Tuesday, January 29, 2008

Money Does Not Grow On Trees

The market is expecting Mr. Bernanke to provide another 50 bp rate cut tomorrow, bringing Fed funds to 3.00%, well below inflation. What is the Chairman trying to do? Simply this:

(a) Prevent adjustable rate mortgages from re-setting higher and so ease the immediate pain in housing and,

(b) Create inflationary pressures to counter - as much as possible - the deflationary spiral that has already started in credit and asset markets.

Point (a) is self-explanatory, but point (b) requires further elaboration.

First, let's look at asset markets and consumer spending.

Economists, and the Fed's own econometric model, estimate that asset wealth has a direct 5% effect on consumer spending, i.e. for every $1 increase or decrease in asset wealth, people adjust their spending by 5 cents. This link derives from two sources: the psychological "wealth effect" (I feel richer, so I can spend more of my income and save less) and using assets as collateral to borrow and spend (I can "unlock" my wealth and spend it now).

As of the third quarter of 2007, American households owned $21 trillion in real estate and $11 trillion in equities. A 10% drop in housing prices and a 15% drop in equities would thus result in a reduction of approximately $187 billion in consumer spending, or 2% of personal consumption expenditures. This may not sound like much, but in fact, there has never been a year (or even a quarter) when US consumers did not increase spending in absolute terms, the Great Depression excepted (see chart below, click to enlarge).

Personal Consumption Expenditure, Percent Change From Prior Period

During other slowdowns growth in earned income and less saving carried people through, allowing them to keep spending until things turned around. Not now: the saving rate is already zero or negative, and wage growth has been very meagre, averaging 3% nominal for 25 years (currently 3.7%).

In other words, people were already spending more than they made and their wages were stuck. Only way out was to borrow in order to increase spending, but the credit crunch has now made this more difficult. The credit crunch begat the asset crunch, which is quickly turning into a spending crunch. Spiral down..

So, Mr. Bernanke, who cannot control wages, can only do one thing: drop interest rates so fast that people will be tempted to borrow again, hopefully assuming more debt than what is being destroyed right now (write-offs, abandoned houses, etc.). Because - and make no mistake about this - the destruction of debt is the destruction of money, and the destruction of money leads to deflation, by definition. Money does not grow on trees, after all - it can only be created via borrowing.. Here's my own version of the Money Tree:

$ Now $
$ Hear This: $
$ Money is debt. $
$ No debt, no money. $
$ Less debt, less money. $
$ Less money, less inflation. $
$ Even less money, is deflation. $
$ Because $
$ "Inflation is always and everywhere $
$ A monetary phenomenon." $

If people and businesses won't or can't borrow, Keynes said the government should, and thus keep the flow of money going, i.e. create a fiscal stimulus. I find it amusing, and highly instructive, to observe how quickly the supposedly most laissez faire US administration in 75 years dumped classical economics and embraced Keynes. Oh yeah, in calm seas everyone is a salty mariner, but let the boat rock a little and watch as they scream and scramble for the life preservers...

OK, bottom line...

Here's a simple assignment: You are Ben Bernanke. Now, create inflation.

Note: it is a lot harder than you think, and please don't just say "run the printing presses".

Feel free to use the comment section.


  1. I'll try:
    1 - suck up as much bad MBS debt as possible into the GSEs (check)
    2 - lend fresh money via repurcase agreement on bad debt with minimal hair-cut from a broad class of financial institutions (let's call this 'TAF') (check)
    3 - when enough debt go bad, let the FED open market account suffer the losses, directly and via the government rescue the GSEs.

    Most of the dollars lost in bad debt will be locked into the open market account, so they will simply not be lost by the system.

    This is the only possible road to create inflation, or most probably hyper-inflation.

    4 - confiscate gold, drop the dollar and prepare for war with China and the gulf.

    I think the US will not follow this road, but they did the first steps in that direction, so I'll keep the possibility open.

  2. Nice answer, but would only work if the US government could borrow the enormous amounts required (trillions). Americans themselves do not save, so all of the money would have to come from abroad (China, Arabs, Russia). But:

    1. There is simply no money on the scale required available from them and,
    2. As the global economy slows foreign surpluses will shrink, making even less money available for the US and,
    3. If it becomes clear that this is the route, no foreigner in his right mind will lend to the US.


