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Is the Inflation Monster Tamed?

January 2, 2006

I am pleased to report the inflation monster has been captured and placed in a jar.

This stunning announcement as well as an accompanying video detailing the highlights was made by the European Central Bank in cooperation with the national central banks of the euro area. Along with the announcement, the ECB has produced an information kit on inflation entitled "Price stability: why is it important for you?" It is targeted at young teenagers and teachers in all the official languages of the European Union.

The ECB's eight minute video is actually somewhat entertaining so I recommend that everyone click on the above link take a look. Even though it is entertaining, it sure flops as an educational tool unless of course the goal is self serving promotion by the ECB, for the ECB.

Unfortunately the video does not explain that the real source of inflation is printing of money by the central bank itself. Nor does it explain why 2% is such a good inflation target. Finally it does not really explain how prices across the board can be contained by broad brushed practices like setting of short term interest rates.

Those things were not explained simply because they can not be explained.

  • Why should inflation be targeted at 2% and not 1% or 3%?
  • Why should any inflation be targeted at all?
  • Even if it was for some reason smart to target prices, can prices really be measured it accurately?
  • What do central banks do to overcome lag effects of monetary tightening and loosening?
  • Is this just blind faith "we know neutral when we see it"?

The problem of course is targeting prices in the first place. Sometimes money flows into houses and stock and bonds instead of goods and services. Sometimes productivity improvements mask inflation. Sometimes falling commodity prices mask inflation. Of course I am talking about "real inflation" as measured by increases in money supply as opposed to hedonically adjusted price inflation as seen through the eyes of central bankers.

The last paragraph is exactly what made a fool out of Greenspan. In the mid-to-late 1990's, "real inflation" (a rampant increase in money supply), was masked by productivity improvements, falling oil prices, and falling prices of goods from Asia.

Greenspan called it a "productivity miracle". It was a "miracle" indeed. Rampant increases in money supply fueled the 2000 stock market bubble and spawned nonsensical talk about "new paradigms". Then in sheer panic "after the bubble pops" adjustments that he likes to make, Greenspan refused to allow a recession run its course. Instead he slashed interest rates to 1%, fueling the biggest housing bubble the world has ever seen. Here we are three short years later now facing a "new paradigm" in housing, with debt levels far worse at both consumer and governmental levels.

Greenspan will soon be gone and Bernanke is next to bat, waiting in the on-deck circle. Like the ECB, Bernanke wants to set price inflation targets of 2%. I have some advice for him: It simply can not work.

With all the hedonic adjustments, with all the nonsense about core inflation vs non-core inflation, with all the imputed economics, with all the understating of medical costs, and with enormous discrepancies between rental costs vs housing ownership costs, there is not a person on this earth that could possibly know 2% price increases if it hit them smack in the face.

Compounding the problem for these so called "inflation fighters" is energy costs. One reason energy costs are rising is peak oil. Another reason oil costs are high is geopolitical tensions. A third reason energy prices are high is supply disruptions. Finally, oil and natural gas demand are relatively inelastic. As prices go up, people more or less have to pay it. To maintain a CPI price target of 2%, central banks might have to raise interest rates to unreasonably high levels if energy prices are included in their measurements. That clearly would be bad policy. The root problem of course is assuming it is wise to target prices rather than money supply in the first place.

The Deflation Monster

 I almost forgot to mention that the ECB claims to have “the deflation monster” bottled up as well. I guess we will see but I think they are hopelessly wrong. The ECB points out "deflation monster" problems when in fact deflation is both a blessing as well as the natural state of affairs.

Rising productivity is "price deflationary": more goods are produced faster by fewer people. Prices naturally decline as a result. Look at how few farmers today produce more grain than 100 times as many farmers did not that long ago. Corn prices fell to 1943 levels a couple weeks ago. Is that a problem? For whom? It's only a problem because the US and ECB blow countless billions of dollars every year on price crop supports.

It is a total waste of money. Bear in mind that China is actually losing textile jobs. The enquiring mind might be asking: to whom? The answer might be shocking: to no one. Fewer workers are needed to turn out the same amount of goods. That is one of the reason this protectionist talk you hear right now out of Congress is total nonsense. Those jobs simply are not coming back ever. Cranking up money supply in an attempt to create jobs lost by productivity improvements and outsourcing can only result in asset bubbles and/or increased overcapacity. Besides, who does not like lower prices on goods and services?

If deflation is such a good thing, why do central banks fear it?

One answer is because deflation is debt's worst enemy.

If asset prices and wages fall, people can not possibly ever pay back what they owe. Banks and credit card companies don't seem to like that state of affairs. Is that a problem with deflation? No, that is a problem created by a reckless lending, easy credit, and endless cheerleading on CNBC every time consumer spending rises and people sink heavier into debt.

