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The Fed and the “Salvador Dali Effect” – Article by Dante Bayona

The Fed and the “Salvador Dali Effect” – Article by Dante Bayona

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Dante Bayona
November 28, 2014
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There is a story about the great Catalan surrealist painter Salvador Dali. It is said that in the last years of his life, when he was already famous, he signed checks knowing that they would not be submitted to the bank for payment. Rather, after partying with his friends and consuming the most expensive items the restaurants had to offer, he would ask for the bill, pull out one of his checks, write the amount, and sign it. Before handing over the check, he quickly turned it around, made a drawing on the back and autographed it. Dali knew the owner of the restaurant would not cash the check but keep it,put it in a frame, and display it in the most prominent place in the restaurant: “An original Dali.”

It was a good deal for Dali: his checks never came back to the bank to be cashed, and he still enjoyed great banquets with all of his friends. Dali had a magic checkbook.

But what would have happened if one day art collectors concluded that Dali’s work really did not capture the essence of surrealism, and therefore that his art was not of great value? If that had happened, every autographed check would have come back to the bank (at least in theory), and Dali would have had to pay up. If Dali had not saved enough money, he would have had to find a job painting houses.

While the analogy is not perfect, we may find that something similar can happen with the Fed and the dollar. For now, The Fed has a magic checkbook that allows it to spend without paying the bill because it thinks the checks will never come back to be cashed.

Dali died long before people stopped valuing his art, but the US economy does not enjoy such a convenient escape. What if, as in the case of art collectors who might no longer see great value in Dali’s work, the world loses faith in the quality of the dollar and stops using it for large international transactions? If that happens, in the same way Dali would have had to pay his bills, the US would also have to make good on the checks it signed. Would the US be able to pay its checks with more checks?

Since each country has its own currency, every central bank around the world has to print more of its national currency to buy the excess of dollars entering the country whenever the US expands its money supply. Thus, in the 1970s, in the wake of the Nixon Shock, members of OPEC accused the US of exporting inflation.

Recall that during the mid-1960s, the US central bank was financing a war in Vietnam and as well as funding Lyndon B. Johnson’s programs of “The Great Society”that supposedly would eliminate poverty. As the Fed was printing money, OPEC members had to inflate their currencies to buy the excess of dollars.

Central banks around the world have to buy excess of dollars entering their countries so their exports do not lose competitiveness. Thus, a double inflation is imposed on every country in the world, one created by its own domestic central bank, because all central banks inflate on their own, and another created by the US central bank. Hans-Hermann Hoppe wrote about the perils of monetary imperialism:

The dominating state will use its superior power to enforce a policy of internationally coordinated inflation. Its own central bank sets the pace in the process of counterfeiting, and the central banks of the dominated states are ordered to use its currency as their own reserves and inflate on top of them. Thus, along with the dominating state and as the earliest receivers of the counterfeit reserve currency, its associated banking and business establishment can engage in an almost costless expropriation of foreign property owners and income producers. A double layer of exploitation of a foreign state and a foreign elite on top of a national state and elite is imposed on the exploited class in the dominated territories, causing prolonged economic dependency on and relative economic stagnation in comparison with the dominant nation. It is this — very uncapitalist — situation that characterizes the status of the United States and the US dollar and that gives rise to the — correct — accusations concerning US economic exploitation and dollar imperialism. 1

While it is true that in the 1970s the dollar enjoyed a worldwide hegemony — given that all European countries had their currencies separated, and given that China and Russia were outside the capitalist world — now the situation is different. Vladimir Putin recently stated that “The international monetary system itself depends a lot on the U.S. dollar, or, to be precise, on the monetary and financial policy of the U.S. authorities. The BRICS countries (Brazil, Russia, India, China and South Africa) want to change this.” 2

Salvador Dali had devised an ingenious method for not paying his bills. Similar stories are told about Pablo Picasso. But the Fed does not produce tangible items that people would rather hold on to, like an original Salvador Dali. The Fed does not produce work or items of value. The Salvador Dali effect, i.e., the ability to prevent checks from being cashed by creating something of real value, does not apply to the Fed. That is why it is good to remind the Fed, and the government, to be careful with the expenditures when partying, just in case the magic checkbook disappears.

  • 1. See Hans-Hermann Hoppe, “Marxist and Austrian Class Analysis.” Journal of Libertarian Studies 9, no. 2 (Fall 1990). www.mises.org/journals/jls/9_2/9_2_5.pdf
  • 2. See Vladimir “Putin, No plans for BRICS military, political alliance.” Russia: RT. Retrieved 16 July 2014. www.rt.com/politics/official-word/172768-putin-brics-economies-alliance

Dante Bayona received his master’s degree in Austrian economics under the direction of Jesús Huerta de Soto in Spain. He was a 2014 Summer Fellow at the Mises Institute, works in the banking sector in New York, and collaborates with MisesHispano.org.

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 End of Quantitative Easing Is Not the End of Bad Policy – Article by John P. Cochran

The End of Quantitative Easing Is Not the End of Bad Policy – Article by John P. Cochran

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John P. Cochran
November 7, 2014
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Recently the financial press and media has been abuzz as the Federal Reserve moved closer to the anticipated end to its massive bond and mortgage backed securities purchases known as quantitative easing. James Bullard, President of the St. Louis Federal Reserve Bank, stirred controversy last week when he suggested the Fed should consider continuing the bond buying program after October. But at the October 29th meeting, the policy makers did as anticipated and “agreed to end its asset purchase program.” However one voting member agreed with Mr. Bullard. Per the official press release, “Voting against the action was Narayana Kocherlakota, who believed that, in light of continued sluggishness in the inflation outlook and the recent slide in market-based measures of longer-term inflation expectations, the Committee should commit to keeping the current target range for the federal funds rate at least until the one-to-two-year ahead inflation outlook has returned to 2 percent and should continue the asset purchase program at its current level” (emphasis added).

