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Chasing 2 Percent Inflation: A Really Bad Idea – Article by John Chapman

Chasing 2 Percent Inflation: A Really Bad Idea – Article by John Chapman

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The New Renaissance HatJohn Chapman

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In just two years, inflation targeting (namely, the quest for 2 percent inflation) has gone from the lunatic fringe of economics to mainstream dogma. Much of the allure springs from notions that a little inflation motivates people to speed up spending, thereby greatly increasing the efficacy of central bank stimulus. It is touted as a cure for sagging demand and a defense against the (overly) dreaded deflation.

Other benefits include melting away some of the massive government and private debts and improving people’s perception of progress as they see their nominal wages rise. Employers can lower real wages without unpopular dollar pay cuts. The Fed can allow price increases to signal the need for production responses, allow for minor supply shocks and for monopolistic industries to increase prices all without a monetary response that would hurt other elements of the economy.

For the politicians it provides a tax windfall in the form of capital gains taxes on inflated assets and income taxes on interest that simply reflects inflation. It also necessitates printing more money thereby earning seigniorage (profits from printing money) for the government. In addition, it provides cover for competitive currency devaluation and is a great excuse to kick the can down the road: “Let’s not tighten before we reach our highly desired inflation target.”

What’s Magical about 2 Percent Inflation?
Then there is the question of why 2 percent? Perhaps that was seen as a still comfortable rate during some past periods of strong growth. Conditions today are very different, which perhaps suggests they are trying to imitate past growth by copying symptoms instead of substance. Of course for politicians, permission to print money is a godsend, and with inflation all around the developed world below 2 percent, it was “all aboard!”

Clearly not all of the features above are desirable, but even some of the touted ones are underwhelming. While increased inflation expectations will speed up spending, it is far from being the reservoir of perpetual demand that some seem to believe. Essentially, a onetime increase in expectations of a new steady rate of inflation would speed up purchases for the period ahead, but with negligible net effects in subsequent periods — a onetime phase shift in demand.

The Danger of Raising Interest Rates
After almost eight years of stimulus, the Fed has taken its first timid steps toward normalizing monetary policy. That means we will soon have to contend with something entirely absent during the years of easy money — a bill for all of the goodies passed out and the distortions created. And what a bill! A 3 percent rise in average interest rates on just our present government debt over the next few years would ultimately amount to over $500 billion a year in additional interest expense, equal to roughly 1/7 of current Federal tax receipts. Those bills start arriving with a vengeance when rates go back up, and for the first time in years the market will see concrete evidence of whether the US and other governments are willing to pay the price of continuing to have viable currencies.

Prior to the appearance of inflation targeting, I was already dreading the impact of political interference with efforts to return to normal. But targeting makes every politician an economist, able to make simplistic, grandstanding statements with the authority of the Fed’s own model. This makes the problem far worse.

Two percent, which has (foolishly) been defined as desirable, will quickly be interpreted as an average. “So what’s the big deal,” critics will say, “about a pop to 3 percent or more, after all it has spent years ‘below target’, and if you excluded a handful of ‘temporary exceptions’, it would still be only 2 percent …?” Imagine the political storm if the Fed decided to quickly raise rates a couple of full percentage points in response to a surge in inflation to 3 percent.

There are a lot of people (especially politicians) whose short-term interests would be harmed by a sharp rise in interest rates. Lulled by today’s relative calm, many fail to appreciate how explosive the situation becomes when we transition from the concerned waiting of the long easy money period to the concrete tests of our credibility during renormalization. If we had to temporarily sacrifice half a percent from our already tepid growth rate to preserve the credibility of the dollar, that would pale next to the cost of worldwide panic and collapse. Unfortunately the sacrifice part is up front.

Americans think of inflation as a purely monetary phenomenon, which the mighty and independent Fed has handled in the past and will again if necessary. Actually once the inflation genie starts to escape from the bottle it becomes purely a political problem. Even the most determined central banker is helpless if the people refuse to accept the paper money, the politicians balk and take away the bank’s independence, or there is an opposition political party promising a credible-sounding and painless alternative plan. It comes down to what the market sees as the political will and ability to pay the short-term cost of reining in the inflation.

The Political Advantages of the 2 Percent Target
Political resistance to the cost of moving back to normal plus our willingness to decisively confront signs of panic will be watched carefully by owners of dollars and dollar instruments. This is a huge liquid pool which could stampede en masse into wealth storage and productive assets. Such a run would quickly become unstoppable and would mean a collapse of the world economy. Inflation targeting greatly facilitates the political opposition to decisive Fed action right at the first critical test points where there might still be hope of heading off an uncontrollable panic.

Deliberately seeking higher inflation amounts to intentionally damaging people’s faith in a fiat currency, one already in danger from massive debt, disquiet over novel monetary policy, and noises from Congress about reducing Fed independence. Targeting also provides a handy excuse to delay returning to normal, thereby worsening the mounting distortions. Finally, it invites wholesale political interference with the Fed’s efforts to manage an orderly return to normal financial conditions.

John Chapman is a retired commodity trader, having headed his own small trading firm for over thirty years. Prior to that he worked in the international division of a large New York bank, managed foreign exchange hedging for a major NY commodity firm, and worked as a silver trader.

Economics, especially money and banking, has been a passion of his since college. In 1990 he took a trip to South America for the express purpose of studying inflation “at its source.” His formal economics credentials consist of half a dozen courses, five of which were as an undergraduate at MIT (where he majored in aeronautical engineering.) He also received an MBA from the University of Arizona.

This article was published on Mises.org and may be freely distributed, subject to a Creative Commons Attribution United States License, which requires that credit be given to the author.

What Did Fed Chairman Yellen Tell Obama? – Article by Ron Paul

What Did Fed Chairman Yellen Tell Obama? – Article by Ron Paul

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The New Renaissance HatRon Paul
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This week, President Obama and Vice President Biden held a hastily arranged secret meeting with Federal Reserve Chairman Janet Yellen. According to the one paragraph statement released by the White House following the meeting, Yellen, Obama, and Biden simply “exchanged notes” about the economy and the progress of financial reform. Because the meeting was held behind closed doors, the American people have no way of knowing what else the three might have discussed.

