Thursday, December 18, 2008

No shortage of money (5)

And so continues the saga of the greatest monetary expansion in the history of modern, industrialized nations. Through massive purchases of all kinds of assets, the Fed has almost doubled the size of the monetary base since early September. Put another way, they have created more high-powered money in the past three months than in the entire history of the Fed.

This hasn't been inflationary yet, because the demand for money has been extraordinarily strong—fueled by outright panic, a flight to safety, deleveraging, commodity price plunges, and the reversal of "carry trades." But surely it's safe to say that there is no shortage of dollars in the world at a time when the world desperately wants them. Indeed, recent weakness in the value of the dollar and strength in gold suggests that the Fed may have finally added enough liquidity to the system to satisfy the market's thirst. That gives us great comfort, since it eliminates entirely one of the major causes of the Great Depression (i.e., a collapse in the money supply and a subsequent deflation).

This expansion of the monetary base has been made possible by the Fed's shift to quantitative easing, something I highlighted about two months ago, but the Fed only admitted to recently. Now that it's official, and the Fed has promised to remain super-accommodative, the next phase of this process will be to see how much and how fast the abundance of base money gets turned into new spendable money. The base has risen by $800 billion since early September, but M2 (the best measure of money in my view) has only risen by $397 billion. Of that, currency accounts for $32 billion, and some portion of the balance can be attributed to a three-fold increase in mortgage refinancing activity. The potential for further money creation is enormous, nevertheless, since each dollar of base money can potentially support ten dollars of new bank deposits.

Further monetary expansion will be up to the public and the banks. Will people be encouraged by historically low mortgage rates to return to the housing market? Will institutional investors decide that taking on leverage—at a time when prices for many physical assets have collapsed and interest rates are relatively low—is not a bad idea at all? Stay tuned, it shouldn't take long before we find out.


dave said...

Hi Scott,
I think the only thing missing in the Feds Q-easy plan ( pronounced queasy as in it's making me sick) is a target.

They are going to ease until what? The cows come home.

This has been the feds problem for years, no target or the the wrong target.

How about a dollar/gold target of lets say $500 per oz.

Tom Burger said...

And if people do use the easy and cheap money to bid up house prices, or if hedge funds once again use leverage to levitate financial asset prices? How is this a good thing? The distorted relative prices will once again cause bad investments galore and set us up for the next crisis.

Maybe the cows are not coming home soon, but they will come home. The chickens will eventually come home to roost, too. These policies are absolutely insane.

My guess is that we have already begun the bust that makes "successful" re-inflation by the Fed impossible. But there is obviously no way to know; it's only a guess on my part.

Tom Burger

Brian H said...

Read yesterday that the bailouts are - inflation adjusted - larger than all of our wars combined. Certainly larger than all the money that has ever been spent through NASA...

The increasing M2 could be likened to the expanding beachfront in advance of a tidal wave - should I be feeling like the owner of a sandcastle at low tide?

I hope not...

Scott Grannis said...

I don't want to appear to advocate easy money, since I know first-hand, from my four years spent in Argentina, the havoc that inflation can cause. But to the extent that the Fed's easy money policy neutralizes the risk/fear of deflation, then I think it is a positive.

The market is clearly obsessed with the risk of a prolonged recession/depression, and adding the risk of deflation to that only magnifies the despair. By taking deflation off the table the future looks much less sinister. So I'm not saying that what the Fed is doing is going to improve our well-being, but instead it will make things much less worse than they otherwise might be. The sooner the market forgets about deflation risk, the faster the market can recover. Does this make sense?

Separately, my guess at the price-stabilizing value of gold would be maybe $400. That's roughly the average of inflation-adjusted gold prices since 1910.

Tom Burger said...

"Does this make sense?"

Not to my mind. I believe all market interventions fail to achieve their intended purpose.

