Archive for December, 2008

Inflation Versus Deflation: Part Two

December 17, 2008

In my previous blog entry, I explained that:

  • The current economic crisis could result in either deflation or inflation;
  • Deflation and inflation have very different effects on savings and investment vehicles, so understanding the probability of one or the other can help you make better decisions with your money;
  • Whether we end up with deflation or inflation depends on whether or not the Federal Reserve can succeed at getting money to move through the economy again.

Our task now is to assess the likelihood of the Federal Reserve achieving its goal.

The Zero-Bound Problem

Ordinarily, the Federal Reserve controls the rate at which money flows through the economy (its “velocity”) by changing the interest rate that it charges member banks for overnight loans (the “Fed funds rate”). Through the mechanics of the commercial banking system, lower short term rates cause a reduction in the rates that banks charge for long term lending, such as car loans and mortgages. Lower long term rates, in turn, stimulate economic activity.

Despite the Fed’s aggressive program of lowering the funds rate in the past year, commercial banks have remained reluctant to lend, and long term interest rates have not declined. Just yesterday, with falling consumer prices raising further fears of deflation, the Fed lowered its funds rate to a record low of 0.25%.

The Fed has arrived at the “zero-bound” problem: it cannot lower interest rates below zero. The Fed has reached the end of the rate reduction paradigm for controlling the velocity of money.

The zero-bound problem explains why, in addition to announcing the rate cut, the Fed announced its readiness to “move to a new phase of monetary policy in which it prints vast amounts of money.” To prevent a deflationary spiral, the Fed must employ other means to get money to move through the system to return the economy to an inflationary track.

Unconventional Measures

In 2002, before he became Chairman Of the Federal Reserve, Ben Bernanke addressed precisely this issue in a speech that earned him the epithet “helicopter Ben.” In his talk, Bernanke reminded his audience of Milton Friedman’s description of a central banker dropping money onto the populace from a helicopter. Also known as the “printing press speech,” Bernanke’s address included the following formulation:

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 my last blog entry I explained that inflation is a monetary phenomenon: very simply, an increase in the supply of money relative to the goods and services produced by the economy causes prices to rise. A steady increase in the nominal prices of goods and services discourages savings because, unless interest rates keep pace, unspent money rapidly loses its value. Thus, the plan to “reduce the value of a dollar” serves as a mechanism to fight deflation. Dollar devaluation, we shall see, lies at the core of the Fed’s deflation fighting strategy.

The Fed has done a lot of creative thinking about the uses to which it can put the printing press in order to revive spending. In 2005, Robert Blumen published an article in which he analyzes a number of papers and speeches on this topic by Bernanke and other Fed officials.   Few people have the interest or patience to wade through this kind of material. But understanding the Fed’s thinking about deflation fighting gives a good deal of insight into current events, such as yesterday’s announcement. Blumen has done a great public service with his analysis. With his help, I shall now enumerate some of the Fed’s tactics.

  • Long-Term Interest Rate Intervention: The Fed can influence long-term interest rates by buying long-term bonds on the open-market.  The Fed has already implemented this strategy in order to lower mortgage rates by purchasing mortgage backed securities. Yesterday’s statement makes it clear that the Fed will continue purchasing mortgage securities as well as long-term US Treasury bonds.
  • Lending: A 1999 paper, Monetary Policy and Price Stability, explains that “A central bank can also attempt to spur private aggregate demand by extending loans to depositories, other financial intermediaries, or firms and households.” The Fed has already engaged in a record level of lending through its discount window and has been buying commercial paper. Yesterday’s announcement says the Fed now intends to implement a “Term Asset-Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses.”
  • Currency Devaluation: In a paper entitled Monetary Policy When the Nominal Short-Term Interest Rate is Zero, Fed officials describe the concept of a “money rain” whereby it would “give money away either through directly disbursing currency to the public or by disbursing it through the banking system.” As I observed above, devaluation forces people to spend their dollars to avoid losing their savings. Devaluation, by the way, can also be achieved through what these papers refer to as “exchange rate intervention.” The central banks of other countries might, for example, agree to sell enough of their dollar reserves into the open market so as to effect a deliberate fall in the dollar.
  • Imposition of Negative Interest Rate: In the paper Monetary Policy in a Zero-Interest-Rate Economy, a Fed official observes that the Fed could induce people to spend by a mechanism to “make money pay a negative nominal interest rate, by imposing some type of ‘carry tax’ on currency and deposits.” In other words, people saving money in dollars would have to pay for the privilege of doing so.
  • Direct Purchase of Goods and Services: By exchanging federal government debt for freshly printed money, the Fed could indirectly “conduct an open market purchase of real goods and services.”  This idea, also presented in Monetary Policy in a Zero-Interest-Rate Economy, may sound far-fetched. But it might be what yesterday’s Fed statement hints at by saying it will “continue to consider ways of using its balance sheet to further support credit markets and economic activity.”