Yellen’s secret meeting at the White House followed an emergency secret Federal Reserve Board meeting. The Fed then held another secret meeting to discuss bank reform. These secret meetings come on the heels of the Federal Reserve Bank of Atlanta’s estimate that first quarter GDP growth was .01 percent, dangerously close to the official definition of recession.

Thus the real reason for all these secret meetings could be a panic that the Fed’s eight-year explosion of money creation has not just failed to revive the economy, but is about to cause another major market meltdown.

Establishment politicians and economists find the Fed’s failures puzzling. According to the Keynesian paradigm that still dominates the thinking of most policymakers, the Fed’s money creation should have produced such robust growth that today the Fed would be raising interest rates to prevent the economy from “overheating.”

The Fed’s response to its failures is to find new ways to pump money into the economy. Hence the Fed is actually considering implementing “negative interest rates.” Negative interest rates are a hidden tax on savings. Negative interest rates may create the short-term illusion of growth, but, by discouraging savings, they will cause tremendous long-term economic damage.

Even as Yellen admits that the Fed “has not taken negative interest rates off the table,” she and other Fed officials are still promising to raise rates this year. The Federal Reserve needs to promise future rate increases in order to stop nervous investors from fleeing US markets and challenging the dollar’s reserve currency status.

The Fed can only keep the wolves at bay with promises of future rate increases for so long before its polices cause a major dollar crisis. However, raising rates could also cause major economic problems. Higher interest rates will hurt the millions of Americans struggling with student loan, credit card, and other forms of debt. Already over 40 percent of Americans who owe student loan debt are defaulting on their payments. If Federal Reserve policies increase the burden of student loan debt, the number of defaults will dramatically increase leading to a bursting of the student loan bubble.

By increasing the federal government’s cost of borrowing, an interest rate increase will also make it harder for the federal government to manage its debt. Increased costs of debt financing will place increased burden on the American people and could be the last straw that finally pushes the federal government into a Greek-style financial crisis.

The no-win situation the Fed finds itself in is a sign that we are reaching the inevitable collapse of the fiat currency system. Unless immediate steps are taken to manage the transition, this collapse could usher in an economic catastrophe dwarfing the Great Depression. Therefore, those of us who know the truth must redouble our efforts to spread the ideas of liberty.

If we are successful, we may be able to force Congress to properly manage the transition by cutting spending in all areas and auditing, then ending, the Federal Reserve. We may also be able to ensure the current crisis ends not just the Fed but the entire welfare-warfare state.

Ron Paul, MD, is a former three-time Republican candidate for U. S. President and Congressman from Texas.

This article is reprinted with permission from the Ron Paul Institute for Peace and Prosperity.

Dumb and Dumber – From Negative Interest Rates to Helicopter Money – Article by Paul-Martin Foss

Dumb and Dumber – From Negative Interest Rates to Helicopter Money – Article by Paul-Martin Foss

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The New Renaissance Hat
Paul-Martin Foss
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We’ve all run into someone who thinks that all it take to bring about prosperity is to give everyone a million dollars. If everyone is a millionaire, we’ll all be rich and be able to afford anything we want, or so the thinking goes. Any sound economist knows that wouldn’t be the case, however. If everyone were given a million dollars the increased amount of money chasing the existing stock of goods would merely result in a massive rise in prices. No one would be better off, at least not once prices were once again equilibrated. The concept of giving everyone a million dollars is so absurd that no one takes it seriously. That is, they don’t take it seriously when a million dollars is the proposed amount. When the amount is smaller, all of a sudden it becomes a viable and increasingly-discussed policy proposal: helicopter money.

Ben Bernanke was derided for bringing up the possibility of helicopter money in 2002, although the idea dates back to Milton Friedman. What Bernanke did say was:

Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.

In fact, if you read that speech you will see Bernanke touting the effectiveness of policies which the Fed has since tried and failed at, as well some policies which the Fed has not yet tried and which we hope it never will.

As a decade of stimulus, quantitative easing, and zero or below-zero interest rates has now proven to be an absolute failure, helicopter money is once again being discussed as a potential central bank action, by central bankers who have no idea what to do and who are grasping at straws. The chief fixed income analyst at Nordea bank has publicly speculated that the European Central Bank (ECB) might be able to distribute 1,300 euros to each European citizen in a bid to boost inflation.

This bid to boost inflation makes the age-old error of confusing more money and higher prices with greater wealth. We know from our million-dollar example that that isn’t the case. So why try on a small scale what fails at the large scale? It is like the minimum wage debate, in which those who favor boosting minimum wages argue that it will result in workers being better-paid and more well-off. Yet we know that raising the minimum wage will result in some workers losing their jobs, as businesses cannot absorb all the increased costs and must dismiss their least-productive workers. The challenge to the proponents of minimum wages always is, if $15 an hour is so good, why not $15,000 an hour? Well, that’s because such a large increase would make abundantly clear what the minimum wage proponents are trying to hide. Minimum wages make some workers better off, but they do so by forcing other workers out of work, thus their wage falls to $0. In the same way, if the ECB could give 1,300 euros to each person, why not 1,300,000 euros? Because prices would rise in result and quickly negate any short-term benefit gained by the monetary increase. That type of hypothetical question exposes the farce of such handouts.

If helicopter money is implemented, those who first gain the use of the new money may benefit by increasing consumption before prices rise, while others will see prices rise before they are able or willing to use the money. But the end result will be higher prices but no overall increase in welfare. The economy will not see any sort of burst in productivity from a one-shot injection. So what will be proposed next? How about multiple injections of helicopter money over extended periods of time? That would seem to follow.

But again, anticipation and expectation of future injections would not lead to economic growth. It would only serve to further raise prices as new money enters the economy and transfers wealth to those who first use the new money from those who don’t. Economic growth comes not from more money or higher prices, but from savings and investment. No matter where in the economy central bank monetary injections enter, they cannot and will not result in real economic growth.