  3. With globalization there's no where for US wages to go but down. Same holds true for all Western economies. The reasons should be obvious, the size of the cake stays the same but 2.5 billion Asians just crashed the party.
    To delay a decline in the standard of living we have been using up our savings, then resorted to borrowing. Then the housing bubble was supposed to come to the rescue. Like a deseperate crack addict trying to score a rock we try every scheme in the book to delay the day of reckoning. Now I hear we will get a $600+- check from the government. Why stop there? How about another $5000 check for X-mas?
    Not matter how we slice it or dice it, we just can't compete with $1/day slave labor. At least not under the current economic model.
    We could maintain an edge through technological innovation. Energy and agriculture/genetics are some of those areas. Unfortunately looking at American Universities it appears our youngsters are more interested in sports, business, speech communications, English and basket weaving. The easy life we've become accustomed too.
    Difficult math & engineering science is almost exclusively left to foreign students. I know first hand as I spend many nights at the lab with fellow Chinese and Indian students.
    So what is Ben Bernanke going to do? Drop rates to 0%, send everybody $1 million and call it a day.

  4. I think Bernanke's stuck.

    Just considering first mortgages (i.e. and not home equity loans, although some of this, i.e. the inventory aspect, applies to them, and they are a huge problem as well), behind every bad (first) mortgage there's a house as collateral. Those houses were built (and money created/lent to buy them) to satisfy a demand that just does not exist anymore on anywhere near the same scale -- speculators ('flippers') and marginal borrowers (subprime, Alt-A, etc). You'd have to refinance a big majority of those people (assuming they'd want that, which in many cases they wouldn't), but that is not possible today with the return to responsible underwriting norms -- even low interest rates will not keep enough of these people in their properties. So house prices will continue to fall, which will destroy the value of MBS paper. Etc etc, on into the foreseeable future.

    Some people suggest, not entirely in jest, that the problem is so bad in some areas that what really ought to be done is the bulldozing of entire subdivisions. This way at least you'd be saving as many of the homebuilders as you can.

  5. Dear eh,

    Bulldoze and save the builders...

    This sounds so like Mellon's "liquidate assets, liquidate labor.." from the 1930's.

  6. For a pilot on a plane's that's crashing, just about anything will do.

    It's no longer about "a good landing".

    It's now about "landing" or "crash avoidance".

  7. Ben doesn't have the power to increase inflation. Policy choices are necesary.

    Raise the minimum wage, extend and raise unemployment benefits, increase food stamp aid and provide universal health insurance.

    Jason B

  8. Oh, yeah. And stop the war in Iraq; legalize, regulate and tax drugs; release non-violent drug offenders from jail and put them to work rebuilding infrastructure (rail, water, sewer), secure the borders and allow in only legal immigrants with valuable skills, and cut defense spending by 1/2.

    Jason B

  9. I wouldn't increase inflation. The money supply is supposed to rise and fall according to the value of its underlying assets, just like stocks. The underlying assets are (increasingly) composed of poorly designed homes (size, location, function, energy consumption profile), aging infrastructure, and mis-trained minds. The value of the underlying assets is falling, so the money supply should fall.

    You should be asking "how can Americans create wealth?", but, maybe because your nom de plume is "HellAsIOUs", you can't seem to transcend the "debt is the problem" mindset.

    Debt isn't the problem. If the debt had been assumed in order to invest in tomorrow's technologies, we'd be in great shape. The problem is that those resources were largely mis-spent.

    Yoski's excellent post, above, has accurately set out the situation we're in. Begging Yoski's permission, I'd like to use his post as a springboard for this statement of the actual problem:

    How do you inspire Americans to invest their minds and energies into activities that create wealth?

  10. Hellasious said: "3. If it becomes clear that this is the route, no foreigner in his right mind will lend to the US."

    Well according do Brad Setser's analysis it is some time that "no foreigner in his right mind" is lending to the US. If he is right, most of the current account deficit is financed by central banks, and it is quite clear that the people there are not in their right mind, at least not from a financial point of view (apparently the Chinese CB is losing $4bn every month! http://www.rgemonitor.com/blog/setser/239429/)

    Anyhow, what Bernanke proposed in his famous "helicopter speech" is that the FED should buy Treasury debt via the open market account (that is, via printing presses) if no other one wants it. See: http://www.federalreserve.gov/boardDocs/speeches/2002/20021121/default.htm

    Obviously, the size of the problem is such that this is equivalent to the US going bankrupt. No one will plan to go this road, but this is the only sure way to create inflation.

  11. Hell, I hear your rebuttal to Alessandro, but it still leaves my question from the other day unanswered: "Would US monetary leaders really ever let current public debt become more expensive thru deflation?"

    Public debt is just as much the out of control freight train that household debt is: Social Security, Medicaid, and the granddaddy of all entitlement programs, Medicare, are a disaster worsening daily.

    What other option is there for US monetary leaders but to default now? (even if it scares foreign central banks away for awhile)

    Wouldn't default later, when the US would have less maneuvering room due to the higher public debt levels, be much worse?

