The ‘Flations – Part II
Frederick Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession (McGraw-Hill, 2009).
Inflation versus deflation discussions are the rule for columnists, economists and Bubble TV. This false distinction is potentially harmful for investors and shoppers who think they must decide between the two, then act. Inflation and deflation act contemporaneously. The relative movement of what is inflating and what is deflating (e.g., common stocks vs. gas, bonds vs. bread) influences, and possibly changes, the way we live.
An additional problem with each of the discussions, at least as presented in popular formats, is misstatements of the nemesis. The deflation to be concerned with is not prices, but rising levels of unserviceable debt and the attendant consequences – for example, falling income and access to credit. The inflation to watch is Federal Reserve and Treasury Department actions, whether a spree of money printing or rearrangement in how the government distributes money in the economy.
As for timing, the undertow of deflationary tendencies is palpable. The ‘Flations addressed the areas most susceptible to this course. Investors should be vigilant of being pulled under water in a deleveraging economy, a process that is still in its childhood. An ever-present possibility is that of frozen credit markets, initiated, for instance, by an institution (a bank, a government) that loses access to funds. The disruption could frighten other markets into panic. A put strategy, either literally or in another form of protection against markets that suddenly break, is advised.
Inflation is also present and is to the primary topic of The ‘Flations – Part II. It goes largely unrecognized because it is most evident in assets, though food prices may be about to burst forth in the United States. They have been rising fast in other parts of the world. An investor should consider the possibility of asset markets rising to new highs if the dollar drops to new lows. The rise in stock prices (for instance), might not fully compensate for higher prices of food, but then again, they might.
The U.S. government seems universally intent on reflating the economy through a tag team effort of spending (fiscal policy) and Federal Reserve money expansion (monetary policy). These tactics have already failed, but reputations demand more of the same.
The federal government is spending as if there is no tomorrow. Assurances of fiscal forbearance are empty. The commitments grow and all we need is for the stock market to fall 40%, quite possible if not predictable, to witness another unseemly spectacle in Washington. An emergency trillion dollar accretion to insolvency will whip its way through a confused Congress, smothered in patriotic ardor but with anarchic purpose, during an emergency government sales campaign that frightens the electorate into temporary fear. This is predictable because the national politicians have ignored our sources of instability (primarily, their own past policies) so have made no other preparations.
Such fiscal inflation will be complemented by more monetary inflation. Headlines such as "Will the Fed Do More" and "What Ammunition Does the Fed Have Left for the Economy?" are daily fare.
Simple Ben has every intention to fulfill his destiny. A century of inflation has reached its final stage. All previous Federal Reserve chairmen inflated the supply of money, but all struggled against the urge to do so. Their statements of rectitude may have been authentic or may have been for show, but they expressed a concern and understanding that money in excess of a constructive need is destructive. Federal Reserve Chairman Ben S. Bernanke’s mind is not so encumbered. His most famous speech was not "Inflation: Making Sure ‘It’ Doesn’t Happen Here." Such a topic would never occur to the professor, though it is a plausible title for a speech delivered by any of his predecessors.
Starting in 1913 with the founding of the Federal Reserve, the stability and strength of the dollar might be pictured as a seven-layer wedding cake, the thickest buffers of confectionary ingredients at the bottom, then rising, in thinner and less resistant stages as time passed until all we have is a little, hollow, plastic man standing on top, cloaked neither in batter nor frosting, bearded and bald.
Bernanke’s most quoted speech was delivered on November 21, 2002. The (then) vice chairman of the Fed delivered a speech to the Washington National Economists Club with the title. "Deflation: Making Sure ‘It’ Doesn’t Happen Here."
To be clear, when Bernanke spoke (and speaks) about deflation, he fears falling prices. As discussed in The ‘Flations, falling prices may be good or bad. The deflation to fear, and which neither the Federal Reserve chairman nor his money-printing policy address, is the debt deflation of a deleveraging economy.
The paragraph most cited from this speech has been quoted so often that only a fragment seems necessary: "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." [My italics.]
It is the acknowledgement of "its electronic equivalent" that ensures Bernanke’s moment of destiny. He is not constrained – as Germany was in 1923 – by the speed of the printing press. Simple Ben was already prepping for this moment in a 1999 paper, "Monetary Policy and Price Stability." He suggested the Fed could go beyond its mandate of purchasing short-term government debt in open-market operations. Long-term Treasury bonds, common stocks, and corporate bonds were his suggestion. In other words, the government could print money and the Fed could buy anything.
The effort to hire Federal Reserve governors who complement the chairman, and are so willing to exceed the institution’s mandate, is a reason to expect vast money printing (or its electronic equivalent) in the months ahead. Bernanke recently stacked the deck by choosing Janet Yellen as his new vice chairwoman. The Senate Banking Committee has approved her selection. The full Senate needs to vote its approval, which looks certain.
As the current president of the San Francisco Federal Reserve Bank, Yellen showed she has what it takes to serve. She is as confused about how the world works as is the chairman: "Even with my moderate growth forecast, the economy will be operating well below its potential for several years," she said on Feb. 22, 2010. "If it were possible to take interest rates into negative territory I would be voting for that."
