Bernanke (and others) One-Dimensional Thinking

Ambrose Evans-Pritchard is entirely off the deep end with this mess:

The West risks a slow grind into debt-deflation unless central banks offset fiscal tightening with monetary stimulus – QE, of course – to keep demand alive. Yet the Fed and the European Central Bank are letting credit contract.

Letting credit contract?

Of course there's the famous 2002 Bernanke Speech, also displaying an amazingly one-dimensional view of reality:

Deflation per se occurs only when price declines are so widespread that broad-based indexes of prices, such as the consumer price index, register ongoing declines.

Amazing.  Here's a man with a mandate to manage credit aggregates and he's talking about one of the effects of credit aggregates - price.

Yet when you read through Bernanke's so-called "seminal" helicopter paper you find even more evidence of one-dimensional thinking.  For example, tidbits like this:

Although deflation and the zero bound on nominal interest rates create a significant problem for those seeking to borrow, they impose an even greater burden on households and firms that had accumulated substantial debt before the onset of the deflation. This burden arises because, even if debtors are able to refinance their existing obligations at low nominal interest rates, with prices falling they must still repay the principal in dollars of increasing (perhaps rapidly increasing) real value.

The implication, of course, is that if one has inflation then the repayment of debts is "easier".  But as I will explore and explain here, that premise is dangerously false.

We must first agree on a few principles which I have espoused for the entirety of the time that The Market Ticker has been in publication (and before, if you find my earlier writings.)

The first and most important of these principles is that nobody works for free.  That is, no business intentionally runs at a loss, and nobody handles a financial transaction of any sort without being compensated in some form.

This is similar to the physical world and the laws of thermodynamics which, in essence, boil down to TANSTAAFL, or "There ain't no such thing as a free lunch."  That is, in the physical world if you wish to convert energy from one form to another, there will be some sort of loss in the conversion, no matter what you do. 

Such is an inescapable reality of the physical world, and it applies to the financial world as well.  While there are certainly isolated cases in which people appear to work for free or a negative cost, when looked at in aggregate the economic world looks an awful lot like the physical world as seen through the lens of thermodynamics.  To put it simply every element of economics has "slippage", or inefficiency, inherent in each and every transaction that takes place.

The general principle of slippage is what makes attempting to use inflation to "reduce debt" a pointless exercise.  Let's take an example.

Let's assume that Joe has $5,000 in credit-card debt.  He makes $30,000 a year.

Bernanke "decides" he is going to implement a policy of debasing the currency by 5% to try to "help" the economy by making it easier to pay debts.

What happens to Joe?

Joe's employer makes widgets.  These widgets have raw materials, energy and labor as inputs and are sold on the marketplace.

When Ben implements his policy the single-dimensional view of the world is by devaluing the currency by 5% means that Joe now "makes" $31,500 a year instead of $30,000, and thus has an "extra" $1,500 to make his debt payments with.

But that sort of single-dimensional view is in fact wrong!

When Bernanke implements his policy the following things happen:

1. The interest rate Joe gets charged goes up, if the interest rate can adjust.  The reason for this, of course, is that the person who loaned Joe the money is unwilling to accept a negative return.  If he can, he will thus immediately adjust upward the demanded interest rate.  We see this in floating-rate credit cards that are tied to various market rates (e.g. the Prime Rate, etc.)
   
   
2. Joe's employer gets a nasty surprise.  Some of the raw materials that go into the widgets contain petroleum.  The price of oil goes up immediately in anticipation of this policy change, and it rises by far more than 5%.  Why?  Because the dollar is the world's "reserve currency" and the oil exporters, as a consequence, hold a lot of dollars.  The price of oil thus adjusts to both reflect the forward risk of even more devaluation and to recover the embedded market loss on the reserves the oil exporters already hold.  So the price of oil goes from $35 to $80 - more than a doubling - in the space of months.
   
   
3. Joe's employer tries to raise prices so he can recover the increased (nominal) costs he is experiencing.  But he runs into a problem - virtually everything that people have to buy contains oil, either directly or indirectly.  Further, all those firms compute profit as a percentage, not as a number of dollars, just as Joe's employer does.  Therefore the price of those necessities rise, and this reduces discretionary income for consumers, making very difficult a 5% increase in price for widgets.  If Joe's employer cannot sustain an increase in price and also cannot operate profitably without it, Joe will be laid off (and now have zero income instead of his $31,500 mythical imputed income Bernanke believes he will obtain.)
   
