Monetary

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.

IRA popped up this morning with an article that makes some of the points I've been harping on for a year or so now....

Even as bank securities holdings are rising in aggregate, loan portfolios and assets overall are shrinking at an accelerating pace - evidence, we believe, that deflation remains the chief threat to the global economy. As we said two weeks ago, when the Fed embraces a zero rate policy, what they are telling investors is that bonds and other rate-sensitive financial assets have no value. We've been talking about the shrinking bank balance sheet for more than 18 months and thankfully this key statistic is starting to get broad attention.

Right.

The problem with this premise is that not only does it destroy the asset base (think savings accounts, CDs, etc) that banks require to have a healthy lending environment, it also drives funds in two corrosive and destructive directions:

1. It encourages carry trades which are inherently destructive because the capital lent leaves the nation where it was borrowed.  That is, it is put to work somewhere else, instead of in the borrowed currency.
   
   
2. It forces people out the risk curve and while at the same time it destroys bank capital bases it exposes the capital that wants a low-risk (or "risk free") home into risk assets where it can be destroyed.

When you look at credit quality of these "assets" (especially MBS) you see a truly frightening picture.  The Fed's intentional overpayment has masked an enormous valuation:coupon disconnect; the internal credit quality in these things continue to go to hell, yet the coupon has been stable rather than rising to reflect this deterioration.  That shouldn't happen in a rational market, but there is nothing rational about The Fed's interference.

Now consider the lowly retail investor who is in a money market fund with his "must not lose" money.  He is earning zero, and many of these funds are at present absorbing fees.  This is causing them to run at a net loss, as any attempt to post a negative interest rate to investors will result in an instantaneous run on the fund.  Yet ZIRP makes it effectively impossible for these funds to return a positive yield.

Remember, without these funds there is no lending base and thus no credit growth.  The perverse impact of ZIRP is that it destroys bank capital bases, as over time people will simply not sit for a zero yield - effectively or otherwise.

As I have noted for the last three years (and which IRA also notes in their paper) the only solution to a debt-overhang economic dislocation is to force the excessive and unpayable debt to default.  These defaults bankrupt the institutions and borrowers that were imprudent, but in doing so they also clear the market.  This also forces yields to rise to reasonable levels, restoring a yield curve that reflects duration and inflation risk, yet allows the capital base of the sound banks to be rebuilt, as they are able to attract deposits, especially time deposits, with reasonable yields on these instruments.

In other words, it attracts capital to the financial institutions - not debased currency or credit.

Only loaned (and thus borrowed) capital promotes economic growth.

The Fed's puerile thought process is that "all yield is the same", "all borrowing cost is the same", and "all credit source is the same."  This is a chimera.  The Fed is incapable of producing capital, even by printing.  It can produce credit and it can debase existing money, diluting all existing currency, but it cannot create capital.

Capital is created only by real production in the economy.  No other action creates it.  Yet the loan of capital is what gives rise to the granting of credit without debasement of all existing currency.

The Fed is powerless to do this, but it can destroy the conditions necessary for capital to be lent.

ZIRP does exactly that by ruining the incentives necessary for those with actual capital to be induced to lend that capital.

The Fed should have learned this from Japan, but refused to look at the evidence under their nose.  Instead, Bernanke has continued down a ruinous ivory-tower path born out of his own fertile imagination in relationship to how markets and incentives actually work, conflating the concepts of "money", "credit" and "capital."

Addressing this problem and correcting it requires admission that both Paulson and Bernanke, along with Summers and Geithner, were wrong.

In the world of Washington DC where "I screwed the pooch" are four words you will never hear a politician utter, such a sea change will require that either President Obama grow a pair of balls or that he be shackled by a massive shift in power in Washington DC - and those who come in to do so actually understand the difference.

Odds on that event were unavailable at presstime.

If you expect Bernanke to "hyperinflate" the economy you need to listen to this - and find the clip, if you can, of California's Mr. Sherman and Mr. Bernanke from yesterday.