Zero interest rates didn’t do what central banks thought they would do, so they moved to quantitative easing. QE didn’t do what central banks thought it would do, so they moved or are moving to negative interest rates. Negative interest rates won’t work either so, assuming they don’t completely destroy the banking system beforehand, central banks may very well resort to helicopter money. Guess what, that won’t work either. How much more suffering will central banks have to impose on their countries before people realize that they are monetarily, morally, and intellectually bankrupt?

Paul-Martin Foss is the founder, President, and Executive Director of the Carl Menger Center for the Study of Money and Banking, a think tank dedicated to educating the American people on the importance of sound money and sound banking.

This article was published on Mises.org and may be freely distributed, subject to a Creative Commons Attribution United States License, which requires that credit be given to the author.

The Fed Passes the Buck: Blame Oil and China – Article by C. Jay Engel

The Fed Passes the Buck: Blame Oil and China – Article by C. Jay Engel

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The New Renaissance HatC. Jay Engel
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There are a handful of themes out there on recent market action that are either totally wrong or otherwise highly misleading. For instance, regarding the recent calamity in the capital markets, one especially apparent dichotomy has presented itself as offering two choices as to what, exactly, is causing the painful turbulence.

There are some who, in a complete echo of the news headlines, are quick to point the finger at both oil and China. And yet there are others who point the finger at the Fed for “raising rates too early.” Along with the second is the observation that “inflation is totally MIA” and therefore it was ludicrous that the Fed felt the need to “raise interest rates.” Both of these tend to express anguish over the “strong dollar.”

Both of these miss the entire point, and the cause of the current trouble. For one thing, it is ridiculous to blame oil for the falling markets when the falling oil is the very thing that needs to be explained. It is wholly unsatisfactory to explain something by describing it. It works well for headlines, and for shifting the blame away from where it really belongs, but one must learn to look deeper. One cannot expect to impress anyone by explaining that the plane is crashing to the ground because it is no longer flying. What is the cause of oil’s magnificent plummet toward the bottom? That is the true question.

Moreover, the problem with the “China thesis” is that it doesn’t explain anything either. It merely observes a correlation in the markets and therefore makes it highly convenient to put the blame on “the other guys.” Let me not be misunderstood here: the Chinese and US economies are certainly influenced by each other, especially in our age of fluctuating fiat currencies. But ultimately, both China and the US — indeed the entire world — are being dragged down by past actions of their respective central banks and more specifically the illusion of prosperity via monetary and credit expansion.

Which leads to the second theme: putting the blame on the Fed for “raising rates” too early. That is, there are a good many who argue that if the Fed had never announced in December that it was going to seek minuscule increases in the Federal Funds rate, none of the recent market drops would have happened. They will say things like “inflation was never a threat, so the Fed was irresponsible to raise rates.”

Money-Supply Inflation vs. Price “Inflation”
This is confused. First, it must be constantly emphasized that the meaning of inflation, contrary to the mainstream’s application of it, is more appropriately defined an increase in the money supply, not “rising prices.” The reason why the Fed and proponents of central banking prefer the “rising prices” definition is because it obscures the chief source of our present economic condition. It rips the blame away from the Fed and toward all kinds of other “market forces” and therefore encourages the central bank to swoop in to the rescue rather than be the object of severe suspicion. Indeed, as Mises observed (page 420 of Human Action):

What many people today call inflation or deflation is no longer the great increase or decrease in the supply of money, but its inexorable consequences, the general tendency toward a rise or a fall in commodity prices and wage rates. This innovation is by no means harmless. It plays an important role in fomenting the popular tendencies toward inflationism.

First of all there is no longer any term available to signify what inflation used to signify. It is impossible to fight a policy which you cannot name. …

The second mischief is that those engaged in futile and hopeless attempts to fight the inevitable consequences of inflation — the rise in prices — are disguising their endeavors as a fight against inflation. While merely fighting symptoms, they pretend to fight the root causes of the evil. Because they do not comprehend the causal relation between the increase in the quantity of money on the one hand and the rise in prices on the other, they practicalIy make things worse.

Rising prices can be a result of inflation, but it is not itself inflation. So then, inflation was actually very high in the last decade due to the Fed’s QE and other monetary policy schemes. Second, it should never be ignored that “rising prices” can easily be found in the capital markets themselves. It doesn’t take an investment guru to observe the staggering levels to which the various market indexes have reached. Digging only a little bit farther into the surface reveals the absurd prices for the so-called highest valued stock such as Facebook, Amazon, Apple, and so on.

Where All That Money Went
More importantly, however, is the fact that much of the newly created money has not even come close to creating “widespread [consumer price] inflation” due to the actual structure of the current, post-crises banking regime. In fact, Jeffrey Snider, among others, have argued that it is literally impossible for “price inflation” to take place as a direct result of QE due to the way that money currently enters the system as reserves. “Price inflation” would need to come from the actions of individual banks themselves who are at present cautious about their consumer lending practices. Therefore the Fed is not creating “price inflation,” but something far worse: capital misallocation.

The point here is simply that those who want the interest rates to be continually suppressed so that economic activity will be encouraged, don’t even realize that this is literally the cause of bubble creations, not productive economic activity.

It used to be, under the pre-crises fractional-reserve model, that there would be loads of malinvestment as a result of banks creating new loans (new economic activity would take place, and then collapse back down). But now, money is created, not by commercial banks, but mostly by the Fed itself. Which means that, in the phraseology of David Stockman, the new money is simply sloshing around the canyons of Wall Street and pushing up equity and bond prices, rather than reaching the “real economy.”

The Bubble Only Prolongs the Problem
Thus, contrary to those blaming the Fed for causing stocks to fall by “raising rates” (which Joe Salerno reflects on here) we want to stress the fact that, in raising rates, the most that the Fed could do is unravel previously made mistakes. In other words, there is nothing praiseworthy in the first place about artificially propped up stock market levels. We have no interest in lauding the longevity of the bubble, because the bubble is the enemy of the healthy economy. The collapsing equity markets reveal where bubbles were formed and that our alleged prosperity is an illusion. And this is precisely what former Dallas Fed Chairman Richard Fisher stated in a conversation on CNBC last week when he confessed: “We frontloaded a tremendous market rally to create a wealth effect.”