  12. OF COURSE debt is perfectly fine when properly used. And, as I said, if there is no debt there would be no money.

    But going into debt to buy uneeded consumer goods, or to inflate asset bubbles that are not supported by earned income, is a gross mistake.


  13. “Land of the free and home of the brave” will soon be replaced internationally with “land of the broke and home of the deadbeat.” Global corporations have served the U.S. middle class a meal containing slow acting systemic poison that slowly destroys their manufacturing base but has the wonderful flavor of inexpensive Chinese gadgetry. The more we eat with the help of international financiers the more our manufacturing withers.

    “Buy American!”is a slogan I’ve heard a lot. I guess it doesn’t matter now since the patient is on Fed life support. I think Hellasious mentioned the opium trade in an earlier commentary. The Chinese now sell us our electronic and other drugs, the Wal-marts distribute them and the financiers profit and encourage our addiction until the patient, broke and destitute, dies. The Chinese lend us just enough money to keep the patient alive so they will have a market for their products.

    The current round of “rebates” are helicopter drops made to look like tax rebates. I think we will see more rebate morphine until the patient expires.

  14. well, Bernanke ( and the US )has a major problem.

    Every possible scenario that comes to mind would result in the cost of debt ramping.

    So when govt debt and private debt go much higher - Private business chokes on the rates and so does Govt

    debt _is_ the problem - the whole problem - it appears that we are entering a deflationary spiral and there is no readily available short-term solution, nor at the moment any viable intermediate solutions being bandied about

  15. Hellasious:

    OK. I'm off your case. Now let me suggest some ideas that can re-direct our most precious asset, e.g. the imagination and intellect of our people.

    1. Elect a leader that knows how to activate this resource. DO NOT elect a leader that vows to continue frittering away our treasure on BusinessAsUsual.

    2. Direct the resource. Tell people to Invest, not Shop. Tell them to Create, not Consume. Tell them the national goal is for production to be 55% of GDP, not 35%.

    3. Institute Fannie-Mae-like entity whose job is to provide conduit-credit functions for those that buy 40MPG or higher autos from U.S. manufacturers. The FedGovt would guarantee repayment, and would provide an investment tax credit on the purchase price, and would provide a subsidized interest rate, ala student loans. The U.S. value-add component of the auto must exceed 80%.

    4. Stiffen math and science performance standards for schools. We are not competitive, and NoChildLeftBehind needs to not leave children behind. Continue to tie federal monies to performance test results.

    5. Provide a household-level deduction for R&D investment. Change the mindset that only companies invent stuff. Individuals invent stuff, and the tax code needs to support that concept.

    6. Add intellectual-property creation and management courses to school curricula at all levels high school and above. Our population needs to understand how to create wealth, and wealth is ideas.

    7. Sponsor more innovation contests, like the advanced energy-saving house contest on the Mall every year, and the solar-car marathon. Increase the prizes to millions of dollars.

    8. Vastly increase the budget and visibility of the National Renewable Energy Laboratory (NREL), and get that money earmarked for tech-transfer and targeted R & D.

    The GDP must shift from consumption more toward production, and the production has to be in areas that create wealth (.vs. stupid home designs, etc.). Energy, water, environment, health are all areas of great future promise. That's where what remains of our credit/capital should be applied.

  16. And for Swing, above:

    Sorry, debt is _not_ the problem. For those debt contracts wherein the recipient invested in non-productive assets, both the creditor and the debtor are going to take the hit, and they should. This is the whole concept of "moral hazard". There's nothing a CB can do to change this reality at the scale we're dealing with now. Don't think this is just about "subprime". It's about re-capturing the U.S. worker's economic relevancy in a rapidly changing world economy.

    Unless you can magically change a sow's ear (non-wealth-producing asset) into a silk purse (highly productive asset) via monetary policy, the issue of reflation .vs. deflation is moot. The underlying assets represented by the money supply are rapidly becoming obsolete.

    Salvation lies in changing the nature of the asset base. Monetary policy is about matching money supply to the value of the underlying assets. It's a dependent variable, not the driving (independent) variable in the equation.

    Repeat: get the asset base to create wealth. Borrow whatever you have to in order to achieve this goal, but make sure all expenditures are on productive plant and equipment (including human capital).

  17. To Alessandro,

    Foreign central banks are who I had in mind when I said 'foreigner". In a rather astonishing turn of events, foreign developing-world governments are financing US consumers to buy their own exports. Vendor financing..

    To Thai,

    "Would US monetary leaders really ever let current public debt become more expensive thru deflation?"

    If they must, yes, absolutely they will. Imagine issuing 30 year Treasurys with 0.3% coupons. And the monstrous future unfunded liabilities will likely disappear if you assume zero inflation - but I haven't run the numbers, so I don't know for sure.

    I am not advocating this as a solution, you understand...