A negative rate would boost price inflation above the cost of borrowing and on savings. This could be the death of money-market funds and salvation of the stock market, though – and this is all-important, the most important sentence in this diatribe – a 10,000% return on stocks might buy 90% less food.
Such Mad Hatter theories are already well-established within the Federal Reserve and among panderers to such. Greg Mankiw, economic adviser to George W. Bush, professor at Harvard, and ingratiating supplicant who can never stoop too low in his attempt to grab the seat Yellen shall soon occupy (See AuContrarian blog post "The Best and Brightest Protect Greenspan and Betray the American People"), proposed to his New York Times readers that the Federal Reserve set a target interest rate of negative 3%. For all his faults, Mankiw is at least worldly enough to understand the banking business is likely to falter, if, for every $100 lent, the borrower pays back $97.
Unlike the present suicidal strategy of the Federal Reserve governors, Mankiw’s (even more suicidal) theory proposed a solution to a practical problem: "We [need to] figure out a way to make holding money less attractive. Imagine that the Fed were to announce that, a year from today, it would pick a digit from zero to 9 out of a hat. All currency with a serial number ending in that digit would no longer be legal tender. Suddenly, the expected return to holding currency would become negative 10 percent. That move would free the Fed to cut interest rates below zero. People would be delighted to lend money at negative 3 percent, since losing 3 percent is better than losing 10."
Mankiw may sound deranged, but most of the actions taken by the Federal Reserve over the past two years were inconceivable ahead of time, other than to those who were already preparing for this opportunity. In May 2003, the Dallas Federal Reserve Bank published a research paper in which the authors proposed a tax on savings, akin to Mankiw’s thesis, which doesn’t even deserve credit for originality. His function was to contaminate the public arena with a notion already articulated in the bowels of the Fed.
To make sure Americans keep spending, according to the Dallas branch, the currency would be stamped periodically, and savers would pay a tax "in order to retain its status of legal tender." The staffers seemed to favor 1% a month, or, 12% a year.
As an alternative approach to achieve Dow One Million, a senior policy staffer at the Fed told the Financial Times in 2002 of how he would turn the dollar into Monopoly money. The Fed "could theoretically buy anything to pump money into the system" including "state and local debt, real estate and gold mines – any asset." So, don’t bet the ranch shorting municipal bonds.
A corollary, in this age of electronic money, is for the Fed to wire dollar deposits to Americans’ banking accounts; let’s say, $100,000 to each. As ridiculous as this sounds, it is worth recalling that Federal Reserve (and Obama administration) policy is the playground for academics, those who have ravaged the economy and left the United States in such an impoverished state. They are fortunate the American people do not understand – yet – their policies are the most compelling source of our woes, and are willing to follow their conclusions to a hyperinflationary end to prove themselves right.
A lingering question is whether the Fed would dare take such steps. Congress has not stopped the Fed from irregular and illegal activities (e.g.: "the Federal Reserve and the Treasury decided to ignore existing law and provide a bailout to the benefit of Bear Stearns’ bondholders at public expense." – John Hussman, Hussman Funds’ Weekly Commentary, March 31, 2008). The legislators are too dumbfounded to press charges. This may change of course, at which point the little man on the wedding cake may be shipped in a wooden crate to Waziristan, but the central banking world is still busy spreading propaganda to boost credibility for its hare-brained plans.
(This raises the all-important question of whether the Fed’s blueprint could be thwarted by peasants bearing pitchforks. Yes, indeed. But the questions of when and if it reaches a fever pitch is difficult to assess. It is better to prepare for the worst and then recalibrate later if the Fed’s inflationary impulses are suppressed.)
The Riksbank is both the central bank of Sweden and supervisor of the annual Nobel Prize in economics. In fact, there is no Nobel Prize in economics. It is officially the "Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel." It was funded by the Riksbank and is awarded annually to some economist who fulfills the current mandates of central banking interests.
In 2009, the Riksbank instituted a negative interest rate for banks (presumably, for those that hold deposits at the central bank.) The Financial Times reported: "[T]he most vocal advocate of the policy is deputy governor Lars Svensson, a world-renowned expert on monetary policy theory and a close associate of Ben Bernanke, chairman of the US Federal Reserve, since they worked together at Princeton University."
Svensson was quoted in the article: "There is nothing strange about negative interest rates." These guys will say anything. Then, they hand out Noble Prizes (sic) to each other knowing the award and those awarded are treated with reverence.
In summary, a deleveraging shock is an ever-present worry, and investors should protect themselves. It is the fear, undoubtedly whispered in Fed governor ears by Wall Street bankers who stand to prosper from ignorance, that the Dow could fall to 1000 and house prices dive another 70%, which helps to explain why the crosscurrents of speeches by Federal Reserve governors sound like transcripts from talent shows at a lunatic asylum. The best protection is to hold real assets, such as gold, silver, a farm, and other commodities, as well as paper assets that are the most likely destination of flows from money-market funds. Common stocks, across a wide spectrum of countries and currencies, are a place to look.