The action yesterday completes the phase out, which began in January 2014, of the controversial QE3 under the leadership of Ben Bernanke and continued unabated under Janet Yellen.

“Not the End of Monetary Easing”

While the headline in the Wall Street Journal highlighted the action as closing a “chapter on easy money,” a closer look illustrates this is perhaps not the case. The Journal, on the editorial page the same day offers a better perspective, supported by data and the rhetoric in the press release. Much to the determent of future economic prosperity, “The end of Fed bond buying is not the end of monetary easing.”

While quantitative easing has contributed to the massive expansion of the Fed balance sheet — now nearly $4.5 trillion in assets — it is not the whole story. Even as the Fed ends new buying of favored assets, the Fed balance sheet will not shrink. As pointed out by the Wall Street Journal, “QE is not over, and the Fed will still reinvest the principal payments from its maturing securities.” Even more relevant, during the phase out there was a continuing expansion of three broad measures of Fed activity; St. Louis Fed adjusted reserves (Figure 1), the monetary base (Figure 2), and Federal Reserve Banks — Total Assets, Eliminations from Consolidation program (Figure 3). (All data from FRED economic data series St. Louis Federal Reserve. Calculations are mine.)

Figure 1: St. Louis Fed Adjusted Reserves

Figure 2: The Monetary Base

Figure 3: Federal Reserve Banks — Total Assets, Eliminations from Consolidation

The Fed’s Balance Sheet Continues to Expand

Despite some ups and downs, adjusted reserves increased 15.8 percent from January 2014 through September 2014, the monetary base by 8.6 percent, and consolidated assets by 10.7 percent. Given QE purchases were $85 billion per month at their peak, this continuing expansion of the Fed balance sheet and the other relevant monetary aggregates, the phase out and end of quantitative easing represents not a change in policy stance, but only a shift in tools. Monetary distortion has continued unabated. The only plus in the change is that more traditional tools of monetary manipulation create only the traditional market distortions; Cantillon effects, false relative prices, particularly interest rates, and the associated misdirection of production and malinvestments. Temporarily gone is the more dangerous Mondustrial Policy where the central bankers further distort credit allocation by picking winners and losers.

As illustrated by the Fed speak in the press release, post QE3-forward policy will, despite John Taylor’s optimism that this would not be the case, continued to be biased against a return to a more balanced, less potentially self-defeating rules-based policy. Instead driven by the Fed’s unwise dual mandate and the strong belief by Fed leadership in Tobin Keynesianism, policy will continue to “foster maximum employment.” This despite strong theoretical arguments (Austrian business cycle theory and the more mainstream natural unemployment rate hypothesis)[1] and good empirical evidence that any short-run positive impact monetary policy may have on employment and production is temporary and in the long run, per Hayek, cause greater instability and potentially even higher unemployment.

The Lasting Legacy of QE

As pointed out by David Howden in “QE’s Seeds Are Already Sown,” and as emphasized by Hayek (in Unemployment and Monetary Policy: Government as Generator of the “Business Cycle”), and recently formalized by Ravier (in “Rethinking Capital-Based Macroeconomics”), the seeds of easy money and credit creation, even when sown during times with unused capacity, bring forth the weeds of instability, malinvestment, bust, and economic displacement. They do not bring the promised return to prosperity, sustainable growth, and high employment.

Since the phase-out is only apparent, and not a real change in policy direction, Joe Salerno’s warning (“A Reformulation of Austrian Business Cycle Theory in Light of the Financial Crisis,” p. 41) remains relevant:

(G)iven the unprecedented monetary interventions by the Fed and the enormous deficits run by the Obama admin­istration, ABCT also explains the precarious nature of the current recovery and the growing probability that the U.S economy is headed for a 1970s-style stagflation.

While highly unlikely there is still time to do the right thing, follow the policy advice of Rothbard and the Austrians, as argued earlier in more detail here and here. Despite some short run costs which are likely small compared to the cost of a decade of stagnation, such a policy is the only reliable route to return the economy to sustainable prosperity.

John P. Cochran is emeritus dean of the Business School and emeritus professor of economics at Metropolitan State University of Denver and coauthor with Fred R. Glahe of The Hayek-Keynes Debate: Lessons for Current Business Cycle Research. He is also a senior scholar for the Mises Institute and serves on the editorial board of the Quarterly Journal of Austrian Economics. Send him mail. See John P. Cochran’s article archives.

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.

Inflation’s Not the Only Way Easy Money Destroys Wealth – Article by Frank Shostak

Inflation’s Not the Only Way Easy Money Destroys Wealth – Article by Frank Shostak

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Frank Shostak
October 14, 2014
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The US Federal Reserve can keep stimulating the US economy because inflation is posing little threat, Federal Reserve Bank of Minneapolis President Kocherlakota said. “I am expecting an inflation rate to run below two percent for the next four years, through 2018,” he said. “That means there is more room for monetary policy to be helpful in terms of … boosting demand without running up against generating too much inflation.”

The yearly rate of growth of the official consumer price index (CPI) stood at 1.7 percent in August against two percent in July. According to our estimate, the yearly rate of growth of the CPI could close at 1.4 percent by December. By December next year we forecast the yearly rate of growth of 0.6 percent.

Does Demand Create More Supply?