  18. Dear outerbeltway,

    I wholly agree with your recommendations.


  19. I do understand you are not advocating this...

    But would you please help me understand as I sense I am missing something: At 0.3%, with inflation 2.5-7% (whose numbers do we believe?) wouldn't this be a negative real interest rate?

    Wouldn't this allow the 'flation' in stagflation to functionally default on our debt?

  20. what about goverment regulating all health costs across the board... it just seems like it's always a nightmare when people finally get their statement

  21. Dear Thai,

    I don't mean long rates could be 0.3% right now, or at any time with inflation at 2.5-7%. This would only be possible under a deflationary scenario - think Japan, for example.

  22. Thanks... but I am still a little confused. Are not long term rates really negative right now (depending what you think inflation is)? And the market is betting the Fed will lower them further.

    I just checked Bloomberg: 10 year treasuries are 3.66% and 30 year are 4.34%. If inflation was 4.1% in December '07 with the governement's own numbers (which you said had significant problems relating to the '?deflator?'), then are we not already defaulting a 'little bit' this very moment?

    Anon.. as to your healthcare question: "it depends". The issue is every bit as complex as how to fix the debt problem (even with political mudslinging left out)... Can answer in more detail if OK with Hell--his blog.

  23. Fed/fiscal efforts to spur on inflation to combat the growing threat of deflation will succeed if cheaper money and maintaining consumption levels results in the re-capitalization of banks.

    Deflation of credit/debt is of course experienced by the consumer (we used to refer to ourselves as citizens) and the banks, etc. Will this deflation be tempered by re-inflating? Would not re-inflating mean higher global commodity prices? Will the higher global commodity prices retain such factors as the recycling of petrodollars, thus allowing the US to expand fiscal deficits to assist in re-inflating, even in the face of a continuing weak dollar? Whether this succeeds may depend on how high price inflation in China, India, and even Japan go, and whether there currencies appreciate.

    So re-inflation has its limits, and in the end will not, I"m guessing, win out over deflation. Should this become more apparent, and with interest rates about as low as they can get by then, then the Fed and the government are certainly left with hands tied.

    My hunch is that as time goes on, it will become increasingly apparent that the 'problem' is way too complex to be resolved with machinations of central banks and governments. We like to think that markets maintain balance and are self-correcting but when they stumble that institutions will fix things. Should this is not be the case, then where are we? Perhaps at that point we will see a deficit of the mass loyalty needed to provide legitimation, the backbone of all democracies.

  24. "Keynes said the government should, and thus keep the flow of money going, i.e. create a fiscal stimulus."

    That should read - create a fiscal DEFICIT met by borrowing money into existance to boost nominal incomes.

    If you want to know how powerful the creation of such a fiscal deficit is have a look at Zimbabwe.

    In 2006, Zimbabwe's money supply was running at 1000% per year.
    Inflation was at 1,070%.
    The fiscal deficit (money borrowed into existance for government cronies to spend) was projected
    at 18% of GDP, and came out at 43% of GDP.

    By 2007 Inflation was running at 7500% offically and in the millions unoffically http://www.guardian.co.uk/zimbabwe/article/0,,2108511,00.html

    The run a large fiscal deficit not met by taxation is to pump money into the ecnonomy from nowhere (borrowed into existance), and this pumps up nominal incomes thus preventing deflation as nominal savings and loans shrivel in real terms.

    The key things to watch is the % of the fiscal deficit as part of GDP.

  25. OuterBeltway has hit the nail on the head.

    Instead of JUST focusing on a doomsday scenario, please address the following in your blog.

    1. Sketch out a plan for the individual investor to possibly benefit from the scenario you propose.

    2. Build a U.S. success model.

    You are clearly capable of doing both in a reasoned and insightful manner.

    Please use your gifts to lead (e.g. benefit more people in concrete terms) rather than just sounding the alarm.

  26. Clearly, the government must act now to dramatically lower lending standards!

    Seriously, H., do not underestimate the government's ability to spend, and to finance this spending via the Fed. That would create inflation, just as it did in Brazil, Argentina, Turkey and countless other examples.

    The only question is, will the politics of deficit spending change? If we enter into the kind of deflation that you are talking about, then I'd say you betcha.

    You may argue that there are no domestic savings to finance deficits. You may argue that foreigners will recoil at our recklessness. You will be right, which is why the Fed will step into the breech and buy t-bonds with abandon. And just to add insult to injury, we'll have exchange controls to prevent those in the know from shipping their wealth elsewhere.

  27. It appears "asphaltjesus" wants Hellasious to fix everything for him. Kill the messenger (or at least make him fix the problem before he tells you what it is)!

