The Grand Experiment and the Catastrophic Flaw
The Weekly Report
Welcome to the Weekly Report. I have seen much head-scratching about the methods being employed by the US authorities in the attempt to turn off the road to depression and onto the highway to prosperity. Many have heard President Obama talk of the failure of government spending to turn around both the US '30s and the Japanese '90-current depressionary eras because the actions taken back then were too slow and too small.
My subscribers have to put up with a lot. My website isn't brilliant, it's cheap to run and has little in the way of extras - but it works. I run the website as though it was a business operating according to Austrian Theory, I don't invest borrowed money and expansion will come from savings, from profits. I haven't invested heavily; current market conditions are not conducive to increasing subscriber numbers. The bonus is it's cheap for members; I have small overheads and can leave the subscription rate as it is for as long as I want. Subscribers have to work their way through some pretty complex, long term ideas to understand what I babble on about, my spell checker is erratic and my grammar can be suspect. However what I say now happens in the future and I have been doing this for some time - it works. I know it works because every so often I get an email saying thank you. We don't chat on line, I don't do a running commentary and even worse, I don't tell them what to invest in but - it works, they subscribe because they read my letters and articles and then see the events I describe unfold in the future. In other words they have a credible expectation that I will get the future right, even if they disagree with how I get there.
It's this credible expectation that keeps readers engaged, if I became a contrarian indicator then people wouldn't subscribe.
President Obama and Co need to engender a credible expectation that a deflationary depression can be avoided. This is no easy task and it requires careful planning and almost perfect implementation. I know this because I divined what the plan was and the methods that would be employed and published my thoughts at the beginning of April '08.
Deflation is a funny beast, it doesn't exist just because a Central Bank reduces the amount of currency in circulation, it can happen in other ways too, as we see today. Deflation can be caused by hoarding, by forming a dam in the flow of money. Right now we have 2 dams in place. The first dam belongs to the Banks who are in real trouble and need to horde cash and cash like assets (liquid and low/no yielding bonds deemed safe) to offset current and future losses. The second dam belongs to business who either cannot get credit to expand (good in my view, it's a silly way to expand.) or prefer to save profits and not spend due to current market conditions and future outlook. Both dams have severely restricted the flow of cash to the rest of the economy, resulting in the turmoil we see today.
If you restrict the availability of an asset that has high demand then it becomes intrinsically more valuable, if you can get hold of the asset you keep it, as it should continue to appreciate. The same can happen with cash, if there is less of it available, yet demand increases, then it will be worth more. So even if the production of money increases, as long as demand remains high (because the dams remain in place) then the appreciation will continue. I could include the velocity of money here too but lets keep this simple, we know that if money doesn't circulate then contraction is a given.
Even if the rate of interest is nominally nil on deposits (or yield on bonds) the capital appreciation means it's still profitable to save. This is a major problem for those in debt as the burden, the capital borrowed, increases in real terms even if interest payments fall. The inflationary effect that reduces the worth of the debt in the long term can no longer be counted on to lessen the burden.
So how can a government make it unattractive to save an appreciating asset? It has to change the expectation that the asset is worth keeping, it needs to encourage (all) savers to change their behaviour and conclude it is better to spend than save. To do this the government must be seen as irresponsible but credible.
It is irresponsible to massively increase government debt to buy toxic assets, to bail out broken banks and failed businesses, to make huge tax cuts and bail out defaulting mortgage holders. Why would good money be thrown into a black pit of losses, especially if the money created to do this increases the debt burden and the eventual liability to the tax payers? Even in the face of criticism the government continues to expand its debt obligations through fiscal and monetary policies, happily quoting figures that end in the word trillion, rather than the old fashioned billion.
How on earth does the government expect to pay off this debt in the future? Surely the only way such sums can be paid off is by monetising the debt, lowering the capital burden through the mechanism of deliberate inflation, allowed by low/no Federal Reserve Fund Rates. Did you nod when you read the last sentence? Good, you have a credible expectation that the government will inflate the amount of currency (including bonds) it produces to pay off the increased debt.
By acting irresponsibly, the government actions will make you credibly expect inflation to appear and increase in the future. By you I mean everyone including banks, businesses, consumers and foreign investors.
How does this become entrenched in the psyche of the population? We have seen a close copy of such a policy, or set of policies in action that struggled to succeed because one ingredient was missing. Japan adopted Quantitative Easing (QE) and Zero Interest Rate Policy (ZIRP) to flood the economy with liquidity in an attempt to lower the burden of debt in the Japanese banks. However they refused to create a credible expectation of future inflation. Without that expectation the Japanese hoarded cash and then decided to invest in higher yielding assets in foreign lands. The carry trade was a direct result of the Japanese failure to discourage savings.
The Fed chairman Ben Bernanke has studied both the Japanese Deflation and the US '30's episodes in great depth. Through his own and others work he formulated a plan to combat deflation should it happen in the US. As we can see today both QE and ZIRP have been adopted as the main enabling platforms to allow the massive increase in debt. However in a break from the plan used by the Japanese (and FDR) Ben Bernanke knows he needs to make saving unattractive by ensuring there is a credible inflation expectation.
That's it, that's the plan, the hopes of the world rest on it working. (I should say here that I do not agree with the Fed/US government plan, I think it will fail.)