It seems that the Minneapolis Fed President holds that by boosting the demand for goods and services — by means of additional monetary pumping — it is possible to strengthen economic growth. He believes that by means of strengthening the demand for goods and services the production of goods and services will follow suit. But why should that be so?

If by means of monetary pumping one could strengthen the economic growth then it would imply that — by means of monetary pumping — it is possible to create real wealth and generate an everlasting economic prosperity.

This would also mean that world wide poverty should have been erased a long time ago. After all, most countries today have central banks that possess the skills to create money in large amounts. Yet world poverty remains intact.

Despite massive monetary pumping since 2008, and the policy interest rate of around zero, Fed policymakers seem to be unhappy with the so-called economic recovery. Note that the Fed’s balance sheet, which stood at $0.86 trillion in January 2007 jumped to $4.4 trillion by September this year.

Production Comes Before Demand

We suggest that there is no such thing as an independent category called demand. Before an individual can exercise demand for goods and services, he/she must produce some other useful goods and services. Once these goods and services are produced, individuals can exercise their demand for the goods they desire. This is achieved by exchanging things that were produced for money, which in turn can be exchanged for goods that are desired. Note that money serves here as the medium of exchange — it produces absolutely nothing. It permits the exchange of something for something. Any policy that results in monetary pumping leads to an exchange of nothing for something. This amounts to a weakening of the pool of real wealth — and hence to reduced prospects for the expansion of this pool.

What is required to boost the economic growth — the production of real wealth — is to remove all the factors that undermine the wealth generation process. One of the major negative factors that undermine the real wealth generation is loose monetary policy of the central bank, which boosts demand without the prior production of wealth. (Once the loopholes for the money creation out of “thin air” are closed off the diversion of wealth from wealth generators towards non-productive bubble activities is arrested. This leaves more real funding in the hands of wealth generators — permitting them to strengthen the process of wealth generation (i.e., permitting them to grow the economy).

Artificially Boosted Demand Destroys Wealth

Now, the artificial boosting of the demand by means of monetary pumping leads to the depletion of the pool of real wealth. It amounts to adding more individuals that take from the pool of real wealth without adding anything in return — an economic impoverishment.

The longer the reckless loose policy of the Fed stays in force the harder it gets for wealth generators to generate real wealth and prevent the pool of real wealth from shrinking.

Finally, the fact that the yearly rate of growth of the CPI is declining doesn’t mean that the Fed’s monetary pumping is going to be harmless. Regardless of price inflation monetary pumping results in an exchange of nothing for something and thus, impoverishment.

Frank Shostak is an adjunct scholar of the Mises Institute and a frequent contributor to Mises.org. His consulting firm, Applied Austrian School Economics, provides in-depth assessments and reports of financial markets and global economies. See Frank Shostak’s article archives.

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 Japanese Deflation Myth and the Yen’s Slump – Article by Brendan Brown

The Japanese Deflation Myth and the Yen’s Slump – Article by Brendan Brown

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Brendan Brown
October 4, 2014
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The slide of the yen since late summer has brought it to a level some 40 percent lower against the euro and US dollar than just two years go. Yet still Japan’s Prime Minister Shinzo Abe and his central bank chief Haruhiko Kuroda warn that they have not won the battle against deflation. That caution is absurd — all the more so in view of the fact that there was no deflation in the first place.

Some cynics suggest that Abe’s and Haruhiko’s battle cry against this phoney phantom is simply a ruse to gain Washington’s acquiescence in a big devaluation. But whatever the truth about their real intent, Japan’s monetary chaos is deepening.

Japanese Prices Have Been Stable

The CPI in Japan at the peak of the last cycle in 2007 was virtually at the same level as at the trough of the post-bubble recession in 1992, and up a few percentage points from the 1989 cycle peak. Hence, Japan alone has enjoyed the sort of price stability as might be enjoyed in a gold-standard world. Prices have fallen during recessions or during periods of especially-rapid terms-of-trade improvement or productivity growth. They have risen during cyclical booms or at times of big increases in the price of oil.

If price-indices in Japan were adjusted fully to take account of quality improvements they would have been falling slightly throughout, but that would also have been the case under the gold standard and was fully consistent with economic prosperity.

yenslumpSuch swings in prices are wholly benign. For example, lower prices during recession coupled with expectation of higher prices in expansion induce businesses and households to spend more. A valid criticism of the Japanese price experience of the past two decades has been that these swings have lacked vigour due to various rigidities. Particularly valid is the claim that price falls should have been larger during the post-bubble recession of 1990-93 and subsequent potential for recovery would have been correspondingly larger.

Prices in Japan did fall steeply during the Great Recession (2008-10) but the perceived potential for recovery was squeezed by the Obama Monetary Experiment (the Fed’s QE) which meant an immediate slide of the US dollar. It was in response to the related spike of the yen that Prime Minister Abe prepared his counter-stroke. This involved importing the same deflation-phobic inflation-targeting policies that the Obama Federal Reserve was pursuing. Washington could hardly criticize Tokyo for imitating its own monetary experiment.

Deflation and “The Lost Decade”

The architects of the Obama Monetary Experiment have cited as justification Japan’s “lost decade” and the supposed source in deflation. In fact, though, the only period during which the Japanese economy underperformed other advanced economies (as measured by the growth of GDP per capita) was from 1992-97. The underperformance of that period had everything to do with insufficient price and wage flexibility downward, the Clinton currency war, and the vast malinvestment wrought by the prior asset price inflation, coupled with a risk-appetite in Japan shrunken by the recent experience of bust.