This idea that you can just dump money into the economy to overcome deflation comes, I think, from the Keynesian macro-economics and the equation of exchange (PT=MV, and variations). The components of this equation cannot even be rigorously defined, and in any event it ignores the specifics. Deflation is happening because specific individuals and institutions are paying down debt instead of taking on more. The new inflation will most likely go to other economic participants and we will have both inflationary and deflationary forces at work in the economy. Since they will be acting on different prices, they will not cancel each other out.

Besides this, deflation is not the problem it is made out to be. Deflation did not cause the Great Depression. The Federal Government created the Great Depreciation by fighting the price adjustments that were essential. Unlike inflation, a deflation is necessarily limited. Let prices adjust to market levels unmoodified by monetary nonsense and everybody in the economy will quickly figure out what they have to do. None of the depressions preceding the 1930s became "great."

Our Fed and government are so far making pretty much exactly the same mistakes as in the 1930s, except they are doing it up bigger and faster.

That's the way I see it.

Tom Burger

Scott Grannis said...

Tom: inflation or deflation doesn't come from the public's demand for debt, it comes from a monetary error. I question whether we are in a deflation in any event, but I know the markets are terrified of deflation. And for good reason, since it makes debt much more onerous to repay. The Fed can absolutely fight deflation, even though it is fraught with difficulties and, as you say, many unintended consequences.

Gene Prescott said...

((Tom: inflation or deflation doesn't come from the public's demand for debt, it comes from a monetary error. ))

Just wondering whether Tom accepts this notion.

Tom Burger said...


The monetary error, in this case, is the arbitrary interest rate and banking reserve manipulation.

It's a well known fact that our banking system increases or decreases the money supply through a leveraged extension of the banking reserves. Scott referred to this phenomenon himself in a recent post, saying something like "whether or not the money supply grows is now dependent on lenders and borrowers."

The ONLY way to experience deflation is through a credit contraction. In the "old" days, a lost shipment of gold could constitute a deflation, but it's difficult to imagine an analogy in the current era of fiat currency.

Scott: if you think deflation is a NET reduction in money, then its existence is certainly in doubt. Likewise, if you think deflation is defined by a general decline in prices. There is little doubt in my mind, however, that we would have a net reduction in money if it were not for the positively outrageous and unprecendented central bank behavior. As I said, however, the induced inflationary processes will not cancel out the deflationary processes - they will simply coexist and we will suffer simultaneous relative price distortions from both monetary processes. Yes, I would say unintended consequences are a certainty.

Tom Burger

Gene Prescott said...

Tom Burger wrote:

((the induced inflationary processes will not cancel out the deflationary processes - they will simply coexist and we will suffer simultaneous relative price distortions from both monetary processes))

The concurrent happening notion implies one part of the population benefits while another suffers?

Tom Burger said...

There are always losers and winners with inflation/deflation. Why the US government thinks debtors deserve to benefit while savers deserved to be ruined, I am not sure. If there were a general deflation, savers and dollar holders in general would benefit, although there is no reason to think that deflation would exactly reverse the damage caused by inflation all these years.

With the Fed pushing new money into the economy on top of the deflationary processes at work, it REALLY becomes difficult to predict the impact on "general prices" or changes in the value of the dollar relative to other currencies.

The worst part of the deflation/inflation mess will perhaps be the distorted market prices for many assets and goods, causing massive new malinvestments throughout the economy and therefore setting us up for even greater turmoil later on.

Everybody loses in that case -- especially if these interventions then breed even more government interference with markets at that later time. As Mises said, unless this cycle is broken at some point, the government will end up trying to control everything -- and that is totalitarianism. I hope these people in Washington will wise up before they destroy the economy and all our liberties.

Tom Burger

Scott Grannis said...

Tom: Deflation does not require a net reduction in money. Indeed, deflation can happen when the demand for money soars but money supply doesn't increase sufficiently. Deflation in the purest sense is when the general price level rises, and it is very likely that the value of the currency is rising against other currencies, gold, and physical assets. I think it is critical to look at the value of the dollar and gold prices in order to judge whether we are deflating or not.

Tom Burger said...


