Sunday, September 12, 2010

The Hyperinflation Mirage

The Fed can create as much money as it likes without any risk of inflation provided the money is tucked away where no one can spend it. And this, in fact, is what the Fed has done. They have exchanged $1.7 trillion in reserves for non performing loans and mortgage-backed securities with the banks. But the banks loan book continues to shrink. In other words, the Fed has increased the money supply, but in real terms, the money supply has shrunk. Thus, the Fed's so called quantitative easing (QE) program has failed to stimulate spending or lead to a credit expansion. Had the Fed chosen to take the $1.7 trillion and bury it in a hole on the White House lawn, the effect would have been exactly the same.

The reason the government increases the money supply during a recession, is to reduce unemployment, stabilize prices and increase economic activity by stimulating demand. And, increasing demand should be fairly easy. It merely requires that consumers have enough liquid reserves (cash) that they feel comfortable spending at levels that will grow the economy. Naturally, full employment helps to increase spending and, thus, strengthens demand. The government can help to speed the process along through targeted fiscal interventions. (aka--stimulus)

At present, demand is weak because working people lost $8 trillion in equity when the housing bubble burst. They also lost another $2 trillion in retirement funds from the correction in equities. That means, it will take a long time before they recover and are able to spend as they did before the crisis. Fortunately, the government is not limited in the same way as everyone else. Consumers cannot print their own money, but a sovereign government (that pays its debts in its own currency) can. The government can print as much money as it likes; it is not capital constrained. And, the government should exercise that privilege when there is a compelling reason to do so, such as, when when the output gap is wide, unemployment is soaring, the economy is sputtering, and the risks of deflation are high.

But increasing government spending also increases the deficits, which creates an opportunity to scare people about future obligations. But deficit scaremongering is politics not economics. What really adds to the deficits are the governments fixed costs (that go up during a recession) and the shortfall in revenues which dwindle because people pay less in taxes. Stimulus is just a small part of the deficits. So, the best way to reduce the deficits is to increase employment, restore consumer spending to prior levels, and grow the economy.

Keep in mind, investors vote every day as to whether they think the deficits are a problem or not (through their purchases of US Treasuries) And, every day, they vote "No"; the deficits are not a problem. The 10-Treasury is currently under 3% (2.82%) while the 2-year is a paltry .57%. The appetite for risk-free liquid assets on the part of the public is so great that they will commit their money to an investment that yields less than 3% over a 10-year period of time. Think about that. That alone should prove that hyperinflation is a mirage invented by demagogues.

The Fed's QE program has not put money in the hands of the people who will spend it and thereby lower unemployment and generate growth. It has stabilized asset prices to some extent which has helped to shore up the stock market and reduce the amount of red ink on bank balance sheets, but the real economy is still flatlining because demand remains weak.

So what was the purpose of the Fed's QE program?

At present, the banks are purchasing significant amounts of US Treasuries which push down long-term yields making it cheaper for the government to finance its deficits. It's a circular trade; the Fed provides extra reserves for the banks, and the banks, in turn, buy heaping amounts of Treasuries. One hand washes the other. But while process may suit the banks and the government, the broader economy continues to languish as the vital flow of liquidity is cut off. Remember, extra bank reserves have not increased the flow of credit to the economy nor have the Fed's low interest rates meant lower rates for consumers--who still pay 18% or higher on the credit cards. They have merely improved the situation for the banks. So, as Obama's fiscal stimulus dissipates, working people will face a tougher economic environment as the flow of liquidity is gradually reduced. Whether this tips the economy back into recession or not, no one knows. But absent additional government spending, deflationary pressures will build as the "real money supply"---not the bogus reserves the Fed has stuffed in the bank vaults--progressively shrinks.

Once again, the government has the ability and the resources to remedy this situation by increasing its budget deficits in a way that reduces unemployment, stabilizes prices, increases economic activity, and stimulates demand. The solutions are known and they work. Unfortunately, policymakers have rejected the conventional remedies because they are afraid of the political backlash. So the suffering of millions of unemployed workers and struggling homeowners will continue for the foreseeable future. Fear and ignorance are a lethal combo.

Federal Reserve chairman Ben Bernanke is a very intelligent man who knows how to read the data. He knows that disinflation is turning to outright deflation, that bond yields are falling, that unemployment is soaring, and that GDP has slipped to 1.6%. He knows that the economy is crying out for more stimulus, but he refuses act. Why? This is the point at which economics and politics intersect.

According to economist David Rosenberg, "We are currently experiencing the recession with the slowest job creation in history. And based on our prior estimates, the recession will last around 85 months before we regain the unemployment rate seen at the onset in December 2007."

So why is Bernanke sitting on his hands?

And, this is from economist Albert Edwards (via zero hedge): "One should follow the leading indicators closely. These are variously pointing either to a hard landing or, at best, a decisive slowdown. In my view we are poised to slide back into another global recession: the data is slowing sharply but, just like Japan in its Ice Age, most still touchingly believe we are soft-landing. But...already in Q2, US productivity growth fell 1.8% - the steepest fall since Q3 2006.....If we plunge back into recession, do not place too much confidence in the Central Banks having control of events."

Bernanke knows the dangers that face the economy. He knows the prospect of a double dip is real.


Finally, this is from Goldman's chief economist Jan Hatzius:

"One important reason why we expect the economy to remain weak is that the household sector is likely to deleverage its balance sheet further. This will require households and the private sector more broadly to run a large financial surplus, which will keep demand weak unless offset by substantial fiscal (and monetary) stimulus.....The still-high ratios of debt and debt service to disposable income suggest that the household sector and the private sector more broadly will need to continue running financial surpluses in coming years. Unless fiscal and monetary policy provide a strong counterweight, this is likely to imply only sluggish growth, with risks tilted to the downside." (zero hedge)

Exactly. Who doesn't know that consumers are retrenching and patching their balance sheets? The deleveraging process could take years which will divert more money away from consumption and create a drag on growth. What's needed is sustained fiscal and monetary support until the the private sector regroups and can spend at precrisis levels.

Ben Bernanke is a brilliant academic and an expert on the Great Depression. He knows what's ailing the economy and he knows how to fix it. He simply chooses not to.

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