Moreover, as time went on, from the early 1990s, huge investment into the Tokyo equity market from abroad compensated for ailing domestic risk appetites. Yes, Japan’s economy could have performed better than the average of its OECD peers if progress had been made in de-regulation, and if Japan had had a better-designed framework of monetary stability to insulate itself from the Greenspan-Bernanke asset price inflation virus of the years 2002-07. (The Greenspan-Bernanke inflation caused speculative temperatures in the yen carry trade to reach crazy heights.) But deflation was never an actual or potential restraint on Japanese prosperity during those years.

True, there was a monetary malaise. Japan’s price stability was based on chance, habit, and economic sclerosis rather than the wisdom of its monetary policy. It had been the huge appreciation of the yen during the Clinton currency war that had snuffed out inflation. Then the surge of cheap imports from China had worked to convince the Japanese public that inflation had indeed come to an end. Lack of economic reform meant that the neutral rates of interest remained at a very low level and so the Bank of Japan’s intermittent zero rate policies did not stimulate monetary growth.

The monetary system in Japan had no secure pivot in the form of high and stable demand for non-interest bearing high-powered money. In Japan the reserve component of the monetary base is virtually indistinguishable from a whole range of close substitutes and banks had no reason to hold large amounts of this (given deposit insurance and the virtual assurance of too-big-to-fail help in need). Monetary policy-making in Japan meant highly discretionary manipulation of short-term interest rates in the pursuance of fine-tuning the business cycle rather than following a set of rules for monetary base expansion.

The Yen After Abenomics

When Prime Minister Abe effected his coup against the old guard at the Bank of Japan there was no monetary constitution to flout. Massive purchases of long-dated Japanese government bonds by the Bank of Japan are lowering the proportion of outstanding government debt held by the public in fixed-rate form. But this is all a slow-developing threat given a gross government debt to GDP ratio of around 230 percent and a current fiscal deficit of 6 percent of GDP. Bank of Japan bond-buying has strengthened irrational forces driving 10-year yields down to almost 0.5 percent despite underlying inflation having risen to 1 percent per annum.

It is doubtless the possibility of an eventual monetization of government debt has been one factor in the slump of the yen. More generally, as the neutral level of interest rates in Japan rises in line with demographic pressures (lower private savings, increased social expenditure) one might fear that BoJ manipulation of rates will eventually set off inflation. Part of the yen’s slump, though, is due to a tendency for that currency to fall when asset price inflation is virulent in the global economy. This stems from the huge carry trade in the yen.

The yen could indeed leap when the global asset price-inflation disease — with its origins in Fed QE — moves to its next phase of steep speculative temperature fall. The yen is now in real effective exchange rate terms at the record low point of the Japan banking crisis in 1997 or the global asset inflation peak of 2007. So, the challenge for investors is to decide when the Abe yen has become so cheap in real terms that its hedge properties make it a worthwhile portfolio component.

Brendan Brown is an associated scholar of the Mises Institute and is author of Euro Crash: How Asset Price Inflation Destroys the Wealth of Nations and The Global Curse of the Federal Reserve: Manifesto for a Second Monetarist Revolution. See Brendan Brown’s article archives.

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.

US Sanctions on Russia May Sink the Dollar – Article by Ron Paul

US Sanctions on Russia May Sink the Dollar – Article by Ron Paul

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Ron Paul
August 10, 2014
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The US government’s decision to apply more sanctions on Russia is a grave mistake and will only escalate an already tense situation, ultimately harming the US economy itself. While the effect of sanctions on the dollar may not be appreciated in the short term, in the long run these sanctions are just another step toward the dollar’s eventual demise as the world’s reserve currency.

Not only is the US sanctioning Russian banks and companies, but it also is trying to strong-arm European banks into enacting harsh sanctions against Russia as well. Given the amount of business that European banks do with Russia, European sanctions could hurt Europe at least as much as Russia. At the same time the US expects cooperation from European banks, it is also prosecuting those same banks and fining them billions of dollars for violating existing US sanctions. It is not difficult to imagine that European banks will increasingly become fed up with having to act as the US government’s unpaid policemen, while having to pay billions of dollars in fines every time they engage in business that Washington doesn’t like.

European banks are already cutting ties with American citizens and businesses due to the stringent compliance required by recently-passed laws such as FATCA (Foreign Account Tax Compliance Act). In the IRS’s quest to suck in as much tax dollars as possible from around the world, the agency has made Americans into the pariahs of the international financial system. As the burdens the US government places on European banks grow heavier, it should be expected that more and more European banks will reduce their exposure to the United States and to the dollar, eventually leaving the US isolated. Attempting to isolate Russia, the US actually isolates itself.

Another effect of sanctions is that Russia will grow closer to its BRICS (Brazil/Russia/India/China/South Africa) allies. These countries count over 40 percent of the world’s population, have a combined economic output almost equal to the US and EU, and have significant natural resources at their disposal. Russia is one of the world’s largest oil producers and supplies Europe with a large percent of its natural gas. Brazil has the second-largest industrial sector in the Americas and is the world’s largest exporter of ethanol. China is rich in mineral resources and is the world’s largest food producer. Already Russia and China are signing agreements to conduct their bilateral trade with their own national currencies rather than with the dollar, a trend which, if it spreads, will continue to erode the dollar’s position in international trade. Perhaps more importantly, China, Russia, and South Africa together produce nearly 40 percent of the world’s gold, which could play a role if the BRICS countries decide to establish a gold-backed currency to challenge the dollar.