And thus, the money expansion must inevitably cycle back down. Fisher himself admits: “… and an uncomfortable digestive period is likely now.” What was inflated up to the top, must deflate down to the floor. That is the only way for an economy to recover: bad credit needs to be liquidated. Unfortunately, it is painful indeed.

That is the true cause of the recent calamity. The dollar is “strengthening” by virtue of our credit system cracking at the seams. In other words, the so-called “strong dollar,” is merely one side of the pendulum swing of a volatile collapsing banking system. It shouldn’t be assumed that the dollar is becoming more sound; it is not. But if we might ever again have a sound currency, we first have to face the music.

And thus oil too, after years of being elevated up toward the heavens via the Fed’s monetary shenanigans, is experiencing its own inevitable bust. The illusion is being exposed.

Unfortunately, the Fed is a wild card, so we stay tuned to whether it will let the markets recover, or continue the perpetual cycle of money creation. My own advice for the Fed is neither to “raise rates” nor to lower them. But rather, to let go and let the market correct itself. For we have a lot of correction ahead of us.

C. Jay Engel is an investment advisor at The Sullivan Group, an independent, Austrian-School oriented, wealth management firm in northern California. He is especially interested in wealth preservation in lieu of our era of rogue Central Banking. He is an avid reader of the Austro-libertarian literature and a dedicated proponent of private property and sound money. Feel free to email C. Jay, visit his blog, and follow him on Twitter.

This article was published on Mises.org and may be freely distributed, subject to a Creative Commons Attribution United States License, which requires that credit be given to the author.

How Money Disappears in a Fractional-Reserve Money System – Article by Frank Shostak

How Money Disappears in a Fractional-Reserve Money System – Article by Frank Shostak

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The New Renaissance Hat
Frank Shostak
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Most experts are of the view that the massive monetary pumping by the US central bank during the 2008 financial crisis saved the US and the world from another Great Depression. On this the Federal Reserve Chairman at the time Ben Bernanke is considered the man that saved the world. Bernanke in turn attributes his actions to the writings of Professor Milton Friedman who blamed the Federal Reserve for causing the Great Depression of 1930s by allowing the money supply to plunge by over 30 percent.

Careful analysis will however show that it is not a collapse in the money stock that sets in motion an economic slump as such, but rather the prior monetary pumping that undermines the pool of real funding that leads to an economic depression.

Improving the Economy Requires Time and Savings
Essentially, the pool of real funding is the quantity of consumer goods available in an economy to support future production. In the simplest of terms: a lone man on an island is able to pick twenty-five apples an hour. With the aid of a picking tool, he is able to raise his output to fifty apples an hour. Making the tool, (adding a stage of production) however, takes time.

During the time he is busy making the tool, the man will not be able to pick any apples. In order to have the tool, therefore, the man must first have enough apples to sustain himself while he is busy making it. His pool of funding is his means of sustenance for this period—the quantity of apples he has saved for this purpose.

The size of this pool determines whether or not a more sophisticated means of production can be introduced. If it requires one year of work for the man to build this tool, but he has only enough apples saved to sustain him for one month, then the tool will not be built—and the man will not be able to increase his productivity.

The island scenario is complicated by the introduction of multiple individuals who trade with each other and use money. The essence, however, remains the same: the size of the pool of funding sets a brake on the implementation of more productive stages of production.

When Banks Create the Illusion of More Wealth
Trouble erupts whenever the banking system makes it appear that the pool of real funding is larger than it is in reality. When a central bank expands the money stock, it does not enlarge the pool of funding. It gives rise to the consumption of goods, which is not preceded by production. It leads to less means of sustenance.

As long as the pool of real funding continues to expand, loose monetary policies give the impression that economic activity is being boosted. That this is not the case becomes apparent as soon as the pool of real funding begins to stagnate or shrink. Once this happens, the economy begins its downward plunge. The most aggressive loosening of money will not reverse the plunge (for money cannot replace apples).

The introduction of money and lending to our analysis will not alter the fact that the subject matter remains the pool of the means of sustenance. When an individual lends money, what he in fact lends to borrowers is the goods he has not consumed (money is a claim on real goods). Credit then means that unconsumed goods are loaned by one productive individual to another, to be repaid out of future production.

The existence of the central bank and fractional reserve banking permits commercial banks to generate credit, which is not backed up by real funding (i.e., it is credit created out of “thin air”).

Once the unbacked credit is generated it creates activities that the free market would never approve. That is, these activities are consuming and not producing real wealth. As long as the pool of real funding is expanding and banks are eager to expand credit, various false activities continue to prosper.

Whenever the extensive creation of credit out of “thin air” lifts the pace of real-wealth consumption above the pace of real-wealth production this undermines the pool of real funding.

Consequently, the performance of various activities starts to deteriorate and banks’ bad loans start to rise. In response to this, banks curtail their loans and this in turn sets in motion a decline in the money stock.

Does every curtailment of lending cause the decline in the money stock?

For instance, Tom places $1,000 in a savings deposit for three months with Bank X. The bank in turn lends the $1,000 to Mark for three months. On the maturity date, Mark repays the bank $1,000 plus interest. Bank X in turn after deducting its fees returns the original money plus interest to Tom.

So what we have here is that Tom lends (i.e., gives up for three months) $1,000. He transfers the $1,000 through the mediation of Bank X to Mark. On the maturity date Mark repays the money to Bank X. Bank X in turn transfers the $1,000 to Tom. Observe that in this case existent money is moved from Tom to Mark and then back to Tom via the mediation of Bank X. The lending is fully backed here by $1,000. Obviously the $1,000 here doesn’t disappear once the loan is repaid to the bank and in turn to Tom.