    I like what Yoski wrote. I'm reading "The World Is Flat" by Thomas Friedman. It should be given to every American 5th grader with a note that says "Learn science or you WILL be poor". It appears that India and China will have more college graduates in 5 years than America has people.

  28. david pearson said:

    ". . . the Fed will step into the breech and buy t-bonds with abandon."

    Should that happen, what might be the rebound effect? Might the drop in long term yields and weakening dollar lead foreign central banks to a Treasury strike? If they stopped buying as a consequence, then the rise in long term yields would result, nullifying any advantage to the Fed buying truck loads of Ts. in the first place.

  29. Don,

    Such "buyer's strikes" are commonplace in emerging markets -- think Mexico in 1995. As long as the Fed elects to expand its balance sheet, it can more than make up for the absence of foreign buyers. Would this tank the dollar? Of course. Hence the need for exchange controls. Would it create inflation? That's the point of doing it!

    Bernanke himself, in his famous "helicopter" speech, argues that "temporary" Fed financing of Federal deficits is a valid deflation-fighting tool.

  30. Hellasious posed a trick question.

    Deflation is inevitable, and started long ago. Bernanke cannot create inflation - he'd be happy if he could.

    Every time a house defaults, it deflates the money supply.. because the money used to purchase the house did not exist before the home loan was signed.

    The reason the monolines are in trouble is because they never had the ability to make the CDS writers "good" ... yet, they're the ultimate bagholder of the world's economy. Unless the monolines can recapitalize the world (the policies they wrote claimed that they could), we're deflating.

    Allesandro, it's actually worse than what you wrote about the TAF. The TAF constitutes the entirety of bank reserves in the US right now. Non-borrowed reserves do not exist. This means the financial system locked up a long time ago and everything from here on out is simply avoiding death.

  31. The Roman Empire lasted for 800 years. Things fell apart and the centre could not hold when the currency was debased for the last time.

    Now what if there was an Emperor 200 years into the Roman empire who said: "I am not like the others. I tell you in advance that I will clip your coins and dilute the metal in your coins, for I am the Emperor and all things shall be rosy thru me.

    Then along comes Mr. Bubblehead, who has lived in an Ivory Tower, and he is given great power in the US Empire only 200 years old. Being an academic, he publishes in advance that he will save the Empire from the Great Deflation.

    Mr. Bubblehead stated: " We will print money with total abandon until we are zero bound. Then we will buy with further printed dollars all manner of physical assets, even antique cars. Then, with interest rates at zero, and all appears lost, we will engineer a 50% devaluation in the footsteps of the great Emperor Roosvelt, who confiscated the gold of the people, with nary a peep.

    Long live Mr. Bubblehead!

    When Ron Paul pointed out in a Senate hearing that Helicopter dumps would destroy the savings of the middle class and millions of baby boomers about to retire, Mr. Bubblehead stared into space, content in the thought that he has spoken, and all will eventually bow before him.

    The over-under on the rule of the US Empire is a lot less that 800 years, because nobody 2000 years ago would be so stupid as to announce a debasing of the currency in advance.

  32. david:

    Should the Fed turn into drunken sailors buying Ts as you suggest, then not only would inflation be found in the US, but it would also be a global phenomenon, leading to steep appreciation of especially Asian currencies, which would precipitate a feedback loop crushing the dollar.

    Granted, Bernanke states that the Fed should be able, even with target rate at zero, to stimulate demand and inflation. However, since credit creation in the 'shadow' banking system has grown to exceed the Fed's ability to create credit (made especially evident since Bernanke wrote his piece), then I doubt buying Ts will overcome that divide. The loss of "securitization" and the level of household debt present obstacles for which Fed (and fiscal) re-inflation attempts will fail.

  33. Hellasious,

    While I think there's a lot that's true in what you said, I think you're missing one important point -- and the Fed is not. While the "originate and distribute" banking model is dead, the banking system itself is not.

    The old-fashioned bank model still works just fine and while we'll go through a nasty recession and it will take a few years for it to gear up to help the economy recover the old-fashioned way, a depression is not on the horizon -- as long as the Fed does not allow the insolvent "originate and distribute" banks to destroy the traditional banking system the way the zombie S&Ls did in Texas.

    I think the Fed understands this and is working towards the dissolution of the "originate and distribute" banks.

  34. H. Like the tree!

    Some time back you asked me to think about money and how it came into being. Nasty questions, by the way!

    What I found was that only a small proportion of money is 'cash', the rest is digital. These digital entries slosh back-and-forth between different accounts, but the total debt level seems to keep rising due to the creation of new credit-lines and the augmentation of existing ones. Stop the creation and augmentation of credit lines and you have stopped the increase in 'money', that is STOP-flation! Is this feasible?