All is not as you have assumed.

The numbers are now in on the first fiscal quarter for 2010, and it's ugly.

Gary North flies off the rails with the following nonsense:

Oddly enough, Keynes' arguments have persuaded a group of non-economists in the hard-money camp. These men are known as deflationists. They predict inevitable deflation. They use Keynes' arguments. Yet they are so poorly informed on economic theory that they are unaware that they are Keynesians. I call them Keynesians in drag.

Keynesians in drag?

Among other things I'm not a "hard money" guy; I have never advocated such.  Mis-characterizing someone (on purpose) is the first resort of those who have no argument to make and therefore try to stake their claim through outright misrepresentation.  But enough of that; this is supposed to be a "scholarly debate", not a name-calling flamefest.

North seems to be unaware that Keynes called for governments (and central bankers) to inexorably rebuild their Treasuries (that is, stuff 'em full of actual savings) during times of economic prosperity, thereby allowing them to spend that excess to level out recessions.

Nobody bothers with that part of Keynes theories - but that doesn't negate them.  Quite to the contrary; they are the essence of Keynes' economic principles: the application of counter-cyclical forces to the markets by governments (and by extension central bankers); a beautiful principle in theory but one never practiced in the history of the markets.

Keynes economic theories are mathematically able to be proved correct.  That's irrelevant since there is no government, now or ever, that will implement them as-written.  As a consequence arguing over the validity of Keynes theories is akin to arguing over whether Christianity is a valid religious path while taking a big fat Sharpie Marker to the 10 Commandments!

The deflationists have taken Keynes' argument one step beyond. They say that we are about to enter an economy in which lenders will not lend at any price. Friedmanite inflation will not save the capital markets this time. Borrowing from the FED will not help. Nothing can prevent a deflationary collapse, because bankers will not lend, and borrowers will not borrow, at any price.

In short, price -- the interest rate -- does not allocate capital. This is Keynes' argument, re-packaged for hard-money investors. Sadly, a lot of them are buying it. They don't understand where it came from.

It is here that North completely flies off the rails into the realm of pure fancy.

The issue is not whether interest rates allocate capital (they do), it is what happens when the marginal productivity of debt disappears.

To review, there are three uses of borrowed funds:

• Productive: The use of borrowed funds to purchase something such as a CNC machine that then produces more in output than it's acquisition cost (including interest) over the lending term.  The net GDP contribution to such lending is positive.
  
  
• Consumptive: The use of borrowed funds to purchase something that is consumed (housing, food, etc.)  While there may be productive components to consumption this use of borrowing is differentiated from the first by the primary character of the consumed good or service.
  
  
• Ponzi: The use of borrowed funds to purchase an item that has as the essence of ownership the intent to sell to someone else at a higher price.  The purchase of stock in the open market (but not in an IPO) is in this category; the company gets no tangible benefit from this transaction, and the intent of the purchase is simply to sell to a "bigger sucker."  The same is true for a home purchased with the intent to flip it, not live in it, or where the intent is to extract equity to spend on consumer goods (the essence of the transaction is that it is able to be completed as agreed only if the "price" of the house rises.)

As interest rates fall it becomes more and more profitable to employ the second and especially the third uses of lending.

But while the second use of lending provides "par" in GDP contribution the third subtracts from GDP over time, because (1) there is no contribution to GDP from the activity itself and yet (2) the funds carry an interest cost up and down the line.

That is, only the first use of lending is productive for society as a whole.

The issue is not whether interest rates allocate capital, it is whether and how the balance of activity with lent funds changes - and whether those activities are of net benefit to the economy.

North, having failed to make his primary case, then turns to the ridiculous to try to buttress a lost argument:

He begins with a crucial error. It is the same error that misleads Keynesians and Chicago School economists. He defines inflation incorrectly.