This inventory of ideas gives a pretty good idea of just how far the Fed will go to reflate the economy. As a  student of the Great Depresion, Ben Bernanke believes it necesary to fight deflation with these types of tools to avoid long-term economic suffering. As one can see from the developments of the past several months and from yesterday’s Fed statement, we must take these ideas at face value. We must understand them not as theoretical possibilities, but as an armamentarium of tactics that it fully intends to deploy now that it has reached the zero-bound. Very simply, the Fed will stop at nothing to prevent deflation.

With this understanding of the Fed’s strategies as background, I am confident that the deflationary trend of the past months will not last long. It could continue for a number of months into 2009, or perhaps even into 2010. But I have little doubt that, by dint of its creative application of monetary authority, the Federal Reserve will prevail.

What Will Happen To All That Money?

Mainstream economists view inflation of around 3% or so as benign. A bank CD paying interest of 5%, or a long-term bond paying 8%, would compensate for inflation and leave the investor with a reasonable return. The mainstream investment and economic community assumes that, one way or another, the Fed will target a reasonable level of inflation once the crisis has subsided.

And, indeed, the Fed has mechanisms for “mopping up” the excess money it creates in order to prevent excessive inflation. The Treasury can deposit the proceeds of bond sales with the Fed, taking those dollars out of circulation and reducing their inflationary effect. The Fed can also increase the reserve requirements for banks. For example, by increasing the deposit to loan ratio from 10% to 15%, less money would circulate through the economy. And of course the Fed can raise interest rates.

But one has to wonder whether the Fed, or the government, would have the discipline to throw cold water on an economy recovering from a severe recession. A monetarily responsible Fed under Alan Greenspan should have raised interest rates when the economy showed signs of recovery from the bust. Its failure to do so led to the housing bubble that caused the current recession. Our economy’s  addiction to credit as a vehicle of economic “growth” will make the Fed reluctant to slow down credit expansion as the economy recovers.

More importantly, in the coming decades our government will be forced to adopt a deliberate policy of inflation to cope with the national debt. Our national debt has reached over $10 trillion. Adding future entitlements such as Social Security and Medicare to the mix brings the total in coming years to a mind-boggling $70 trillion. And, of course, all of the bad corporate debt that the Fed continues to buy in order to rescue the banks adds to this burden.

Inflation can serve as a release valve for any government facing this level of debt obligation. You’ll recall from my discussion of the mortgage as a hedge against inflation that inflation transfers wealth from creditors to debtors because the nominal value of the loan decreases as the nominal value of the underlying asset inflates. In a similar way, the government’s obligation to entitlement beneficiaries (most notably retirees) becomes a smaller burden when inflation persistently and steadily devalues the nominal value of the fixed payment. It has the same effect on the government’s debt to international creditors, such as China, who hold large dollar reserves in treasury debt.

Bear in mind, too, that since the government controls inflation statistics, it can control whether and to what extent entitlement payments keep pace with true inflation. Please review John Williams’ work on inflation for more about the true rate of inflation.

Ultimately, an economy that depends on an indefinite expansion of credit to sustain its growth cannot go on forever. Eventually, debts must be paid. In the current crisis the Fed is introducing the world to the printing-press approach that will later serve to cope with the country’s debt.

But eventually this strategy must fail. Relentless devaluation of currency renders it worthless.  The dollar must die eventually.

How To Save And Invest

I do not believe that a currency collapse is imminent. The more likely scenario is a slow burn lasting for decades in which a series of booms and busts will obfuscate the underlying trend towards hyperinflation.