When everyone decides that saving cash and low/no yield debt is no longer profitable then only one path remains, to spend the cash on assets that have a better rate of return. Ben Bernanke and President Obama are waiting for you to realise this. Ben Bernanke will keep rates artificially low and President Obama will continue to commit funds even when inflation appears and starts to rise, just to make sure everyone gets the message.
Ben Bernanke did something over the past month that put the final touches to the trebuchet that will hurl the buckets of liquidity into the walls of the dams. On 16 January by conference call, he re-opened the discussion about setting an inflation target:
On January 16, 2009, the Committee met by conference call to discuss issues associated with establishing an explicit numerical objective for inflation . The Committee made no decisions on whether to establish such an objective. Most meeting participants expressed the view that an explicit numerical objective for longer-run inflation would be fully consistent with the Federal Reserve's dual mandate of promoting maximum employment and price stability and would not impede fostering the stability of the financial system.......Some indicated that the establishment of a numerical inflation objective could be particularly helpful under present circumstances in forestalling an unwelcome decline in longer-run inflation expectations---and hence in contributing to economic recovery--while also assuring the public that actions taken to counter economic weakness will not lead to high inflation over the longer-run . However, several participants expressed concern that an initiative to clarify the Committee's longer-run inflation objective could be confusing to the public in the current context of economic weakness and financial market strains."
In other words, it's going to happen but not right at this moment (back in January). The minutes from the FOMC meeting some 11 days later reveal that the Fed didn't get the expected result from the December release and the adoption of ZIRP:
- "The decisions of the Federal Open Market Committee (FOMC) at its December 15-16 meeting reportedly were more aggressive than investors had been expecting. Market participants reportedly were somewhat surprised both by the size of the reduction in the target federal funds rate, to a range of 0 to 1/4 percent, and by the statements that policy rates would likely remain low for some time and that the FOMC might engage in additional nontraditional policy actions such as the purchase of longer-term Treasury securities. Over the intermeeting period, investors marked down their expectations for the path of the federal funds rate , as measured by money market futures rates."
I suspect the reaction referred to above (that would have been known to the Fed by late December / early January) was the initiator for re-opening the discussion about an explicit inflation target. Ben Bernanke was ready to add that extra ingredient missing from the Japanese menu:
- "The deflation bias is closely related, and in some sense, a formalization of, a common objection to Krugman's policy proposal for the BOJ . To battle deflation he suggested that the BOJ should announce an inflation target of 5% for 15 years . Responding to this proposal, Kunio Okina, director of the Institute for Monetary Studies at the BOJ, said in DJN (1999): "Because short-term interest rates are already at zero setting an inflation target of say 2% would not carry much credibility. " Similar objections were raised by economists such as, e.g., Dominiguez (1998), Woodford (1999), and Svensson (2001)" From "An interpretation of The Deflation Bias and Committing to Being Irresponsible" by G B Eggertsson
On the day of the release of the January minutes Ben Bernanke gave a speech that drew attention to the adoption of a long term explicit inflation rate. The detail was not in the minutes but in an addendum, the Summary of Economic Projections:
- "All participants anticipated that unemployment would remain substantially above its longer-run sustainable rate at the end of 2011, even absent further economic shocks; a few indicated that more than five to six years would be needed for the economy to converge to a longer-run path characterized by sustainable rates of output growth and unemployment and by an appropriate rate of inflation."
As can be seen the Fed is placing a credible expectation of inflation into the public arena, rising to 2% and staying at such levels for at least the next 6 years. We can also see that the preferred measure is PCE (Personal Consumption Expenditures) and not core PCE. This explicit target gives the Fed (and US government) 2 new weapons. Until the target is achieved and maintained the QE and ZIRP policies can remain in place, ensuring inflation expectations remain anchored even if (and when) the various Fed liquidity schemes are drawn down. Secondly it allows the Fed to focus on talking about inflation rather than deflationary aspects in their public announcements and encourage a belief that 2% of "gentle" inflation is good (it isn't).
A paper written by GB Eggertsson, adopted as a theory by Ben Bernanke has become the method employed for the greatest monetary experiment the world has ever seen. The result of this experiment will set the scene for the US and the world for the next 50 years. There are already parts of the method that will need to be re-examined as the experiment begins to yield results, especially the implicit level of inflation. More importantly the whole success of the experiment hinges on that most ephemeral of subjects, the expectations of the individual.
There can be no going back now the experiment has begun, this is a one way trip that will either fail or succeed. The Fed/US Government believe success will allow the current financial system to be revitalised, depression avoided and a continuance of a fiat currency, credit based economic system. Failure will result in a severe, prolonged depression that will destroy confidence in any fiat currency system and irreversibly change the balance of power around the globe.
All the constituent parts required to enable recovery are now in place and the battle between Keynesian and Monetarist theory has begun:
- "Can the government lose control over the general price level so that no matter how much money it prints, it's actions have no effect on inflation or output? Economists have debated this question ever since Keynes' General Theory. Keynes answered yes, Friedman and the monetarists said no." (Eggertsson)
So far this week I have recapped and updated what I call The Eggertsson Theory. All the components are now in place but as subscribers are about to learn I have discovered a flaw in the plan that will lead to catastrophe.