The second answer is because inflation benefits those that receive money first: the government and banks. The former is via automatic tax increases not indexed to inflation (especially property taxes), the latter simply because banks are first in line to receive money from the FED at rates no one else sees. By the time lending standards drop so that the masses have access to credit, the boom is well underway. By the time credit is granted to anyone that can fog a mirror, the boom is nearly over. Those buying assets late in the game will eventually be crushed by those selling assets that got in early. Simply put, inflation eventually becomes a moral hazard.

The Pivot Point

 We are now at or close to the pivot point. The pivot point or tipping point if you prefer, is the point at which consumers can not or will not take on any more debt and/or corporations simply are unwilling or unable to extend more credit. I have been writing about various tipping points for some time now and we seem to be hitting those tipping points simultaneously in many areas: jobs, housing, consumer spending, and credit expansion.

The malinvestments of the have-it-now, me too, ownership society is about to be unwound. We are where we are because Central Banks have printed ever expanding amounts of money to prevent normal business cycles, to satisfy politicians wanting to waste more taxpayer money with silly projects, and to foolishly fight deflation. The only thing the Central Banks have accomplished is putting off the inevitable deflationary credit crunch while making it worse along the way.

There are many that think true deflation (decrease in money supply) can not happen under a fiat system. I disagree but perhaps the point is moot. Money supply itself actually never contracted in Japan. Instead, it grew very slowly for quite some time. However, bank credit outstanding contracted for 60 months in a row. Clearly there was a credit contraction. How did money supply still manage to grow? Fiscal deficits were ramped up immensely, roads to nowhere were built, and the Bank of Japan monetized all of it.

In addition, money velocity plummeted. The net effect of the credit contraction on prices was clearly what one would nowadays call "deflationary". Prices across a broad range of assets and goods and services fell. Indeed, practically everything fell but government bonds.

People were amazed at the alleged "bond bubble" as well as the Zero Interest Rate Policy (ZIRP) of the BOJ. However, a 1% interest rate on a 10-year bond makes sense when prices fall 2.5% annually. The real yield is obviously far higher than 1%. Perhaps a practical way to think of deflation under a FIAT system is the destruction of credit/debt that exceeds growth in money supply.

Regardless of social and economic differences I fully expect the US to follow in the footsteps of Japan. Although a central bank might be able to sustain a certain amount of inflation by resorting to extreme measures, it can not stop a credit contraction in the private sector. Nor will a central bank bail out consumers at the expense of themselves and other creditors. The Fed like the BOJ will stop short of destroying themselves and their power.

At some point, most likely tied to a property bubble implosion, consumers will refuse to take on more debt and/or banks will refuse to lend consumers credit as the value of assets behind the loans plunge. Consumer bankruptcies will soar as various credit bubbles implode. Furthermore, in a world awash in overcapacity there will be no reason for corporations to borrow. That is why the Bank of Japan failed to defeat deflation and that is why Bernanke will fail as well.

In due time I suspect we will find out that the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 will fail its intended purpose.

We have already seen massive bankruptcy filings to beat the October filing deadline. That is one such consequence. Given there is now a "means test" based on median family income, I just wonder if the way around that test is for someone to manage to lose their job. If so, that will only increase the size and number of writeoffs during the established credit counseling and waiting periods.

One of the complaints by the US and others against Japan in their long battle with deflation was Japan's refusal to write off bad banking sector loans. The US "solution" to that problem was to pass legislation designed to make people debt slaves forever. I am convinced that legislation will backfire in ways we have not yet begun to understand.

The problem by now should be obvious. Central Banks are attempting to do the impossible as well as the unwise. Arguably the best thing that could happen would be for the Central Banks to abolish themselves. Since that is not about to happen for many reasons, let's instead turn to more practical solutions for "stability".

Instead of trying to achieve "price stability" which as we noted is something that can neither be achieved nor measured, how about shooting for "money supply stability" instead?

  • Central banks should refuse to monetize government spending and trade deficits
  • Central banks should let the market set interest rates
  • Central banks should embark on a campaign of tightening reserves requirements over time to rein in fractional reserve lending

Life would be so much simpler if Central Banks everywhere would stop trying to micromanage both prices and economic cycles. Quite simply, they are trying to achieve nirvana when nirvana can not possibly be measured, nor can nirvana be achieved in the first place with the policies they have in place. Of course if they stop doing these things, they will cease to be Central Banks in the modern sense, so perhaps they will get the hint and just close shop.

Yes we will still have economic cycles if Central Banks do those things, but the cycle peaks and valleys would not be as exaggerated as they are now. It seems as if we have learned nothing from the great depression or the more recent experience by  Japan. I fear we may get a second chance.

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Mike Shedlock works in the financial services industry. mishedlo@sbcglobal.net. Common on the blog.


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