prices high, countering the natural occurring deflation from forcing prices downward.
Now the next question, why are interest rates so low anyway? The currency is losing buying power as the money supply in expands and the money in circulation expands. If the money is losing buying power at a rate faster than interest, then why are interest rates at a level whereas the creditor is setting the interest rate too low?
The answer seems to be that US banks are not holding on to that many loans, but selling these loans to foreign banks. The foreign banks are buying these loans in order to keep their currency low so that they are on the receiving side of the negative trade balance. Thus they loose money on the loan but make the money back and then some on the sale of tangible goods. This is often referred to a foreign vendor financing.
The Federal Funds Rate
The next question is what happens when the Federal Reserve increases the short term interest rate known as the Federal Funds rate and what impact does that have.
The federal funds rate is an overnight loan made to banks. This is normally related to the clearing of checks and other everyday misc banking business. If a bank wants too it can borrow the money from another bank if it wishes. Nothing is really stopping them except maybe for convience issues.
Why is the federal funds rate changed and the long term rate is never changed.
The long term rate is set by the market for long term US debt (i.e. treasury bonds). Therefore if the Fed artificially raised the rate of US long term debt the government would have to pay the holders of that debt more money. This is clearly not an option as the government want to pay as little as possible on the interest on the national debt.
Therefore it is easy to see that the federal funds rate is considered to be a very safe loan and the only rate in which the Fed can manipulate. Other loans generally use this rate as the basis for setting their rates for loans as it gives a general indicator for risk. However this is in no way necessary and lenders may use whatever benchmark they wish.
Here then is the great conundrum, the Fed manipulated the federal funds rate so that loans tracking the federal funds rate may also be manipulated. However, since no lender has to use the federal funds rate for this purpose and interest rates are really set by supply verses demand, then manipulating the federal funds rate really is only symbolic.
If the Federal Reserve was serious, then they would increase the interest rate being paid out on long term bonds. This would have a much higher impact than the federal funds rate. However they have not because this would increase the amount of money the US would have to spend on the interest on the national deficit.
Increasing Interest Rates
If it is so politely popular to manipulate interest rate by inflating the amount of credit available, therefore inducing low interest rates though supply outpacing demand, then why does interest rates go up during a banking crisis?
I think this is a knee jerk reaction in a vain attempt to gain back money lost during the bankruptcy part of a banking crisis. This is of course the time in which money is destroyed and absolute price deflation is seen the most.
I would also agree that if the rise in interest rates caused debt holders to default, this would send various people into bankruptcy and cause deflation. Cross defaults would also cause deflation as money is destroyed as hedge funds die and destroy money.
Hyperinflation
Hyperinflation is never very sustainable for all kinds of reasons, but the important factor is that hyperinflation destroys savings as creditors lose all the buying power of their debt to debtors who pay the debt back with money which has lowered in buying power.
What happens after and during hyperinflation?
I would suggest that deflation occurs as measured in relative buying power verses the earning power of a salary year after year is experienced in the relative prices of goods, services, and assets.
So after the inflation/ hyperinflation ends then prices relative to income shall be deflated. This will also make foreign made products more expansive as hyperinflation will also end the negative trade balance.
How is hyperinflation caused in the first place?
Huge deficit spending without a comparable negative trade balance shall cause inflation/ hyperinflation as more and more money enters general circulation.
Taking money out of hyperappreciated assets (i.e. homes) through HOLC loans and buying everyday items without a negative trade balance.
Foreign holders of US debt, sovereign and otherwise selling their debt en-mass. This will cause the buying power of the US dollar to plummet as huge amounts of US currency enters the world market. It is currently trapped in bonds.
Does hyperinflation mean that deflation cannot exist?
No, prices may deflate relative to income. You must always decide what is deflating when stating you think you have deflation. In absolute dollar terms when the US dollar standard ends, then the currency hyperinflates as countries get rid of US dollars and purchasing power of the US dollar declines.
The Fate of the Euro
The Euro is really a US dollar substitute, 80% of its value is based on the US dollar through the holding of some form of US denominated debt. Therefore if the US dollar hyperinflates, so does the Euro. The two currencies are linked together.
The Great Depression
During the Depression was really the end of the British pound sterling as a world currency. This is very much like the US dollar standard of today. When the British pound sterling fell, it came back en-mass back to England, causing massive inflation. Too many British pound sterling chasing too few products in general circulation, causing a huge loss of their purchasing power.
I am running out of time, I shall have to finish tomorrow.
Chromatic Dispersion
Chromatic,
I dont think Fed can act all along the yield curve (although Ben Bernanke has said Fed can do it). They can only set the short term rate. The reason for this is that -if govt guarantess 30 year is 6% and 90 days is 1%, people will enmass carry trade with the assumption that if things go bad, Fed will again forcible change the rate structure/yield curve!!! You are advocating moral hazard as the solution which leads to bigger problems (and ultimately deflation)...