Why the Money Supply Shrinks
Things are, however, completely different when Bank X lends money out of thin air. How does this work? For instance, Tom exercises his demand for money by holding some of his money in his pocket and the $1,000 he keeps in the Bank X demand deposit. By placing $1,000 in the demand deposit he maintains total claim on the $1,000. Now, Bank X helps itself and takes $100 from Tom’s deposit and lends this $100 to Mark. As a result of this lending we now have $1,100 which is backed by $1,000 proper. In short, the money stock has increased by $100. Observe that the $100 loaned doesn’t have an original lender as it was generated out of “thin air” by Bank X. On the maturity date, once Mark repays the borrowed $100 to Bank X, the money disappears.

Obviously if the bank is continuously renewing its lending out of thin air then the stock of money will not fall. Observe that only credit that is not backed by money proper can disappear into thin air, which in turn causes the shrinkage in the stock of money.

In other words, the existence of fractional reserve banking (banks creating several claims on a given dollar) is the key instrument as far as money disappearance is concerned. However, it is not the cause of the disappearance of money as such.

Banks Lend Less as the Quality of Borrowers Worsens
There must be a reason why banks don’t renew lending out of thin air. The main reason is the severe erosion of real wealth that makes it much harder to find good quality borrowers. This in turn means that monetary deflation is on account of prior inflation that has diluted the pool of real funding.

It follows then that a fall in the money stock is just a symptom. The fall in the money stock reveals the damage caused by monetary inflation but it however has nothing to do with the damage.

Contrary to Friedman and his followers (including Bernanke), it is not the fall in the money supply and the consequent fall in prices that burdens borrowers. It is the fact that there is less real wealth. The fall in the money supply, which was created out of “thin air,” puts things in proper perspective. Additionally, as a result of the fall in money, various activities that sprang up on the back of the previously expanding money now find it hard going.

It is those non-wealth generating activities that end up having the most difficulties in serving their debt since these activities were never generating any real wealth and were really supported or funded, so to speak, by genuine wealth generators. (Money out of “thin air” sets in motion an exchange of nothing for something — the transferring of real wealth from wealth generators to various false activities.) With the fall in money out of thin air their support is cut-off.

Contrary to the popular view then, a fall in the money supply (i.e., money out of “thin air”), is precisely what is needed to set in motion the build-up of real wealth and a revitalizing of the economy.

Printing money only inflicts more damage and therefore should never be considered as a means to help the economy. Also, even if the central bank were to be successful in preventing a fall in the money supply, this would not be able to prevent an economic slump if the pool of real funding is falling.

Frank Shostak is an Associated Scholar of the Mises Institute. His consulting firm, Applied Austrian School Economics, provides in-depth assessments and reports of financial markets and global economies. He received his bachelor’s degree from Hebrew University, master’s degree from Witwatersrand University and PhD from Rands Afrikaanse University, and has taught at the University of Pretoria and the Graduate Business School at Witwatersrand University.

This article was originally published by the Ludwig von Mises Institute. Permission to reprint in whole or in part is hereby granted, provided full credit is given.

The Fed Desperately Tries to Maintain the Status Quo – Article by Ronald-Peter Stöferle

The Fed Desperately Tries to Maintain the Status Quo – Article by Ronald-Peter Stöferle

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The New Renaissance HatRonald-Peter Stöferle
November 5, 2015
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During the press conferences of recent FOMC meetings, millions of well-educated investment professionals have been sitting in front of their screens, chewing their fingernails, listening as if spellbound to what Janet Yellen has to tell them. Will she finally raise the federal funds rate that has been zero bound for over six years?

Obviously, each decision is accompanied by nervousness on the markets. Investors are fixated by a fidgety curiosity ahead of each Fed decision and never fail to meticulously observe Janet Yellen and the FOMC, and engage in monetary ornithology on doves (growth- and employment-oriented FOMC members) and hawks (inflation-oriented FOMC members).

Fed watchers also hope for some enlightening information from Ben Bernanke. According to Reuters, some market participants paid some $250,000 just to join one of several dinners, where the ex-chairman spilled the beans. Apparently, he does not expect the federal funds rate to return to its long-term average of about 4 percent during his lifetime.

In a conversation with Jim Rickards, Bernanke stated that a rate hike would only be possible in an environment in which “the U.S. economy is growing strongly enough to bear the costs of higher rates.” Moreover, a rate increase would have to be clearly communicated and anticipated by the markets — not to protect individual investors from losses, Bernanke assures us, but rather to prevent jeopardizing the stability of the “system as a whole.”

It is axiomatic that zero-interest-rate-policy (ZIRP) cannot be a permanent fixture. Indeed, Janet Yellen has been going on about increasing rates for almost two years now. But, how much more lead time will it require to “prepare” the markets? In both September and October the FOMC chickened out, even though we are not talking about hiking the rate back to “monetary normalcy” in one blow. The decision on the table is whether or not to increase the rate by a trifling quarter point!

The Fed’s quandary can be understood a little better by examining what “monetary normalcy,” or a “normal interest rate,” is supposed to be. Or, even more fundamentally: what is an interest rate?

We “Austrians” understand an interest rate as an expression of market participants’ time preference. The underlying assumption is that people are inclined to consume a certain product sooner rather than later. Hence, if savers restrict their current consumption and provide the resources for investment instead, they do so only on condition that they will be compensated by increased opportunities for consumption in the future. In free markets, the interest rate can be regarded as a measure of the compensation payment, where people are willing to trade present goods for future goods. Such an interest rate is commonly referred to as the “natural interest rate.” Consequently, the FOMC bureaucrats would ideally set as a goal a “normal interest rate” that equals the “natural” one.This, however, remains unlikely.

Six Years of “Unconventional” Monetary Policy
ZIRP was introduced six years ago in response to the financial crisis, and three QE programs have been conducted. This so-called “unconventional monetary policy” is supposed to be abandoned as soon as the economy has gathered pace. Despite the tremendous magnitude of these market interventions, the momentum in the US economy is rather lame. Weak Q1 data, which probably resulted from a weak trade balance due to a 15 percent rise of the US dollar, shocked even the most pessimistic of analysts; the OECD and the IMF have revised down their 2015 growth estimates. A long-lasting, self-sustaining growth is out of the question. This confirms the assumption that ZIRP fuels everything under the sun — see “The Unseen Consequences of Zero-Interest-Rate Policy” — except long-term productive investment.And what about unemployment and inflation that are key elements of the Fed’s mandate? The conventional unemployment rate (U3) has returned to its long-run normal level, so the view prevails that things are developing well. However, those figures conceal a workforce participation rate that has fallen by more than 3 percent since 2008, indicating that some 2.5 million Americans are currently no longer actively looking for a new job. However, should the economic situation improve, they would likely rejoin the labor force. Furthermore, the proportion of those only working part-time due to a lack of full-time positions is much higher now than before the crisis. “True” unemployment currently stands rather at about 7.25 percent.