    A Central Bank, which prints new notes to replace worn-out ones, now mints coins only instead of notes. So now a stationary supply of money sloshes - EQUI-flation! The export or repartriation of money would have to be prohibited to close the box.

    Destruction of money implies either the permanent loss of coin and paper or some of those digital entries - DE-flation, is this correct?

    Some of the contributors have linked assets and money. Which is the horse? which the cart? Food, fuel and dwellings are assets, but not exactly equal! What's the economic model? See my next comment.

    I have serious concerns about a model of economic growth which assumes even a small, annual, exponential increase - ie. additional consumption, more money, more debt! Sheer lunacy! If the US GDP went to zero and stayed there for some considerable time, what would be the economic outcome?

    Can the US become a Closed Economic System? Is there an absolute need for an annual incremental economic growth, in any semi-open global system, to avoid significant social and political upheaval? What would be the political reaction in the US if the Administration said that they could 'correct' the current situation, but it would mean a return to the living standards of the early 1950s?

    Inflation in the US? - might be a tad tricky with an open system. You would have to place a mandatory upper limit on all domestic debt (personal and corporate), proscribe interest on that debt, stabilise the amount of cash in circulation, close the lid, then start minting!

    Brian P

  35. OK, I think I am finally seeing Hell and Gavin's point...

    Though trampjuicerocks' point-- if 'Zimbabwe' can do it, so can we-- somehow seems true at a gut level... And didn't Hell propose just this himself the other day when he called for a 'new deal' focusing on envirmental/alternative energies? ... An approach that my gut still tells me 'seems' a little dangerous-- I am a advocate of a massive basic science research funding (I would fix it as % GDP for ever if I could!), but that is only because most basic science research does pay ROI for 30+ years. It's hard to swallow that somehow the governement should pick up the tab if the plan is to help the economy in the short term/intermediate term for a project private investors won't touch-- Investor time frames may be fickle, but they are not that fickle (look at the railroads)... People always seem a little more generous/cavalier with the govenement's money than their own.

    Still, I see your point.

    One other question (the idea of inflating the debt away Zimbabwe style does play against my guilt)--
    wasn't a lot of this ALSO caused by foreign 'beggar thy neighbor' monetary policies? Did the monetary policies of Japan and China effectively 'export' their inflation to us?

    If so, aren't they as much to blame for this mess as we are?

  36. The government will easily be able to run a fiscal deficit - government debt is 'low' at 60% of GDP in historic terms having been inflated away in the 1970s and climbed upwards from 40% of GDP since the 1980s Have a look at what happened after the 1930s. http://upload.wikimedia.org/wikipedia/en/2/27/US_Public_debt_per_GDP_1791-2006.svg

    I believe Richard Duncan, a government official (IMF, World Bank) who wrote a book about the collapse of the dollar, also keeps pointing this out. Although he points out why the moneytary system will collapse first before a world wide minimum wage is established.

  37. Japan is the best model to follow for what we can expect given the recent housing and credit bubbles. In 89 Japan was the world leader in financial engineering and gaining large amounts of capital inflows into its equity markets. By 92 money was leaving for the American equity and venture capital markets.Take a long view of Japan's equity market vs the DOW will give you a excellent read.
    What we are experiencing now is the end of American financial power in world markets which will reduce the role of the financial sector in the US GDP. The US has many issues to resolve and its going to be pretty clear to the political establishment that the FED really does have limited options and they are going to have to begin the process of doing more then juicing up consumer spending to keep the masses happy and content.

  38. Hellasious, I wonder if you could help me out on this one.

    I don't understand why foreigners are prepared to fund the U.S deficit through the sale of T bills, Treasuries and Agency debt when the effective real returns on these assets are negative.
    Interest rate-(CPI + Devaluations of U.S. Dollar).

    As I see it, the average foreign investor would have done better in putting money into corn, wheat and Europe rather than the U.S.

    The scale of the Fed's actions are pretty puny against the scale of foreign capital inflows. I imagine if foreign investors stop buying U.S debt, Bernake's actions would be pretty much irrelevant.

    I don't think Bernake can really create inflation but I think the U.S Government can, through massive deficit spending in non productive areas such as benefits and entitlements (Bank bailouts?)in the absence of capital inflows, a.k.a the Zimbabwe method.

    The question I want to know is U.S debt seems pretty unattractive at the moment, so why are foreign investors still piling in.

    Sorry if this is a bit off topic.

  39. For your delectation from "Mish"

    I have been watching a chart of Borrowed Bank Reserves for several weeks. The action is unprecedented.

    Borrowed Reserves of Depository Institutions

    Here's an interesting excerpt from the book Investing Public Funds by Girard Miller about borrowed reserves.