Jay,
I would agree that keeping a permanent gap between the short and long term rates would cause the carry trade and that the carry trade depends upon this property by definition. However, the carry trade has existed for a very long time even without fixing the long term rate because of the tendency for the short term debt to have a lower interest rate than long term debt. Therefore as long as there is a gap between the long and short term rates, then the carry trade by design shall exist.
It is a legitimate point that the government may be pressured to change to yield curve, however this is really no different than lowering the loan loss reserve ratio of banks to facilitate the creation of credit, forcing interest rates down. Obviously this technique can also works in reverse in order to raise interest rates by chocking off credit creation.
I don’t think it would be healthy for the government to fix the long term interest rate, however breaking a bubble always leads to the moral hazard if the government bails the banks out. It seems to me that we have this huge asset bubble due to government pursuing a policy of moral hazard, therefore any government attempt to pop the bubble would also lead to moral hazard. However the bubble is popped then the government would be promoting moral hazard when the bubble pops by bailing out the banks.
If the government got serious to reduce the expansion of credit they could change banking policy in order to facilitate this. This was done during the S&L Scandal to pop the asset bubble then.
Therefore I would also agree that in the past, currently, and in the future the government does in fact facilitate the moral hazard by either manipulating interest rates directly or indirectly by changing the ability of banks to create credit.
If the Fed really wanted to get serious about popping the asset bubble, than the Fed needs to stop the exponentially increasing supply of credit. Increasing the long term rate would be far more effective than raising the short term rate. The government could also mandate that interest rate for mortgages increase at an interest rate premium. This is just one option open to the Federal Reserve if it wished to pop the bubble.
Does raising the interest rate cause bankruptcy in an economy with a high level of leveraged debt?
Yes
Does escalating credit cause oversupply?
Yes
Therefore in this situation does a rise in the interest rate cause bankruptcies and falling prices through oversupply?
Yes
Does the government response to a banking crisis ultimately cause inflation in absolute monetary amounts, but relative deflation?
If the government bails out the bank, then yes, if they let the banking system die, then this would cause deflation. Thus I would expect that if the government bailed out the banking system that inflation would hit. However prices compared to incomes would deflate as effects of world wide deflation takes hold.
So we would have an inflationary deflation.
Meaning that initially prices shall fall in absolute terms. Then as the government policies were felt in the money supply, the negative trade balance is reduced, and money comes back into the country then prices and incomes would go up, but prices relative to income would go down.
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Chromatic,
I agree with your bank bailout analysis. What are the possible options do you think they have
1) loan-loss reserve - as it happened in Japan. But this process will not push money at a faster rate than bankruptcy.
2) Decrease fed funds rate so that carry trade can go on. But this has a limitation - if inflation flares AND also, long term REAL rate is already at a low value (currently negative!). Also, this method might still not be able to push enough credit into the economy.
- Do you know what the Fed can do to force lending at a faster rate than bankruptcy destroying debts? I often hear people say, Fed bailing banks - Other than (1 - 2) mentioned above, I dont know of any other.
Thanks,
Jay
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Chromatic,
I've heard ONLY Gold Bugs say, Fed will hyperinflate to reduce the burden of debt. But I've never heard an argument why. Most of the dumb argument is that - well you pay the debt in depreciated money. This is not a very good argument - for the simple reason that - if everyone is defaulting and causing deflation - it is even a much better solution to the debt burden!!! Because, it is so painless!!! You owe nothing!!! Nada!! As opposed to hyperinflation - where you owe something (whose value is less though)!!!Also, at the end of deflation, the currency value is preserved!!! There is no disadvantage in deflation at all!!! It is just that Gold Bugs want their gold value to go up and hence they argue for hyperinflation!! If the government defaults on its loan - it is much easier!! The future generation dont have to pay this loan back!! But, by hyperinflating - they still have to pay some money. I'm not sure why people say govt will hyperinflate to reduce the debt burden. Ofcourse, whether the govt defaults OR hyperinflates - either case it is going to have tough time getting fresh loans in the future!! So why choose hyperinflation (as if hyperinflation is less painful than deflation)? If at all, deflation is better because government can print more money!!! Do you see any reason why government should hyperinflate?
One vague argument one might give is that - if government deliberately defaults it is like scar on the prestige - but if it hyperinflates, it can blame it on something like oil price instead of money printing. That is plain wrong. For instance, government can allow GSEs to fail and say - oops it is the business that failed - but the US govt still pays the govt debt!!! How about that? Government will put the GSE executives in jail and tell the world - these greedy bastards...i.e instead of oil (as in the case of hyperinflation), they can blame the deflation on GSE/bank executives!!! Can you give me any reason why the Fed/Govt considers deflation as a bad problem as opposed to hyperinflation?