A Weak Economy and Weak Inflation
With regard to inflation, the Fed’s target is 2 percent, as measured by growth of the PCE-index. This aims to buffer the fiat money system against the threat of price deflation. In a deflationary environment, it is believed, the debt-servicing capacity of market participants (e.g., governments, private enterprises, financial institutions, and private households) would come under intense pressure and likely trigger a chain reaction in which loans collapse and the monetary system implodes.

In many countries, and among them the US, inflation is remarkably low — partly due to transitory effects of lower energy and import prices — while low interest rates have merely weaved their way to asset price inflation so far. But, as price reactions to monetary policy maneuvers may occur with a lag of a few years, we should expect that sooner or later inflation will also spill over to normal markets.

As a response to anything short of massive improvement of economic and employment data, a rate hike is scarcely likely, and inflation in the short-term is also unlikely. Moreover, the current composition of the FOMC — which is extremely dovish — implies inflation-sensitive voices are relatively underrepresented. This gives rise to the suspicion that rate hikes are not very likely at all in the scenario in the short-term.

What Will the Fed Do If There’s Real Economic Trouble?
One is concerned about economic development, which has a shaky foundation and headwinds from other parts of the world; it appears that growth has cooled down substantially in the BRICS countries. Meanwhile, China might be on the brink of a severe recession. (Indeed, China was possibly the most decisive factor to nudge the Fed away from raising rates in September and October.) This implies that world-wide interest rates will remain at very low levels and a significant rate hike in the US would represent a sharp deviation in this environment, bringing with it massive competitive disadvantages.

The markets are noticeably pricing out a significant rate hike. The production structure has long since adapted to ZIRP and “short-term gambling, punting on momentum-driven moves, on levered buybacks” are further lifting the opportunity costs of abandoning it. In order to try to rescue its credibility, the Fed may decide to try some timid, quarter-point increases.

But what will they do if markets really crash? Indeed, they are terrified of the avalanche that they might trigger. If there are any symptoms that portend calamity, the Fed will inevitably return to ZIRP, launch a QE4, or might even introduce negative interest rates. Hence, there does not seem to be a considerable degree of latitude such that a return to conventional monetary policy could seriously be expected.

“The Fed is raising rates!” — This has become a running gag.

Ronald-Peter Stöferle is a Chartered Market Technician (CMT) and a Certified Financial Technician (CFTe). During his studies in business administration and finance at the Vienna University of Economics and the University of Illinois at Urbana-Champaign, he worked for Raiffeisen Zentralbank (RZB) in the field of Fixed Income/Credit Investments. In 2006 he began writing reports on gold. His six benchmark reports called “In GOLD we TRUST” drew international coverage on CNBC, Bloomberg, the Wall Street Journal, The Economist and the Financial Times. He was awarded “2nd most accurate gold analyst” by Bloomberg in 2011.

This article was originally published by the Ludwig von Mises Institute. Permission to reprint in whole or in part is hereby granted, provided full credit is given.

Today’s War Against Deflation Will Make Us Poorer – Article by Frank Shostak

Today’s War Against Deflation Will Make Us Poorer – Article by Frank Shostak

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The New Renaissance HatFrank Shostak
October 29, 2015
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The yearly growth rate of the US consumer price index (CPI) fell to 0 percent in September 2015, from 0.2 percent in August and, 1.7 percent in September last year.

The yearly growth rate of the European Monetary Union CPI fell to minus 0.1 percent in September from 0.1 percent in the previous month and 0.3 percent in September last year.
Shostak 1 102915_0
Also, the growth momentum of the UK CPI fell into the negative in September with the yearly growth rate closing at minus 0.1 percent from 0 percent in August and 1.2 percent in September last year.

The growth momentum of China’s CPI eased in September with the yearly growth rate falling to 1.6 percent from 2 percent in August.

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Deflation Fears Gain Steam
Consequently, many experts are expressing concern regarding the declining growth momentum of the CPI and are of the view that rather than tightening the monetary stance, central banks should loosen their stance further in order to counter the emergence of deflation, which is regarded as a major threat to economic well-being of individuals. For most experts, deflation is bad news since it generates expectations of a decline in prices. As a result, they believe, consumers are likely to postpone their buying of goods at present since they expect to buy these goods at lower prices in the future. This weakens the overall flow of spending and in turn weakens the economy. Hence, such commentators believe that policies that counter deflation will also counter the slump.
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Will Reversing Deflation Prevent a Slump?

If deflation leads to an economic slump, then policies that reverse deflation should be good for the economy, so it is held.

Reversing deflation will simply involve introducing policies that support general increases in the prices of goods, i.e., price inflation. With this way of thinking inflation could actually be an agent of economic growth.

According to most experts, a little bit of inflation can actually be a good thing. Mainstream economists believe that inflation of 2 percent is not harmful to economic growth, but that inflation of 10 percent could be bad for the economy.

There’s good reason to believe, however, that at a rate of inflation of 10 percent, it is likely that consumers are going to form rising inflation expectations.

According to popular thinking, in response to a high rate of inflation, consumers will speed up their expenditures on goods at present, which should boost economic growth. So why then is a rate of inflation of 10 percent or higher regarded by experts as a bad thing?

Clearly there is a problem with the popular way of thinking.

Price Inflation vs. Money-Supply Inflation
Inflation is not about general increases in prices as such, but about the increase in the money supply. As a rule the increase in the money supply sets in motion general increases in prices. This, however, need not always be the case.