US policymakers fail to realize that the United States is not the global hegemon it was after World War II. They fail to understand that their overbearing actions toward other countries, even those considered friends, have severely eroded any good will that might previously have existed. And they fail to appreciate that more than 70 years of devaluing the dollar has put the rest of the world on edge. There is a reason the euro was created, a reason that China is moving to internationalize its currency, and a reason that other countries around the world seek to negotiate monetary and trade compacts. The rest of the world is tired of subsidizing the United States government’s enormous debts, and tired of producing and exporting trillions of dollars of goods to the US, only to receive increasingly worthless dollars in return.

The US government has always relied on the cooperation of other countries to maintain the dollar’s preeminent position. But international patience is wearing thin, especially as the carrot-and-stick approach of recent decades has become all stick and no carrot. If President Obama and his successors continue with their heavy-handed approach of levying sanctions against every country that does something US policymakers don’t like, it will only lead to more countries shunning the dollar and accelerating the dollar’s slide into irrelevance.

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.

Europe and Deflation Paranoia – Article by Frank Hollenbeck

Europe and Deflation Paranoia – Article by Frank Hollenbeck

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Frank Hollenbeck
April 30, 2014
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There is a current incessant flow of articles warning us of the certain economic calamity if deflation is allowed to show its nose for even the briefest period of time. This ogre of deflation, we are told, must be defeated with the printing presses at all costs. Of course, the real objective of this fear mongering is to enable continued national-government theft through debasement. Every dollar printed is a government tax on cash balances.

There are two main sources of deflation. The first comes from a general increase in the amount of goods and services available. In this type of deflation, a reduction in costs, in a competitive environment, leads to lower prices. The high technology sector has thrived in this type of deflation for decades as technical progress (e.g., the effect of Moore’s Law) has powered innovations and computing power at ever-decreasing costs. The same was true for most industries during much of the nineteenth century, as the living standard increased considerably. Every man benefited from the increase in real wages resulting from lower prices.

The second source of deflation is from a reduction in the money supply that comes from an increase in the desire of the public or banking sectors to hold cash (i.e., hoarding).[1] An uncomplicated example will make this point clearer. Suppose we have 10 pencils and $10. Only at an equilibrium price of $1 will there be no excess output or excess money.

Suppose the production cost of a pencil is 80 cents. The rate of return is 25 percent. Now suppose people hoard $5 and stuff money in their mattress instead of saving it. The price of a pencil will be cut in half, falling from $1 to 50 cents, since we now have a money supply of $5 chasing 10 pencils. If input prices also fall to 40 cents per pencil then there is no problem since the rate of return is still 25 percent. In this example, a drop in output prices forced an adjustment in input prices.

The Keynesian fear is that input prices will not adjust fast enough to a drop in output prices so that the economy will fall into a deflation-depression spiral. The Keynesian-monetarist solution is to have the government print $5 to avoid this deflation.

Yet, this money creation is distortive and will cause a misallocation of resources since the new money will not be spent in the same areas or proportions as the money that is now being “hoarded” (as defined by Keynesians). Furthermore, even if the government could find the right areas or proportions, it would still lead to misallocations, since the hoarding reflects a desire to realign relative prices closer to what society really wants to be produced. The printing of money may actually increase the desire to hold cash, as we see today. Holding cash may be the preferred choice over consumption or investment (savings) when relative and absolute prices have been distorted by the printing press.

Of course, no one is really asking the critical questions. Why does holding more cash change the money supply, and why did the public and banks decide to increase their cash holdings in the first place?[2] Without fractional reserve banking, neither the public nor the banks could significantly change the money supply by holding more cash, nor could banks extend credit faster than slow-moving savings. The boom and ensuing malinvestments would be a thing of the past and, thus, so would the desire to hold more cash during the bust phase of the business cycle. If central banks are really concerned about this type of deflation, they should be addressing the cause — fractional reserve banking — and not the result. Telling a drunk that he can avoid the hangover by drinking even more whiskey is simply making the situation worse.[3] The real solution is to have him stop drinking.

According to the European Central Bank’s Mario Draghi,

The second drawback of low inflation … is that it makes the adjustment of imbalances much more difficult. It is one thing to have to adjust relative prices with an inflation rate which is around 2%, another thing is to adjust relative prices with an inflation rate which is around 0.5%. That means that the change in certain prices, in order to readjust, will have to become negative. And you know that prices and wages have a certain nominal rigidity which makes these adjustments more complex.

Draghi is confusing the first source of deflation with the second. The recent low inflation in the Euro zone can be attributed primarily to a strengthening of the Euro, and a drop in food and energy prices.

Economists at the Bundesbank must be quietly seething. They are obviously not blind to the ECB’s excuses to indirectly monetize the southern bloc’s debt. Draghi’s “whatever it takes” comment gave southern bloc countries extra time. Yet, little has been done to reign in the size of bloated public sectors. Debt-to-GDP ratios continue to rise and higher taxes in southern bloc countries have caused an even greater contraction of the private sector. Many banks in southern Europe are technically bankrupt. Non-performing loans in Italy have gone from about 5.8 percent in 2007 to over 15 percent today. And, the situation is getting worse.

Greece recently placed a five-year bond at under 5 percent which was eight times oversubscribed. This highlights the degree to which the financial sector in Europe is now dependent on the “Draghi put.” As elsewhere in the world, interest rates in Europe are totally distorted and no longer serve the critical function of allocating resources according to society’s time preference of consumption, or even reflect any real risk of default.

The ECB will likely impose negative rates shortly but will discover, as the Fed and others did before it, that you can bring a horse to water but cannot make him drink. QE will then be on the table, but unlike the Fed, the ECB is limited in the choice of assets it can purchase since direct purchase of Euro government bonds violates the German constitution. One day, Germany and the southern bloc countries, including France, will clash on what is the appropriate role of monetary policy.

Germany would be wise to plan, today, for a possible Euro exit.