    "Another useful indicator of the Federal Reserve's relative monetary policies can be found weekly in the Federal Reserve data. A key statistic is the net free reserves or net borrowed reserves line item. This statistic measures the degree to which depository institutions have found it necessary to obtain funds in the Fed Funds market and through the Fed discount window in order to obtain required reserves.

    During periods of central bank credit-tightening operations, the depository sector might find it necessary to borrow funds to meet reserve requirements. This practice results in net borrowed reserves, which shows as a negative number. Conversely, if ample funds are available through the banking system to meet reserve requirements, banks can become net lenders of reserves through the Fed Funds markets" Given that the Fed is not in a credit tightening mode, we must look for a better explanation. Here it is: Banks in aggregate have now burnt through all of their capital and are forced to borrow reserves from the Fed in order to keep lending.


  40. @Gavin

    I just read about the negative bank reserves on Mish's Blog. That's really scary!

    And this is exactly why I still don't feel like dropping the possibility for the hyper-inflation scenario. No one in his right mind will plan to go down that road, but moving one panicked step at the time they are heading that way.

    BTW want more data on the effective bakruptcy of the US financial system? Go read http://www.rgemonitor.com/blog/economonitor/237277/

    @David Pearson

    the FED cannot control the rate of the inflation once it starts monetizing the US debt. Due to the high leverage of the fractional reserve banking such massive injections will not be enough until they are too much. That is, the only way the FED can surely defeat deflation is with hyper-inflation and the consequent effective default on dollar denominated debt.

  41. Ben Bernanke and Congress are going to find that if they continue down the road of undisciplined "debt"
    creation that the Bond market will enforce market discipline in a way that will really upset the apple cart.

    This is why "inflating" our way out of our present predicament is well nigh impossible. It isn't just a matter of sacrificing the dollar in exchange for stopping the deflationary super train. Having said that, I am amazed at how many folks adhere to and propagate the hyper-inflationary argument.

  42. Here's a suggestion-why not a refi boom, especially of the cash out variety? It would be restricted to "prime" borrowers with low LTV's who could stand to save a few bucks on either a monthly payment or on amortized interest payments. The trouble is that mortgage rates would have go much lower than they are now since rates over the past few years have been so low historically. But this is one way to do it if could be engineered.


  44. Fire Henry Paulson @ Treasury and hire Robert Mugabe.

    You want inflation.....? You sure bout that....?


  45. Re: Sporadic

    The profile of the borrower you describe would either 1) refi for rate and not take any cash out, or 2)take the cash out and squirrel it away out of fear of an oncoming recession. They're not the type to spend recklessly.

  46. Hellasious,
    Is this scenario financially feasible?

    1. FED progressively slashes the interest rates all the way to zero thus letting the Housing party continue or stay afloat for many years...

    2. In the meantime, FED decouples the domestic inter-bank interest rate from the external Treasury/bond rates. With government understanding, treasury bill rates are adjusted upwards as necessary(say 5% or 6% or higher) to continue to attract the foreign investors(like China/India).

    3. To keep the public engaged and job numbers high, Government takes up massive investment in public transport infrastructure across entire United States (buses, railways, electric trains, bullet trains etc). And/or invest a lot of money in renewable energy research and deployment (windmills, solar installation etc). The idea is to create sufficient number of govt jobs to feed the consumer spending (without getting involved in war)so foreign countries will continue to export the cheap goods in return for paper $$.

    If this is feasible, the only question is, will foreign countries spot this trick?


  47. Edwardo --
    "Ben Bernanke and Congress are going to find that if they continue down the road of undisciplined "debt"
    creation that the Bond market will enforce market discipline in a way that will really upset the apple cart"

    What will the Bond market do?

  48. 2 page article:

    Cash-strapped states resort to odd taxes

  49. Start another war or arms race and inspire Americans to invest their minds and energies into activities that create wealth for the military industrial complex.

    This time if we conquer another country, we make sure and plunder all the natural resources.

  50. But Bernanke has already said that his greatest weapon is his dollar bill copy machine...in exactly those words:


  51. What do you think about the recent development in the fed's reserve statistics? http://www.nakedcapitalism.com/2008/01/bank-reserves-now-negative.html
    Can't figure out how significant they are and wondering what you think of them. Thanks or the great blog.

  52. About banks' non-borrowed reserves..

    It looks like rate arbitrage between the Fed'd TAF operation (~$30 billion cheap money) vs. banks' own cost of funds. Banks are replacing expensive "own" money as reserves with cheap money borrowed from the Fed.

    I noticed that the numbers match, i.e. before the TAF ops. the non-borrowed reserves were around $35 billion, now they are slightly negative (non-seasonally adjusted numbers). They cancel out...