The price of a good is the amount of money asked per unit of it. For a constant amount of money and an expanding quantity of goods, prices will actually fall.

Prices will also fall when the rate of increase in the supply of goods exceeds the rate of increase in the money supply.

For instance, if the money supply increases by 5 percent and the quantity of goods increases by 10 percent, prices will fall by 5 percent.

A fall in prices cannot conceal the fact that we have inflation of 5 percent here on account of the increase in the money supply.

The Problem Is Really Wealth Formation, not Rising Prices
The reason why inflation is bad news is not because of increases in prices as such, but because of the damage inflation inflicts to the wealth-formation process. Here is why:

The chief role of money is the medium of exchange. Money enables us to exchange something we have for something we want.

Before an exchange can take place, an individual must have something useful that he can exchange for money. Once he secures the money, he can then exchange it for the good he wants.

But now consider a situation in which the money is created “out of thin air,” increasing the money supply.

This new money is no different from counterfeit money. The counterfeiter exchanges the printed money for goods without producing anything useful.

He in fact exchanges nothing for something. He takes from the pool of real goods without making any contribution to the pool.

The economic effect of money that was created out of thin air is exactly the same as that of counterfeit money — it impoverishes wealth generators.

The money created out of thin air diverts real wealth toward the holders of new money. This weakens the wealth generators’ ability to generate wealth and this in turn leads to a weakening in economic growth.

Note that as a result of the increase in the money supply what we have here is more money per unit of goods, and thus, higher prices.

What matters however is not that price rises, but the increase in the money supply that sets in motion the exchange of nothing for something, or “the counterfeit effect.”

The exchange of nothing for something, as we have seen, weakens the process of real wealth formation. Therefore, anything that promotes increases in the money supply can only make things much worse.

Why Falling Prices Are Good
Since changes in prices are just a symptom, as it were — and not the primary causative factor — obviously countering a falling growth momentum of the CPI by means of loose a monetary policy (i.e., by creating inflation) is bad news for the process of wealth generation, and hence for the economy.

In order to maintain their lives and well-being, individuals must buy goods and services in the present. So from this perspective a fall in prices cannot be bad for the economy.

Furthermore, if a fall in the growth momentum of prices emerges on the back of the collapse of bubble activities in response to a softer monetary growth then this should be seen as good news. The less non-productive bubble activities that are around the better it is for the wealth generators and hence for the overall pool of real wealth.

Likewise, if a fall in the growth momentum of the CPI emerges on account of the expansion in real wealth for a given stock of money, this is obviously great news since many more people could now benefit from the expanding pool of real wealth.

We can thus conclude that contrary to the popular view, a fall in the growth momentum of prices is always good news for the wealth generating process and hence for the economy.

Frank Shostak is an Associated Scholar of the Mises Institute. His consulting firm, Applied Austrian School Economics, provides in-depth assessments and reports of financial markets and global economies. He received his bachelor’s degree from Hebrew University, master’s degree from Witwatersrand University and PhD from Rands Afrikaanse University, and has taught at the University of Pretoria and the Graduate Business School at Witwatersrand University.

This article was originally published by the Ludwig von Mises Institute. Permission to reprint in whole or in part is hereby granted, provided full credit is given.

The Fed Can’t Raise Rates, But Must Pretend It Will – Article by Thorsten Polleit

The Fed Can’t Raise Rates, But Must Pretend It Will – Article by Thorsten Polleit

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The New Renaissance HatThorsten Polleit
October 26, 2015
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Waiting for Godot is a play written by the Irish novelist Samuel B. Beckett in the late 1940s in which two characters, Vladimir and Estragon, keep waiting endlessly and in vain for the coming of someone named Godot. The storyline bears some resemblance to the Federal Reserve’s talk about raising interest rates.

Since spring 2013, the Fed has been playing with the idea of raising rates, which it had suppressed to basically zero percent in December 2008. So far, however, it has not taken any action. Upon closer inspection, the reason is obvious. With its policy of extremely low interest rates, the Fed is fueling an artificial economic expansion and inflating asset prices.

Selected US Interest Rates in Percent
Selected US Interest Rates in Percent

Raising short-term rates would be like taking away the punch bowl just as the party gets going. As rates rise, the economy’s production and employment structure couldn’t be upheld. Neither could inflated bond, equity, and housing prices. If the economy slows down, let alone falls back into recession, the Fed’s fiat money pipe dream would run into serious trouble.

This is the reason why the Fed would like to keep rates at the current suppressed levels. A delicate obstacle to such a policy remains, though: If savers and investors expect that interest rates will remain at rock bottom forever, they would presumably turn their backs on the credit market. The ensuing decline in the supply of credit would spell trouble for the fiat money system.

To prevent this from happening, the Fed must achieve two things. First, it needs to uphold the expectation in financial markets that current low interest rates will be increased again at some point in the future. If savers and investors buy this story, they will hold onto their bank deposits, money market funds, bonds, and other fixed income products despite minuscule yields.

Second, the Fed must succeed in continuing to postpone rate hikes into the future without breaking peoples’ expectation that rates will rise at some point. It has to send out the message that rates will be increased at, say, the forthcoming FOMC meeting. But, as the meeting approaches, the Fed would have to repeat its trickery, pushing the possible date for a rate hike still further out.

If the Fed gets away with this “Waiting for Godot” strategy, savings will keep flowing into credit markets. Borrowers can refinance their maturing debt with new loans and also increase total borrowing at suppressed interest rates. The economy’s debt load can continue to build up, with the day of reckoning being postponed for yet again.

However, there is the famous saying: “You can fool all the people some of the time and some of the people all the time, but you cannot fool all the people all the time.” What if savers and investors eventually become aware that the Fed will not bring interest rates back to “normal” but keep them at basically zero, or even push them into negative territory?

If a rush for the credit market exit would set in, it would be upon the Fed to fill debtors’ funding gap in order to prevent the fiat system from collapsing. The central bank would have to monetize outstanding and newly originated debt on a grand scale, sending downward the purchasing power of the US dollar — and with it many other fiat currencies around the world.