In the short term (for the next year or so), the prices of stocks and consumer goods may continue to fall due to the the effects of defaulting credit and gloomy economic reports. In any economic climate, a prudent savings and investment strategy would keep enough emergency funds in cash (short-term bonds and bank CDs) in case of protracted unemployment or other exigencies. Just bear in mind that the cash you would need in the short term for emergencies will lose its value over the long term as the Federal Reserve pursues its policy of relentless and deliberate devaluation of the dollar.

A long-term portfolio should include some percentage of investments that hold their value independently of the monetary system, such as commodities, precious metals, and businesses that produce food and energy.

DISCLAIMER: I am not a professional financial planner and have no credentials in this area. You should always review your financial plan with a qualified financial planner. I recommend finding one who understands monetary inflation and peak oil.

© 2008 Philip Glaser


Inflation Versus Deflation: Part One

December 14, 2008

Benjamin Roth’s Depression Diary chronicles the impressions of an Ohio lawyer during the Great Depression. He paints a poignant picture of things that happened to investors in that era. “For over a year now,” he writes in 1931, “people have been buying stocks at what they think are bargain prices.” But, he adds later in 1936, “these early buyers were badly mistaken and many of them were wiped out.”

The process that took stock values down by 90% from 1929 to 1932, and depressed the prices of virtually everything else, is known as “deflation.” The story makes plain the danger of investing in any financial asset during a deflationary spiral: if that asset’s market has not truly bottomed, you risk great losses. Today one frequently hears in the financial news what a bargain good companies are selling for on the stock market. Roth’s journal entries provide a scary backdrop to this advice.

Last week I alluded to a debate that his been raging for several years within the contrarian financial community between the inflationaistas and the deflationistas. Both sides have always agreed that excess consumer and government debt would lead to an economic crisis.  They continue to disagree about the outcome, even as the outcome unfolds before our eyes.

Roth’s diary should clue us in to the fact that either outcome, deflation or inflation,  bears more than academic curiosity. Either one can change the results of any particular savings and investment strategy. It matters even — or rather, especially — if all you ever do is save money in a passbook savings account or Certificate of Deposit. Deflation would magnify the purchasing power of your savings , whereas inflation would diminish it. Generally, the strategies for dealing with inflation and deflation have little overlap. In making up your mind about how to proceed, you’ll want to have some idea about the probability of one outcome over the other.

My discussion will be lengthy and will occupy this week’s and next week’s blog entries. It will challenge your attention span and your willingness to follow technical detail.  So please bear with me. I promise to reward your attention with a greater understanding of current economic events.

Credit: Bubbles And Contraction

To understand how a deflationary spiral works, you have to understand the inflationary bubble that precedes it. The bubble begins with the availability of cheap credit. First the central bank lowers the interest rate on short term loans.  Then, through the mechanics of fractional reserve lending, the member commercial banks offer lower interest rates on long term loans to their customers. As more money enters the system, nominal asset prices rise. But eventually prices get so high that buyers stop buying and the bubble reverses itself. The weakness in such bubbles lies in the understatement of risk by lenders.

Let’s look closer at this phenomenon through the lens of the subprime mortgage meltdown.  Subprime mortgage lenders (and apparently rating agencies) assumed that the economy would remain strong enough for borrowers to sustain their mortgage payments. They also assumed that the values of homes would remain high enough to cover the mortgages in the case of default.

Of course, the inevitable happened.  Home prices got so high that, even at low interest rates, buyers stopped buying, and prices began to fall. And when initially low “teaser rates” on mortgages re-adjusted to their higher long-term rates, borrowers became unable to make their mortgage payments. An increase in defaults put more homes on the market in distressed circumstances, reducing the value of homes to below the amount of the mortgages that financed them.

Such loan defaults end up as losses on the balance sheets of the banks, causing some of them to go out of business. If those banks owe money, their creditors also suffer losses. As loan defaults cascade through the banking system, banks hoard their cash to maintain the integrity of their balance sheets and become reluctant to lend.  When they lend, they do so at prohibitively high interest rates.

The contraction of credit wreaks havoc on other financial assets.  In our day, hedge funds had attempted to magnify their earnings by borrowing heavily against their assets. As credit tightened due to subprime mortgage losses, the hedge funds’ creditors  raised borrowing rates and demanded additional collateral even for relatively safe investments. To raise cash, the hedge funds had to sell off holdings in stocks and commodities, resulting in price declines.