Notes

[1] Keynesians view holding cash, and even holding savings in banks as “hoarding,” but properly understood, only the equivalent of stuffing money in a mattress is hoarding.

[2] Fractional-reserve lending is inflationary, thus contributing to inflationary booms. In turn, banks hold more cash when they fear a confidence crisis, which is also a result of the boom.

[3] Since inflationary fractional-reserve lending is a source of the problem, additional lending of the same sort is not the solution.

Frank Hollenbeck teaches finance and economics at the International University of Geneva. He has previously held positions as a Senior Economist at the State Department, Chief Economist at Caterpillar Overseas, and as an Associate Director of a Swiss private bank. See Frank Hollenbeck’s article archives.

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.

Revolutionary France’s Road to Hyperinflation – Article by Frank Hollenbeck

Revolutionary France’s Road to Hyperinflation – Article by Frank Hollenbeck

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Frank Hollenbeck
December 15, 2013
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Today, anyone who talks about hyperinflation is treated like the shepherd boy who cried wolf. When the wolf actually does show up, though, belated warnings will do little to keep the flock safe.

The current Federal Reserve strategy is apparently to wait for significant price inflation to show up in the consumer price index before tapering. Yet history tells us that you treat inflation like a sunburn. You don’t wait for your skin to turn red to take action. You protect yourself before leaving home. Once inflation really picks up steam, it becomes almost impossible to control as the politics and economics of the situation combine to make the urge to print irresistible.

The hyperinflation of 1790s France illustrates one way in which inflationary monetary policy becomes unmanageable in an environment of economic stagnation and debt, and in the face of special interests who benefit from, and demand, easy money.

In 1789, France found itself in a situation of heavy debt and serious deficits. At the time, France had the strongest and shrewdest financial minds of the time. They were keenly aware of the risks of printing fiat currency since they had experienced just decades earlier the disastrous Mississippi Bubble under the guidance of John Law.

France had learned how easy it is to issue paper money and nearly impossible to keep it in check. Thus, the debate over the first issuance of the paper money, known as assignats, in April 1790 was heated, and only passed because the new currency (paying 3 percent interest to the holder) was collateralized by the land stolen from the church and fugitive aristocracy. This land constituted almost a third of France and was located in the best places.

Once the assignats were issued, business activity picked up, but within five months the French government was again in financial trouble. The first issuance was considered a rousing success, just like the first issuance of paper money under John Law. However, the debate over the second issuance during the month of September 1790 was even more chaotic since many remembered the slippery slope to hyperinflation. Additional constraints were added to satisfy the naysayers. For example, once land was purchased by French citizens, the payment in currency was to be destroyed to take the new paper currency out of circulation.

The second issuance caused an even greater depreciation of the currency but new complaints arose that not enough money was circulating to conduct transactions. Also, the overflowing government coffers resulting from all this new paper money led to demands for a slew of new government programs, wise or foolish, for the “good of the people.” The promise to take paper money out of circulation was quickly abandoned, and different districts in France independently started to issue their own assignats.

Prices started to rise and cries for more circulating medium became deafening. Although the first two issuances almost failed, additional issuances became easier and easier.

Many Frenchmen soon became eternal optimists claiming that inflation was prosperity, like the drunk forgetting the inevitable hangover. Although every new issuance initially boosted economic activity, the improved business conditions became shorter and shorter after each new issuance. Commercial activity soon became spasmodic: one manufacturer after another closed shop. Money was losing its store-of-value function, making business decisions extremely difficult in an environment of uncertainty. Foreigners were blamed and heavy taxes were levied against foreign goods. The great manufacturing centers of Normandy closed down and the rest of France speedily followed, throwing vast numbers of workers into bread lines. The collapse of manufacturing and commerce was quick, and occurred only a few months after the second issuance of assignats and followed the same path as Austria, Russia, America, and all other countries that had previously tried to gain prosperity on a mountain of paper.

Social norms also changed dramatically with the French turning to speculation and gambling. Vast fortunes were built speculating and gambling on borrowed money. A vast debtor class emerged located mostly in the largest cities.

To purchase government land, only a small down payment was necessary with the rest to be paid in fixed installments. These debtors quickly saw the benefit of a depreciating currency. Inflation erodes the real value of any fixed payment. Why work for a living and take the risk of building a business when speculating on stocks or land can bring wealth instantaneously and with almost no effort? This growing segment of nouveau riche quickly used its newfound wealth to gain political power to ensure that the printing presses never stopped. They soon took control and corruption became rampant.

Of course, blame for the ensuing inflation was assigned to everything but the real cause. Shopkeepers and merchants were blamed for higher prices. In 1793, 200 stores in Paris were looted and one French politician proclaimed “shopkeepers were only giving back to the people what they had hitherto robbed them of.” Price controls (the “law of the maximum”) were ultimately imposed, and shortages soon abounded everywhere. Ration tickets were issued on necessities such as bread, sugar, soap, wood, or coal. Shopkeepers risked their heads if they hinted at a price higher than the official price. The daily ledger of those executed with the guillotine included many small business owners who violated the law of the maximum. To detect goods concealed by farmers and shopkeepers, a spy system was established with the informant receiving 1/3 of the goods recovered. A farmer could see his crop seized if he did not bring it to market, and was lucky to escape with his life.

Everything was enormously inflated in price except the wages for labor. As manufacturers closed, wages collapsed. Those who did not have the means, foresight, or skill to transfer their worthless paper into real assets were driven into poverty. By 1797, most of the currency was in the hands of the working class and the poor. The entire episode was a massive transfer of real wealth from the poor to the rich, similar to what we are experiencing in Western societies today.