(Me) - Now remember: The definition of "inflation" in the monetary sense is the growth of money beyond the growth in goods and services. Deflation is the opposite.

The correct definition was offered by Ludwig von Mises and his Austrian School followers: inflation is an increase in the supply of money. We can debate how best to define and measure money, but to discard this definition is to discard the foundations of economic analysis.

What part of reading comprehension did North fail?

Inflation is the increase in "money" beyond output.

The Austrian School (and Mises) look at a stasis system in terms of output and then define inflation in terms of that.  This is a perfectly legitimate exercise for academic purposes but of course output is never static.

The error that North (and most of the rest of the crooners make) is to define "money" for the purpose of inflation (or deflation) in terms of Mx, where "x" is whatever you choose - M1, M0, M', M2, M3, whatever.

That's wrong and it takes an extreme level of willful blindness to continue to tout that which every person in the United States and indeed the Western World knows for a fact from their personal experience is wrong.

I'll prove it right here and now for you.

Go get your wallet and value every item in it for its maximum purchasing power - that is, what you could spend right now should you choose to do so.

If you're like most people there is a small amount of paper currency.  Perhaps $100 or so?

You probably have an ATM card in there that is also a debit card.  That is, you can spend the entire contents of your checking and/or savings accounts using that electronic piece of plastic.

But you also probably have in there one or more credit cards which provide you access to many times the amount of money you have in your checking and savings accounts.  Right now, right here, on (your) demand.

So what is the supply of money? 

It is in fact that which you both can and will borrow plus the total of your actual stored funds.

As I have repeatedly stated: When you put forward a false premise as the foundation of your argument everything you do from that point forward is wrong.

Now let's examine the rest of North's premise:

On the contrary, there was no price deflation occurring. That is why the CPI rose. Yes, rose. The deflationists have kept predicting a fall in prices (CPI), and they have been wrong.

Oh really?  So now we turn to an intentionally-cooked number that excludes the largest single component of every person's spending - housing - from influencing its reading - and then claim that "CPI rose"?

That's ridiculous.

Housing expense is typically 30 to as high as 50% of one's after-tax income.  It is the single largest line item on virtually everyone's personal balance sheet.  The price of houses has fallen by double-digit percentages in the last two years; in some parts of the country, like SW Florida, you can now buy a house for $50,000 that in 2005 sold for $500,000!

CPI-U (or any of the other CPIs) willfully and intentionally ignored this on the way up in the housing bubble.  They now ignore it on the way down.

This is outrageously dishonest and so is basing an argument on anything reported via CPI.

If we went back to how CPI was computed before the government tampered with it (post-Carter) we would have seen double-digit inflation rates for the period from 2000-2007.  Why?  Because housing was rising at double-digit rates and that, plus the rest of prices, would have resulted in a CPI print in the teens.

But in 2008 and 2009 we would have seen massive negative CPI prints - that is, price deflation - for the same reason.

Why did the government change the reporting rules? 

Simple: they are complicit in the bubble game but more importantly entitlement payments are linked to CPI; with an honest CPI Social Security would have instantaneously exploded in the 1990s and 2000s.  They therefore changed the rules to exclude where the inflation was showing up - which not coincidentally now excludes where the DEFLATION is showing up!

The rest of North's sophomoric attack is unworthy of digital ink.

I can forgive the mistake made in the definition of "money" (North prefers M1 and M1MULT as his indicators, which many others do as well) even though that requires willful blindness.

But to claim that government-reported CPI measures "inflation" when it (intentionally) failed to capture the entire housing price rise, given that housing expenses are anywhere from 30-50% of the average person's after-tax expense, is beyond willful blindness.  That crosses into the realm of intentional deception and those who choose to go there have voided the entirety of their argument.

For that reason I will stop here, and strongly suggest that anyone relying on someone's "analysis" that includes in their claims changes in "CPI" change horses now - you're going to be bankrupted following the so-called path put forward, and that's a certainty.