  53. H. best explanation so far!

  54. The Dollar is (was) a special currency. It is (was) the world's reserve currency. The last time the world changed reserve currencies was (I am guessing) when it moved from the Pound Sterling to the US Dollar - right around 1917. Perhaps there are parallels between the over streched British Empire and the USA today, with the Euro becoming the new reserve currency.

    So what did the British do ? I honestly don't know, perhaps we should investigate.

  55. Hello Sally, The bond market will cause rates to spike up hard. Rates will go through the roof. They will have to in anticipation that the risk of default by Uncle Same will have risen by virtue of taking on even more
    enormous piles of IOUs.

  56. How to increase inflation dramatically:

    Compel debtors to borrow and lenders to lend.

    Passing federal laws to that effect, with fines and jail time for offenders, is the only way.

    Anything that relies on voluntary action by U.S. citizens will not suffice.

  57. It's really touching, no matter what happens, that we still get told that we need to make people take even more math and spend more time in school. Why do you think this works any different than say customer service jobs? If India and China turn out more engineers who are willing to work cheaper than people can work in the US, it simply doesn't matter. It also ignores that most of the innovations of the last century did not come from engineers. What is killing us is the lack of imagination and ingenuity of our people. There's probably no fix for that, as long as we have tv.

  58. BRAVO on the piece.

  59. Teri:

    That was a very insightful remark you made. I was busy advocating for more math and science (which are pretty handy when it comes time to implement your imaginative idea) but what we really need are the big ideas.

  60. Thanks Edwardo -- I appreciate the translation from the pro's language.

  61. I will take a stab at creating inflation...

    Asia and the Middle East have high inflation rates because their currencies are pegged to the dollar.

    So we peg our currency to the Zimbabwe dollar and party like it's 1999!

  62. Don't blame Keynes. Keynes said (and I heard this in a speech from one of his foremost interpreters, the late Joseph Pechman of the Brookings Institution) that you balance the budget when the economy operates at full employment.

    Guess what!? Bush made tax cuts (presumably he would like tax collections to go to zero) a religion, and ran up the deficit while the economy operated at full employment. He further increased the deficit by prosecuting a war that he financed with government borrowing.

    As the economy rolls over into recession, it does so while government borrowing power (or rather the ability for the government to borrow in a sane manner) is severely constrained.

    Yes, Keynes said, additional, deficit financed government spending, can pull us out of recession. On the other hand, Keynes never said to be imprudent, let alone run a deficit during periods of full employment. True Keynesians even talk about running a government surplus during boomtimes, so that the money will be there for a rainy day. That is just what Bill Clinton did.

    Unfortunately Bush spent the surplus. Again, it might make sense to do that if you were going to fund productive assets that would increase GNP: domestically situated factories, scientific research, improved education. Instead Bush threw the equivalent of a protracted and extravagant party. Everyone below the top 1% income bracket will get to share the hangover.

  63. anon, true enough. Keynes favored alternation of surplus and deficit as a means to smooth the cycle though I don't believe he - in contrast to some later - ever considered that this could do more than mitigate.

  64. To Edwardo
    You keep insisting that the bond
    market will prevent the Fed from
    inflating by spiking long rates but
    the Fed can borrow in foreign currency from foreigners while it
    inflates at home. In the face of a
    depression exchange controls will be imposed to prevent citizens from
    expatriating their money. Domestic
    consumption will have to crash so that exports can be ramped up to pay for vital imports, i.e. oil.

  65. W/respect to mechanisms for inflating, the federal govt doesn't
    have the infrastructure to massively ramp up spending quickly
    (rebates not very effective and not
    at all targeted unless govt issues
    directed debit cards a la Peter
    Schiff's Jan 18 commentary "A
    Modest Proposal" @www.europac.net)
    but the states do. The most likely
    scenario would be to massively
    increase budget aid to the states
    for infrastructure repair and
    building projects but even more
    importantly to prevent the mass
    firing of state employees (clerks,
    cops, fire fighters) when private
    employment would be contracting.
    The amount necessary may approach
    or even exceed $1 trillion that
    would be disguised amongst various
    block grants thru different govt

  66. Anonymous @ January 31, 2008 7:30 AM:

    You have hit the nail right on the head. You should get a cookie, too.

  67. 1) we can have commodity place inflation at the same time we can have house and stock deflation, and I think we are seeing both
    2) as for foreign "investment", consider I just read that 99% of Iraq oild money is being "invested" into T-bills in BONY -- monetary inflation stimulus
    3) US stopped reporting M3 in '06, probably because the govt. doesn't want us to see true increase in money supply

  68. This comment has been removed by a blog administrator.

  69. This comment has been removed by a blog administrator.

  70. This comment has been removed by a blog administrator.

  71. This comment has been removed by a blog administrator.

  72. This comment has been removed by a blog administrator.

  73. This comment has been removed by a blog administrator.