   
4. Joe's employer, assuming he can manage to get a 5% increase in the price of his widgets to stick, has a further problem.  He wants to make money.  Joe therefore will get something less than a 5% raise, simply because Joe's employer must compensate for the forward risk of further devaluation and the uncertainty of his input costs.  Again, the inherent inefficiency in economic decisions makes this necessary.  Therefore, Joe likely only gets a $1,000 raise, not a $1,500 one.  Thus, Joe "sees" only a 3% increase in his gross wages, while the general price increase predicted by the monetary inflation is 5%.  Joe is now behind.
   
   
5. It is often said that inflation "taxes savers."  The truth is that it taxes everyone because all economic decisions have a time component to them and time has a price associated with it both in direct cost and uncertainty premium.  The oil-rich firm holding dollars has a "time horizon" on their reserves that is imputed into their holdings, as does the vendor who quotes steel for delivery three months from today.  Due to the reality of slippage - both the uncertainty represented in time value and the inefficiency of all business activity - this causes the pass-through as "desired" and "expected" to always fall short.  In short, the "inflation tax" screws everyone.
   
   
6. Finally, the ignobility of the government comes in.  The income tax system is progressive.  Joe's "raise" pushes him into a higher tax bracket, and in so doing his "raise" is further diluted.  Sometimes the government indexes taxes for inflation - but not always.
   
   
7. To make it worse, government cooks the inflation numbers.  If steak is too expensive they substitute hamburger under "hedonic adjustment" (after all, they're equal because they're both beef, right?)  They count "owners equivalent rent" for housing instead of house prices, even though more than 60% of people are homeowners.  In short the government intentionally and willfully understates price inflation - which it then, of course, bases things like inflation-indexing of taxes upon.  This screws Joe even further (not coincidentally it really screws Joe's Grandfather, who is on Social Security!)

The "one-dimensional" economic theorists such as Bernanke believe that this 5% devaluation will "flow through" to Joe, giving him $1,500 more a year to make debt payments with. 

But the seven effects above, along with many more that are not accounted for in this simplified analysis, show that one-dimensional thinking is Ivory-tower garbage! 

In the real world Joe experiences a decrease in his disposable income in both nominal and real dollars.  He gets creamed from all sides - his interest expenses rises immediately to compensate for the devaluation plus the risk that Bernanke will "do it again", suppliers of things he must buy (energy in all its forms) jack up their prices to compensate not only for the devaluation but also to recover their reserve currency holdings FX loss, his tax expense rises due to the progressive nature of income taxes and to top it off his employer is an imperfectly-efficient firm (as are all) and as such he only got a $1,000 raise instead of the $1,500 that the idealized one-dimensional model says should happen.  Worse, the longer the view those who Joe deals with have (e.g. his health insurance company) the more uncertainty such a change introduces, and as a consequence the higher the premium that is charged for that uncertainty goes.

Joe gets squeezed and his disposable income margin - the amount of money he has every month after he makes his mandatory expenditures - is destroyed. 

What if we instead allowed or forced increases in currency valuation - that is, monetary deflation.  Well, that would be undesirable too, on-balance.  Again, while interest rates would drop, inefficiency says that Joe would lose once again, because not only is the drop in interest rates inefficient (that is, the lender won't give him the entire 5%) but in addition the drop his employer experiences in input costs won't be efficiently transmitted to him either!  Because his employer is not a perfectly-efficient business he will not contract Joe's earnings by 5%, he'll probably contract them by 10%.  Joe once again gets screwed, and while the interest rate on his (variable rate) debt will come down, it will not do so to the same extent as does the deflation.

If, from this analysis, you deduce that there is no solution to excessive debt to be found in monetary policy you are correct. 

Due to inefficiency in the economy it is not possible to tamper with monetary policy without introducing harm to everyone involved.  The only monetary policy that does no harm is one that has zero inflation - that is, one in which the currency's value is free from tampering, and where the aggregate credit is matched as precisely as possible to the actual performance of the economy in output.

Since both measurement and execution of policy decisions are imperfect such an exact match cannot be obtained - but it should, nonetheless, be the only goal of a central bank or monetary policy body within the limits of ability.

This, incidentally, is rather close to what "Swarm USA" is trying to accomplish.  I have some issues with the finer points of the plan, but the top-level view is spot-on.  Specifically:

b. Create controls that tie overall money quantity to PRICE of ALL asset classes. Target ZERO price inflation and adjust quantity of money spent into existence without debt. Interest rates are set by the free market. This means no more long term inflation or deflation.

Hopefully you now understand by Ambrose-Evans is wrong, why Bernanke is wrong, why Paulson is wrong, why Geithner and Summers are wrong, and why Krugman is wrong.  Why their single-dimensional views of the world are not only inaccurate they're dangerous, as they promote not economic stability and growth but rather the destruction of the economy over the intermediate and long term, presenting a false "prosperity" through serial asset bubbles that are both mathematically unsustainable and must burst, destroying value in each and every instance.

We must do better, and we can.