It depends on your definition of deflation. Until the Fed redefined inflation/deflation to mean changing "general price levels" these concepts were in fact just names for a growing/shrinking money supply.

It certainly is true, though, that you can have falling prices without a net reduction in money. I believe you have a typo in your statement about the "purest definition of deflation"? You meant to say when the general price level falls?

Defining inflation/deflation in terms of the general price level was done, IMO, so that the Fed can pursue its inflationary purposes while talking in terms of "fighting" inflation or deflation, as the case may be.

Speaking in terms of rising or falling prices is very problematic, however. First of all there are huge and variable lags between monetary changes and consequent changes in price indices. Furthermore, during periods of economic growth prices would tend to fall slowly if we had an unchanging money supply. The Fed uses the low CPI numbers during these periods to justify ongoing inflation -- with its attendant price distortions and malinvestments. That happened in the 1920s and again in recent decades. Given that the Fed is running a banking cartel, its purpose is to keep bank assets and profits rising for as long as it can -- and then it covers banks' losses when they inevitably appear!

Defining inflation/deflation in terms of price changes, in other words, leads to bad monetary policies.

Given where we are now, it sure seems like it must be getting more difficult for the inflationists to deny this simple fact?

Tom Burger

Scott Grannis said...

Tom: I meant to say "Deflation in the purest sense is when the general price level falls." Thanks for catching that.

I don't think deflation has ever been defined as a shrinking supply of money.

A short-hand way to judge whether you have inflation or deflation is to watch the price of gold or the value of the dollar. If the dollar gains purchasing power relative to other currencies and to gold, it's a good bet you have the makings of deflation. But in the end, a deflation must be defined as a decline in the general price level as measured by the unit of account.

Tom Burger said...


In the early 20th century and before, inflation/deflation was defined as an increase/decrease in the money supply. Mises and others have discussed this change of definition at length.

Mises also argues that there really is no such thing as the "general price level." Prices change all the time for many reasons, as you know. The impact on your standard of living depends on what you buy and in what proportions.

When prices change because of a change in the quantity of money, those changing prices are a symptom of inflation/deflation, not inflation/deflation itself.

It's also well understood that inflation/deflation doesn't have a uniform impact on prices. Certainly not in the short run and there is no reaason to believe that the changes will be perfectly uniform in the long run, either. If price changes were uniform and instantaneous the equation of exchange wouldn't be totally worthless -- but that is not the case, and PT=MV is in fact totally worthless.

Defining inflation/deflation in terms of a changing price level is an inflationist's device to allow expansionary banking policies. I understand that this opinion is in contradiction to mainstream economic thinking. But that is my story and I am sticking to it.

Tom Burger

Randy R said...

Tom and Scott,

The discussion is very interesting, thanks. Tom - you make strong arguments that the fed monetary policies(with it's inflationary bias) are a major problem. At least to me, it begs the question "so what should the feds role be?" Not necessarily in the current crisis, but in general. It seems outrageous to argue there should be no centralized monetary policy making. I know you've posted links to Mises articles, that may have the answer. I've meant to follow those but confess I haven't.

Tom Burger said...


The central bank together with fractional reserve banking is the problem. Mainstream economists do not buy all the Austrian arguments about the damage caused by inflation, but I am convinced the Austrian School arguments have it mostly right.

The solution is problematic because these institutions are now taken for granted around the world. And why not? Banking in this incarnation is the greatest theft machine ever invented. It works for government as well as banking, so government grants the necessary monopoly.

If it were possible to impose 100% reserve requirements on all demand deposit accounts, for example, that would dramatically reduce the potential for mischief -- but neither government nor the Fed is motivated to do anything like that. Even a 50% reserve requirement would help, instead of the de facto zero percent reserve requirement in the US.

Jesus Huerta de Soto wrote a book recently called Money, Bank Credit, and Economic Cycles in which he spells out the theory and offers his concept of a solution. That's one source of ideas. There is no concensus on what to for many reasons -- political reality being the strongest constraint.

Tom Burger