What's Happening on the Inflation Front?
Below is an excerpt from a commentary originally posted at www.speculative-investor.com on 5th April 2009.
The Fed scaled back its money-pumping efforts over the first three months of this year, which is not surprising given that it would have been almost impossible to sustain the frenetic pace achieved during the final four months of last year. But even though the Fed's actions have become less frenzied of late, the Fed-Treasury tag team has made sure that the rate at which new money is borrowed into existence continues to exceed, by a substantial margin, the rate at which money is extinguished via debt repayment. This has mostly been accomplished via the US Government increasing its debt load at a much faster pace than the private sector de-leverages. As mentioned in previous TSI commentaries, the private-sector debt bubble is in the process of being replaced by a public-sector debt bubble.
The following chart shows the year-over-year percentage change in True Money Supply (TMS). Note that TMS does not include bank reserves. When the banks eventually start lending their excess reserves the result will be a further increase in TMS, but there is no telling when that will happen. It could, for example, happen within the next few months, but on the other hand the commercial banks could decide to sit on their excess reserves for several years. Either way there is likely to be a lot more monetary inflation over the coming 12 months for the same reason there has been a lot of monetary inflation over the past 12 months: increased government borrowing and Fed monetisation of both government and private debt.
On the above TMS chart we have identified three separate periods. Period A (mid-2001 through to mid-2004) had fast money-supply growth, Period B (early-2005 through to early-2008) had slow money-supply growth, and Period C, which began during the final quarter of 2008, has thus far been characterised by fast money-supply growth. The fast money-supply growth of Period A fueled rapid price rises in houses, housing-related debt securities and commodities, and the slow money-supply growth of Period B led to large price declines in houses, housing-related debt securities and (eventually) commodities. The fast money-supply growth of Period C WILL fuel rapid price rises SOMEWHERE in the economy.
There is nothing novel or complicated about the theory that fast money-supply growth over a prolonged period leads to substantial price rises and that a subsequent sharp slowing in the pace of money-supply growth causes prices to retrace; it is just basic supply and demand. However, the effects of monetary inflation are non-uniform and the time delays are both lengthy and variable. The challenge, therefore, lies in determining which prices will be affected the most by the money-supply changes and how much time will elapse before the effects of the money-supply changes become evident in prices. This is not only a challenge for investors; it's also a challenge for policymakers. One of the main problems faced by policymakers (central banks and governments) in their efforts to manipulate the economy to their own best advantage is that they will always be able to inflate the money supply but they will never be able to control the effects of the inflation. Sometimes they will get lucky and the right things (stocks and real estate, for instance) will be the primary beneficiaries of the inflation, but at other times they will be unlucky and the wrong things (gold and oil, for instance) will gain the most ground in response to the inflation. We suspect that over the next few years they will be as unlucky as they can be in that gold will be by far the biggest winner.
Will the Fed eventually 'soak up' the excess money?
Bernanke and his Fed cohorts will naturally say that they plan to remove much of the recently injected money once the economy recovers. In all likelihood they will also go as far as making preparations to drain away the "excess liquidity"; for example, getting approval for the Fed to issue its own bonds. This is all part of managing inflation expectations. However, there is almost no chance that the Fed will actually engineer a significant slowing in the rate of money-supply growth until it is way too late (until a major inflation problem is 'baked into the cake'). The reason is that the inflationary policies implemented to date will not only fail to turn the economy around, they will very likely make things worse. To put it another way: the harder they try to stimulate the economy by creating money out of nothing the more economic damage they will do (counterfeiting money transfers wealth from productive enterprises to the counterfeiter and thus reduces the economy's growth potential) and the longer it will take for a sustainable economic turnaround to begin.
Rather than draining away the so-called "excess liquidity" that was injected in an effort to boost the economy, it is more likely that the obvious failure of Fed-sponsored inflation and increased government spending will lead to even more of the same. After all, every good doctor knows that if a patient becomes sicker after taking a certain medicine then the correct response is to double the dosage. And if that doesn't work, double it again.
The cost of "flexible" money
One of the most popular arguments against having gold as money is that a gold-based monetary system would be inflexible, the implication being that today's dynamic economy requires a more flexible, or elastic, form of money. Well, if by "inflexible" it is meant that under a gold-based monetary system the supply of money could not be arbitrarily expanded by governments and banks, then yes, a gold-based monetary system would be inflexible, but such inflexibility is a consummation devoutly to be wished. In our opinion the ideal money would be as constant as the sun, enabling each of us to calculate exactly how much money we needed to save to cover our future living expenses.
Today's official money is very flexible, and it's not hard to see the cost of this flexibility. The following chart from http://mwhodges.home.att.net/nat-debt/debt-nat.htm reveals one method of quantifying this cost. The chart shows that the total quantity of debt in the US economy was around 185% of net national income in 1957 and was still around this level at the beginning of the 1970s. However, by 2008 the total debt had grown to about 500% of net national income. Bear in mind that the current "flexible" monetary system came into being in the early-1970s. In other words, the introduction of "flexible" money led to a veritable explosion in the quantity of debt.
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