The “Waiting for Godot” strategy does not rule out that the Fed might, at some stage, nudge upward short-term borrowing costs. However, any rate action should be minor and rather short-lived (like they were in Japan), and it wouldn’t bring interest rates back to “normal.” The underlying logic of the fiat money system simply wouldn’t admit it.

Selected Japanese Interest Rates in Percent
Selected Japanese Interest Rates in Percent

The Fed — and basically all central banks around the world — are unlikely to accept deflation clearing out the debt, which would topple the economic and political structures built upon it. Fending off an approaching recession-depression with more credit-created fiat money and extremely low, perhaps even negative, interest rates is what one can expect them to do.

Murray N. Rothbard put it succinctly: “We can look forward … not precisely to a 1929-type depression, but to an inflationary depression of massive proportions.”

Dr. Thorsten Polleit is the Chief Economist of Degussa (www.degussa-goldhandel.de) and Honorary Professor at the University of Bayreuth. He is the winner of the O.P. Alford III Prize in Political Economy and has been published in the Austrian Journal of Economics. His personal website is www.thorsten-polleit.com.

This article was published on Mises.org and may be freely distributed, subject to a Creative Commons Attribution United States License, which requires that credit be given to the author.

Keeping the Bubble-Boom Going – Article by Thorsten Polleit

Keeping the Bubble-Boom Going – Article by Thorsten Polleit

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The New Renaissance HatThorsten Polleit
August 19, 2015

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The US Federal Reserve is playing with the idea of raising interest rates, possibly as early as September this year. After a six-year period of virtually zero interest rates, a ramping up of borrowing costs will certainly have tremendous consequences. It will be like taking away the punch bowl on which all the party fun rests.

Low Central Bank Rates have been Fueling Asset Price Inflation

The current situation has, of course, a history to it. Around the middle of the 1990s, the Fed’s easy monetary policy — that of Chairman Alan Greenspan — ushered in the “New Economy” boom. Generous credit and money expansion resulted in a pumping up of asset prices, in particular stock prices and their valuations.

US Federal Funds Rate in Percent and the S&P 500 Stock Market Index

A Brief History of Low Interest Rates

When this boom-bubble burst, the Fed slashed rates from 6.5 percent in January 2001 to 1 percent in June 2003. It held borrowing costs at this level until June 2004. This easy Fed policy not only halted the slowdown in bank credit and money expansion, it sowed the seeds for an unprecedented credit boom which took off as early as the middle of 2002.

When the Fed had put on the brakes by having pushed rates back up to 5.25 percent in June 2006, the credit boom was pretty much doomed. The ensuing bust grew into the most severe financial and economic meltdown seen since the late 1920s and early 1930s. It affected not only in the US, but the world economy on a grand scale.

Thanks to Austrian-school insights, we can know the real source of all this trouble. The root cause is central banks’ producing fake money out of thin air. This induces, and necessarily so, a recurrence of boom and bust, bringing great misery for many people and businesses and eventually ruining the monetary and economic system.

Central banks — in cooperation with commercial banks — create additional money through credit expansion, thereby artificially lowering the market interest rates to below the level that would prevail if there was no credit and money expansion “out of thin air.”

Such a boom will end in a bust if and when credit and money expansion dries up and interest rates go up. In For A New Liberty (1973), Murray N. Rothbard put this insight succinctly:

Like the repeated doping of a horse, the boom is kept on its way and ahead of its inevitable comeuppance by repeated and accelerating doses of the stimulant of bank credit. It is only when bank credit expansion must finally stop or sharply slow down, either because the banks are getting shaky or because the public is getting restive at the continuing inflation, that retribution finally catches up with the boom. As soon as credit expansion stops, the piper must be paid, and the inevitable readjustments must liquidate the unsound over-investments of the boom and redirect the economy more toward consumer goods production. And, of course, the longer the boom is kept going, the greater the malinvestments that must be liquidated, and the more harrowing the readjustments that must be made.

To keep the credit-induced boom going, more credit and more money, provided at ever lower interest rates, are required. Somehow central bankers around the world seem to know this economic insight, as their policies have been desperately trying to encourage additional bank lending and money creation.

Why Raise Rates Now?

Why, then, do the decision makers at the Fed want to increase rates? Perhaps some think that a policy of de facto zero rates is no longer warranted, as the US economy is showing signs of returning to positive and sustainable growth, which the official statistics seem to suggest.

Others might fear that credit market investors will jump ship once they convince themselves that US interest rates will stay at rock bottom forever. Such an expectation could deal a heavy, if not deadly, blow to credit markets, making the unbacked paper money system come crashing down.

In any case, if Fed members follow up their words with deeds, they might soon learn that the ghosts they have been calling will indeed appear — and possibly won’t go away. For instance, higher US rates will suck in capital from around the word, pulling the rug out from under many emerging and developed markets.

What is more, credit and liquidity conditions around the world will tighten, giving credit-hungry governments, corporate banks, and consumers a painful awakening after having been surfing the wave of easy credit for quite some time.

China, which devalued the renminbi exchange rate against the US dollar by a total of 3.5 percent on August 11 and 12, seems to have sent the message that it doesn’t want to follow the Fed’s policy — and has by its devaluation made the Fed’s hiking plan appear as an extravagant undertaking.

A normalization of interest rates, after years of excessively low interest rates, is not possible without a likely crash in production and employment. If the Fed goes ahead with its plan to raise rates, times will get tough in the world’s economic and financial system.

To be on the safe side: It would be the right thing to do. The sooner the artificial boom comes to an end, the sooner the recession-depression sets in, which is the inevitable process of adjusting the economy and allowing an economically sound recovery to begin.

Dr. Thorsten Polleit is the Chief Economist of Degussa (www.degussa-goldhandel.de) and Honorary Professor at the University of Bayreuth. He is the winner of the O.P. Alford III Prize in Political Economy and has been published in the Austrian Journal of Economics. His personal website is www.thorsten-polleit.com.

This article was published on Mises.org and may be freely distributed, subject to a Creative Commons Attribution United States License, which requires that credit be given to the author.