Credit contraction also slows down economic activity. For example, the banks’ unwillingness to extend letters of credit has seriously affected international trade. Many businesses depend on short-term loans known as commercial paper in order to function on a day-to-day basis. Commercial paper, too, has suffered from the credit contraction.

As businesses fail or contract from the paucity of credit, they lay people off. Fewer people have money to spend or are afraid to spend it for fear of losing their jobs, slowing the economy even further.

If it continues unchecked, credit contraction leads to the general price decline known as deflation.

Inflation And Deflation Are Monetary Phenomena

Almost everyone has heard of the law of supply and demand. Very simply, the more scarce a product or service, the higher its price. The requirement that plastic surgeons go through many years and hundreds of thousands of dollars in medical training makes them relatively scarce. But almost anyone can, with enough motivation, clean a house. Thus you pay a plastic surgeon thousands of dollars for the few hours of time it takes her to fix your nose,  whereas the house cleaner earns $10 per hour.

The price effects of inflation and deflation differ quite a bit from supply-demand dynamics. For many economists,  and for the purpose of our discussion, changes in the money supply cause inflation and deflation. The great economist Milton Friedman is famous for saying that “Inflation is always and everywhere a monetary phenom­enon.”  That is, inflation results from an increase in the supply of money relative to the goods and services in the economy; deflation results from a decrease of money supply.

With this point in mind, remember that, in our system, all money is debt. All money flowing through the system began as the transfer of money from a creditor to a debtor. If everyone in the world paid off their loans at once, all money would disappear from the economy. Availability of credit increases the money supply and thus creates “economic growth,” while the unavailability of credit results in economic contraction. Please watch Paul Grigon’s documentary, Money As Debt, for a really good explanation of this concept.

So, credit contraction plays the lead role in the drama of a deflationary spiral.

For the moment, although the price of oil and other commodities has dropped, true deflation has not yet taken hold of the economy. The prices of food, housing, and health care remain relatively stable. But if the contraction of credit continues, the supply of money to the economy will eventually decrease and all prices will fall.

How To Save Or Invest For Deflation

In investing and saving, inflation and deflation have different consequences. In deflation, the dollar-denominated value of everything drops. Relative to goods and services, then, the purchasing power of cash increases. But since less of it flows through the economy, cash is hard to come by.

Although I do not believe that true deflation has taken hold at this point, the desire for cash in a credit contraction might explain the behavior of investors in US bonds. The demand for short-term US bonds has pushed their yield almost to zero. When transaction fees are figured in, investors are paying a premium over par value for these securities because of their perceived safety.

In inflation, on the other hand, cash becomes less valuable because prices expressed in the currency become higher. In such an environment, it becomes advantageous to buy stocks, commodities, and real estate because their prices will rise in nominal value, thus preserving the original value of the investment.

I should add that deflationista extraordinaire Mish Shedlock believes gold to be a good investment for both deflation and inflation because of its true role as money.  Robert Prechter, on the other hand, insists that even precious metals will decline in nominal value under deflation.

What Can Be Done?

Though complicated by the many intracacies of modern economics and finance, the argument between the deflationistas and the inflationistas boils down to one fundamental question: will the monetary authorities succeed in reflating the economy?

Once deflation sets in, stopping it becomes very difficult. The deflationistas assume that the monetary authorities are ultimately powerless against the economic forces driving deflation. They foresee a sustained period of monetary contraction resulting in a global depression with chronic and high unemployment. The inflationistas argue that the monetary authorities will succeed in getting money to move through the economy again and thus put the economy back on the inflationary track to “growth.”

To make up your own mind about this question, you will need to understand  how the Federal Reserve seeks to accomplish this goal. I shall examine the Fed’s strategy in my next blog entry.

© 2008 Philip Glaser

Debt As An Inflation Hedge

December 4, 2008

I highly recommend Axel Merk’s latest discussion of the Fed’s fight against deflation. He addresses many of the currency and debt dynamics I have touched upon here in the past weeks, but with greater technical depth and detail. One element of Merk’s discussion deserves particular focus:

Banks are in the business of borrowing short and lending long: typically, banks would have deposits (short-term loans from depositors, callable at any time) and lend to finance long-term projects. This may well be the greatest carry trade of all times, except that it has neither credit, nor currency risk; it does have interest risk, i.e. if long-term interest rates go up because the market prices in the risk of inflation, then banks could lose money.