The French government tried to issue a new currency called the mandat, but by May 1797 both currencies were virtually worthless. Once the dike was broken, the money poured through and the currency was swollen beyond control. As Voltaire once said, “Paper money eventually returns to its intrinsic value — zero.” In France, it took nearly 40 years to bring capital, industry, commerce, and credit back up to the level attained in 1789.

Frank Hollenbeck, PhD, teaches at the International University of Geneva. See Frank Hollenbeck’s article archives.

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.

Price Fixers of the World, Unite! – Article by Bradley Doucet

Price Fixers of the World, Unite! – Article by Bradley Doucet

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The New Renaissance Hat
Bradley Doucet
December 4, 2013
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Venezuela’s President Nicolas Maduro has never met a price control he didn’t like. The latest news is that he will regulate the price of new and used cars in order to fight inflation, which hit 54% in October. This is a lot like using leeches to balance the four humours: It’s discredited nonsense that does more harm than good (and shame on Bloomberg.com for its uncritical report on the matter, though I’m sure many other news outlets are just as bad).

As Matt McCaffrey and Carmen Dorobat pointed out in the International Business Times last month, inflation in Venezuela (and elsewhere) is quite simply the result of monetary expansion. The government prints money like a lunatic, which makes each single unit of currency worth less (and eventually worthless). More units of the debased currency are therefore needed to purchase goods and services, which is just another way of saying that prices go up.

Imposing controls to stop nominal prices from rising therefore actually lowers real prices below market rates. This leads to shortages, something long-suffering Venezuelans know a thing or two about. Their country is tragically being gutted of its accumulated capital by disastrously wrongheaded economic policies.

Equally mistaken, though not quite as harmful, is the Quebec government’s plan to control the price of books in order to keep sellers from selling them too cheaply. Pauline Marois’s Parti Québécois wants to cap discounts on new books at 10% to protect small booksellers from competition from online and big-box retailers. Whereas Maduro imposes price ceilings, Marois wants to impose a price floor, which will keep books above their market rate. As my Québécois Libre colleague Larry Deck quipped, “Surely nobody would buy fewer books just because they cost more, right?”

Ceilings or floors, fixing prices by diktat distorts market signals and makes most everyone worse off. Depending on their pervasiveness, price controls can lead to a little—or a lot—of hardship. Quebec’s politicians would do well to think twice before emulating an economic basket case like Venezuela.

Bradley Doucet is Le Québécois Libre‘s English Editor and the author of the blog Spark This: Musings on Reason, Liberty, and Joy. A writer living in Montreal, he has studied philosophy and economics, and is currently completing a novel on the pursuit of happiness. He also writes for The New Individualist, an Objectivist magazine published by The Atlas Society, and sings.

New Fed Boss Same as the Old Boss – Article by Ron Paul

New Fed Boss Same as the Old Boss – Article by Ron Paul

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The New Renaissance Hat
Ron Paul
October 13, 2013
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The news that Janet Yellen was nominated to become the next Chairman of the Board of Governors of the Federal Reserve System was greeted with joy by financial markets and the financial press. Wall Street saw Yellen’s nomination as a harbinger of continued easy money. Contrast this with the hand-wringing that took place when Larry Summers’ name was still in the running. Pundits worried that Summers would be too cautious, too hawkish on inflation, or too close to big banks.

The reality is that there wouldn’t have been a dime’s worth of difference between Yellen’s and Summers’ monetary policy. No matter who is at the top, the conduct of monetary policy will be largely unchanged: large-scale money printing to bail out big banks. There may be some fiddling around the edges, but any monetary policy changes will be in style only, not in substance.

Yellen, like Bernanke, Summers, and everyone else within the Fed’s orbit, believes in Keynesian economics. To economists of Yellen’s persuasion, the solution to recession is to stimulate spending by creating more money. Wall Street need not worry about tapering of the Fed’s massive program of quantitative easing under Yellen’s reign. If anything, the Fed’s trillion dollars of yearly money creation may even increase.

What is obvious to most people not captured by the system is that the Fed’s loose monetary policy was the root cause of the current financial crisis. Just like the Great Depression, the stagflation of the 1970s, and every other recession of the past century, the current crisis resulted from the creation of money and credit by the Federal Reserve, which led to unsustainable economic booms.

Rather than allowing the malinvestments and bad debts caused by its money creation to liquidate, the Fed continually tries to prop them up. It pumps more and more money into the system, piling debt on top of debt on top of debt. Yellen will continue along those lines, and she might even end up being Ben Bernanke on steroids.

To Yellen, the booms and bust of the business cycle are random, unforeseen events that take place just because. The possibility that the Fed itself could be responsible for the booms and busts of the business cycle would never enter her head. Nor would such thoughts cross the minds of the hundreds of economists employed by the Fed. They will continue to think the same way they have for decades, interpreting economic data and market performance through the same distorted Keynesian lens, and advocating for the same flawed policies over and over.

As a result, the American people will continue to suffer decreases in the purchasing power of the dollar and a diminished standard of living. The phony recovery we find ourselves in is only due to the Fed’s easy money policies. But the Fed cannot continue to purchase trillions of dollars of assets forever. Quantitative easing must end sometime, and at that point the economy will face the prospect of rising interest rates, mountains of bad debt and malinvested resources, and a Federal Reserve which holds several trillion dollars of worthless bonds.

The future of the US economy with Chairman Yellen at the helm is grim indeed, which provides all the more reason to end our system of central economic planning by getting rid of the Federal Reserve entirely. Ripping off the bandage may hurt some in the short run, but in the long term everyone will be better off. Anyway, most of this pain will be borne by the politicians, big banks, and other special interests who profit from the current system. Ending this current system of crony capitalism and moving to sound money and free markets is the only way to return to economic prosperity and a vibrant middle class.