Also, people often say Bernanke said - helicopter money if there is deflation. The reason why Bernanke said this was that he was seeing deflation ahead. Guess what? if he sees hyperinflation ahead - he will convert to - money destructor - i.e burn as much money as possible instead of burning heating oil!!! I think Bernanke is only addressing the imminent threat - he will act either way depending on the situation. I believe, the gold bugs are arguing that hyperinflation is easy to achieve. By now it is obvious to you deflation is also as easy to achieve!!! Your argument is that - deflation is easy to fight - just print money is your argument!!!
The argument you fail to see is that - Hyperinflation is also easy to fight!!! Just stop printing money and increase the interest rate!!! In Weinmar Republic, Hyperinflation STOPPED soon after Bundesbank stopped the printing press!!! You are very well aware of that, arent you? So why do you think goverment wont stop hyperinflation by raising interest rates - like Paul Volcker did? If hyperinflation happens - you will see that Bernanke is better than Volcker!!! Are you telling me that is not the case? I hope, you are not taking cheapshot argument like Bernanke is an idiot. Bernanke is only showing the colors that he wants you to see. Why should he show you the side that is not relevant i.e his capability to fight hyperinflation better than Volcker when hyperinflation arrives? So, in short can you explain why hyperinflation is preferred in US than Deflation?
Ofcourse, when you say govt will go to any length to cure deflation - you have to assume they can also repeal the newly enacted bankruptcy law as well (so that it is easy on people to unload the debt burden!!!). It has the same weightage as - govt preferring to hyperinflate.
Ofcourse, I agree that, Fed will fight deflation with a vengeance. But they will only try to cause mild inflation - NOT hyperinflation as you envision.
One another argument gold bugs put forward is: the money that is printed to fight deflation will turn into hyperinflation!! However, they are blind to the fact that - the money that has been printed so far will not cause deflation!!! So, deflation will happen first. If the country goes in the path of hyperinflation - the Fed will immediately stop it. Fed will distribute "Whip inflation now" badges etc!! Tell me why Fed loves hyperinflation? They love mild inflation - that is all they want. Neither hyperinflation nor deflation. The moment they see higher inflation, they will rein in the money supply - the equivalent of helicopter money will be to increase the reserve ratio!! Can you tell me why the Fed wont do this to stop hyperinflation? If you are assuming deflation will be very brief, tell me why hyperinflation wont be. Are you telling me Fed is powerless to raise the reserve ratio, or raise interest rates like Volcker did?
Bottom line, my PPI vs CPI argument above is what is important, I believe. So, the deflation only goes deep as the Fed fights the deflation!! What people find hard to understand in the above statement is: As govt prints money in deflation, how can CPI directly go low? The mechanism is different in deflation. As Fed prints money PPI goes up - so more layoffs - so few people having money to buy - so products will be bought only if the prices are even lower!! i.e Jobless people can afford only if the prices are lower!! As more and more money is printed, more and more jobs are lost!!! Hence CPI falls!!!
Do you still think, hyperinflation is going to happen?
Jay,
Sorry it took so long to respond, I am very busy lately. Work and family sometimes takes up a lot of time.
Some of these answers take some time to research properly, meaning I didn’t know good answers that were actually implemented off the top of my head.
In the S&L Scandal the S&L’s debt bubble was finally broken when the chairman of the banking board Edwin Gray introduced restrictions on growth, since the credit growth of the S&L’s were based on a ponzi scheme, dependent on growth, this
Gray started to break the S&L debt bubble when in November of 1983 he adopted a rule requiring new S&L’s to have 7% capital, up from 3% for other S&L’s in order to receive FSLIC insurance.
This was followed up by the direct investment rules. The Bank Board implemented these rules in order to stop another large S&L failure after 1984 (i.e. Empire Savings). The direct investment rule limited direct investment up to 10% of total assets
In enacting these rules was the first step in stopping the uncontrolled expansion of credit creation, therefore stopping the ability to keep the ponzi scheme going. These rules were the death of the S&L’s as they depended on an expanding credit base to keep going.
As you can see the government can implement any rule not related to interest rates, the only requirement being is that it limites further credit creation and growth. Any such rule would in fact break the current asset bubble.
Why does the government avoid such regulation now?
Simple, it doesn’t want the blame and to lose political power. The currency batch of elected officials would much rather the system fall apart under the someone else’s watch.
Chromatic Dispersion
I am going to start anther string
Chromatic Dispersion
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