A bank pays a lower rate of interest to its depositors than it charges for the long-term loans it lends. If it gives its depositors 2%, but charges its debtors 6% for a mortgage, it profits from the 4% spread.

The risk to the bank from rising interest rates deserves our attention because, as Merk explains in his article, it now drives a number of the Fed’s current actions. I have already alluded to the possibility that China may grow increasingly reluctant to purchase US debt obligations. The drop in oil prices now makes it less likely that oil producing countries will want to purchase US debt, as well. By the simple law of supply and demand, a decrease in demand for US Treasury Bonds would force interest rates to go up.

Now imagine a scenario in which rising interest rates force the banks to pay its depositors 4%. The higher payment to the depositors squeezes its spread on the mortgage loan down to 2%. Many banks mitigate this kind of risk by selling mortgages to third parties. But of course that just transfers the problem to bigger banks.

As the bank of all banks, the Fed must do everything to protect the interests of the banking industry. Thus, as Merk observes, on November 25 the Fed announced that it would purchase $600 billion of mortgage-backed securities. This announcement signaled to the market an increase in demand for these securities and consequently sent their yields lower. The Fed publically justifies these actions as a means of unfreezing the credit markets. But they also have the effect of protecting the banks’ profits. The Fed has many other tricks up its sleeves to accomplish these goals, all euphemistically defined as Quantitative Easing.

The debate rages between the deflationistas, such as Mish Shedlock and Robert Precther, and inflationistas such as James Turk and Peter Schiff. The question boils down to one’s belief in the the Fed’s ability to accomplish its goal of getting money to move through the economy to prevent a deflationary spiral (a state of high unemployment and consequent decrease in prices as the country suffered in the Great Depression). If it succeeds, but fails to remove the excess money it created from the system, inlation will result.

As a believer in both the Fed’s ingenuity and the inevitability of inflation, I have suggested investing a limited but steady stream of savings in precious metals, for reasons that I have outlined in this blog. But, in the interest of diversification, I am now scrutinizing another tool for coping with inflation: a fixed rate mortgage.

If you have the nerve to tolerate the gory details of how badly our government manipulates inflation statistics, I recommend having a look at John Williams’ Shaddow Stats. Using the same inflation calculation methodology that the government used in the 1970s (when it counted food and energy in its inflation formula), Willams estimates current inflation to be at around 11%. But because the government’s official inflation numbers understate inflation by about 7%, salaries have not kept pace. The 1970’s differed insofar as the government did not lie about inflation so that salaries did increase with inflation.

Daniel Amerman makes an important observation about all this: people who held fixed rate mortgages from the 1960s paid those mortgages off in inflated dollars throughout the 1970s and got their homes virtually for free. The fixed interest rate guaranteed that the payment in nominal dollar terms stayed the same, while salaries, again in nominal dollar terms, increased. This dynamic made the mortgage payments an increasingly smaller expense of household budgets. In effect, inflation transferred wealth from creditors to debtors.

Now it should be even more clear why, as I discussed above, the Fed will do anything in its power to prevent interest rates from rising.

No one can know for sure whether or not the Fed will succeed in preventing a deflationary spiral, or whether inflation will become undeniable enough that salaries have to rise. But Amerman would argue that even people who can afford to own their homes outright can benefit from mortgaging some percentage of their home as a hedge against inflation.

In order for this strategy to work, a number of conditions must be met:

  • The homeowner must have emergency cash available for making the mortgage payments for any foreseeable period of unemployment;
  • The homeowner must also have diversified their portfolio into assets that would do well if inflation does not turn out as predicted;
  • The mortgage’s interest rate must be fixed; an adjustable rate mortgage in a period of inflation is disadvantageous to the mortgage consumer.

To be honest, I am not sure whether I believe this strategy to be practical or ethical. But it intrigues me. If nothing else, this discussion will have given you a better understanding of how the banking system works and how it could even work to your advantage.

DISCLAIMER: I am not a professional financial planner and have no credentials in this area. You should always review your financial plan with a qualified financial planner. I recommend finding one who understands monetary inflation and peak oil.

© 2008 Philip Glaser