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.

Mainstream Economists Prove Krugman Wrong About Hayek and Mises – Article by John P. Cochran

Mainstream Economists Prove Krugman Wrong About Hayek and Mises – Article by John P. Cochran

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John P. Cochran
September 13, 2013
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Paul Krugman has recently been critical of Friedman (and Phelps), the Phillips curve, and the Natural Unemployment Rate (NUR) theory in the process of arguing that due to the recent Great Recession, the accompanying financial crisis, and Bush-Obama-Fed Great Stagnation, Friedman has vanished from the policy front. Krugman makes this claim despite the fact there is an on-going vigorous debate on rules versus discretion with at least some attention to Friedman’s plucking model. While maligning Friedman’s contributions, Krugman manages a slap at Austrians and claims a renewed practical relevance for Keynes:

What I think is really interesting is the way Friedman has virtually vanished from policy discourse. Keynes is very much back, even if that fact drives some economists crazy; Hayek is back in some sense, even if one has the suspicion that many self-proclaimed Austrians bring little to the table but the notion that fiat money is the root of all evil — a deeply anti-Friedmanian position. But Friedman is pretty much absent.

The Friedman-Phelps hypothesis was the heart of the policy effectiveness debate of the 1970s and early 80s. The empirical evidence developed during the debate over the policy implications of the NUR model, at least temporally, discredited active Keynesian discretionary policy as an effective tool to reduce unemployment in the long run. One result of the debate: monetary policy appeared to improve, especially compared to the Fed’s dismal record in the late 1920s and 1930s and the mid 1960s to the late 1970s. Central banks, à la Friedman, focused on rules-based policy and inflation targeting resulting in what many, following John B. Taylor, call the Great Moderation of the early 1980s to the early 2000s.

Krugman does recognize the “stagflation (of the 1970s) led to a major rethinking of macroeconomics, all across the board; even staunch Keynesians conceded that Friedman/Phelps had been right (indeed, they may have conceded too much [emphasis added]), and the vertical long-run Phillips curve became part of every textbook.”

My early work on Hayek and Keynes (see here and here) argued that this development was important, but misleading. The then current business cycle research and its newer variants could benefit from re-examining the issues at the heart of the Hayek-Keynes debate.

Money, banking, finance, and capital structure were, and still are, for the most part ignored in much of the new (post-Friedman-Phelps) macroeconomics including the new–Keynesian approaches. In this regard, Hayek (and Mises) had then, and has now, more to offer than Keynes.

Recent papers by respected mainstream economists are beginning to recognize that attention to Hayek and Mises can be useful. Guillermo Calvo of Columbia University, in a recent paper [PDF], has even gone so far as to argue, “the Austrian school of the trade cycle was on the right track” and that the Austrian School offered valuable insights and noting that:

There is a growing empirical literature purporting to show that financial crises are preceded by credit booms including Mendoza and Terrones (2008), Schularik and Taylor (2012), Agosin and Huaita (2012), and Borio (2012).

Calvo adds “[t]his was a central theme in the Austrian School of Economics.”

Claudio Borio highlights what Austrians have long argued is a key flaw in inflation-targeting or stable-money policy regimes such as many central banks either adopted or emulated during the 1980-2008 period. This flaw contributed to back-to-back boom-busts of the late 1990s and 2000s:

A monetary policy regime narrowly focused on controlling near-term inflation removes the need to tighten policy when financial booms take hold against the backdrop of low and stable inflation. And major positive supply-side developments, such as those associated with the globalisation of the real side of the economy, provide plenty of fuel for financial booms.

Borio thus recognizes that a time to mitigate a bust is (contra-Keynes) during the boom:

In the case of monetary policy, it is necessary to adopt strategies that allow central banks to tighten so as to lean against the build-up of financial imbalances even if near-term inflation remains subdued.

William R. White, another economist who has worked at the Bank of International Settlements (BIS) and has been influenced by Hayek, has come to similar conclusions as does Calvo, who argues “Hayek’s theory is very subtle and shows that even a central bank that follows a stable monetary policy may not be able to prevent business cycles and, occasionally, major boom-bust episodes.”

In the current environment, many, including Krugman, have argued for a higher inflation target or a higher nominal GDP target to jump start the current sluggish recovery.

Austrian business cycle theory on the other hand, as recognized by Borio and Calvo, provides analysis on why such a policy may be ineffective and if temporarily effective in the short run, harmful if not destructive, in the long run. (See here and here for more.)

An easy money and credit policy impedes necessary re-structuring of the economy and new credit creation begins a new round of misdirection of production leading to an “unfinished recession.” Calvo expounds:

Whatever one thinks of the power of the Hayek/Mises mix as a positive theory of the business cycle, an insight from the theory is that once credit over-expansion hits the real sector, rolling back credit is unlikely to be able to put “Humpty-Dumpty together again.”

It is too bad it took back-to-back harmful boom-bust cycles for the profession at large to begin to again examine Austrian insights, but it does illustrate how foolish Krugman is when he argues Austrians have nothing to bring to the table.

John P. Cochran is emeritus dean of the Business School and emeritus professor of economics at Metropolitan State University of Denver and coauthor with Fred R. Glahe of The Hayek-Keynes Debate: Lessons for Current Business Cycle Research. He is also a senior scholar for the Mises Institute and serves on the editorial board of the Quarterly Journal of Austrian Economics. Send him mail. See John P. Cochran’s article archives.

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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.