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Wednesday, October 28, 2009

The Fed's Wish Part III: Exit Strategy and Deflation Confusion

In two previous posts, The Fed's Wish, and The Fed's Wish Part II: Coup D'Etat?, I explained the recent activity of the Federal Reserve including the explosion of its balance sheet and its unprecedented creation of excess reserves. I also noted that In the process of this expansion, it has taken on unprecedented power and is "now threatening even greater usurpations of our liberty in the name of promoting financial 'stability'".

What has happened since?

In essence, the Fed has continued to purchase government securities and mortgage backed securities in the open market using money it creates out of thin air. As of October 21, 2009, the Fed's balance sheet reveals that reserve balances total $1.056 Trillion. Since "currency in circulation" has not changed as dramatically this year, these reserve balances represent the money created by the Fed in the past year. Analysts expect this number to go to $1.4 Trillion if the Fed stays committed to its treasury and agency purchase programs which are supposed to end in March 2010.

Typically, these excess reserves would be used by financial institutions to make loans to the public. Due to fractional reserve banking, this trillion dollars could be multiplied to perhaps as much as 10 trillion dollars by the banking system. Such an increase in the quantity of money would lead to hyperinflation and perhaps the total collapse of the monetary system. However, the Fed has induced these banks to leave these excess reserves at the Fed by paying them interest for the first time in history.

The problem now concerns what the Fed will do with these excess reserves? They could remove reserves by selling securities from their portfolio. However, this would put upward pressure on interest rates. They could raise the rate they pay banks to hold the excess reserves but this would only delay the inevitable and would require ever more credit expansion. They could allow the money into the banking system and cause a hyperinflation.

In addition to my first two posts, I recommend two more articles that nicely detail this problem. The Fed's Dilemma by Professor Philipp Bagus discusses the origin of the problem and possible solutions. Does the Fed Need an Exit Strategy by Robert P. Murphy provides good overview and, in particular, rebuts Paul McCulley's recent argument that the Fed can simply increase the rate they are paying banks to hold reserves.

Ultimately, there is no way to cheat reality. No matter how many PhD.'s and Nobel prize winning economists try, reality will win.

There is another interesting aspect to this problem which is rarely discussed. The bust portion of the boom-bust cycle caused by the government's credit expansion must result in a natural deleveraging process. In other words, recession or depression is the recovery process. As malinvestments (investments thought to have been sound on the basis of an expectation of continual credit expansion now revealed to be unsound) are liquidated and as firms and individuals rebuild their cash holdings, businesses go bankrupt, unemployment rises, and consumer prices tend to fall. This is the unfortunate price that must be paid to restore economic prosperity on a sound foundation.

Many economic pundits falsely characterize the path before us as one of either inflation or deflation. In other words, they mistakenly define these concepts as "increasing prices" or "decreasing prices", respectively. Consequently, they mistake the symptoms of economic fundamentals with the cause. Since they mistakenly believe that deflation is "falling prices", this natural deleveraging process described above is characterized as an evil to be avoided at any cost. Rather than understanding that falling prices are the "antidote to deflation" as Dr. Reisman explained, they advocate that the government print money on a massive scale in order to halt the so-called "deflation."

Inflation, properly defined, is an increase in the quantity of money above the increase in precious metals. If the government prints a massive amount of money as they are doing now, even though prices are not rising presently, inflation still has the same deleterious effects. Prices do not have to go up under inflation. They simply have to go down less than otherwise. In other words, in the absence of inflation, prices would naturally tend to go down due to increasing productivity. In the present circumstance, prices should drop precipitously. Due to the Fed's creation of money, prices are not falling as fast as they would otherwise. The Fed is propping up zombie banks that should go bankrupt or restructure. If interest rates were not being held artificially low, house prices would likely drop even further and even faster ultimately restoring growth to the housing market. In effect, the Fed's inflation is causing malinvestment and inducing less savings than would otherwise be the case in the absence of this money creation.

(Note, for example, that many economists currently regard increasing prices in the housing market as signs of recovery. Don't we like it when computer prices go down or when car dealers have sales? Why would rising prices ever be "good" for the economy?)

Furthermore, the Fed's purchase of government securities is enabling the federal goverment to temporarily spend with impunity. Such government spending encourages wasteful consumer spending and crowds out productive private capital investment. Currently, banks are borrowing money at 0 percent and lending to the government at 3 percent. Is this "good" for the economy?

The entire experience of Japan over the last 20 years is analogous. Rather than allowing the system to heal itself by facing reality, the Japanese government has propped up insolvent banks, rewarded politically powerful special interests, and therefore, never restored economic growth. Japan has been mired in stagnation for over twenty years.

The best thing the government could do is to recognize that it caused the problem, stop interfering, let the market heal itself naturally, and commit to a program of sound money, private property, and limited government. Yeah, right.


garret seinen said...

Very clearly stated Doug, Thanks.

Am I correct, that the low interest rates show the government is inflating the money supply rather than borrowing to cover the committed expenditures?

Again, thanks gs
...the tangled webs we weave when first set out to deceive.

The Rat Cap said...


Actually, it is doing both.

The government is borrowing unprecedented amounts of money in order to fund its deficits. All else equal, such borrowing would tend to put upward pressure on interest rates as the government must compete for dwindling pools of capital.

However, at the same time, the Fed has committed itself to purchasing several hundred billion dollars worth of government bonds on the open market. The Fed creates reserves to pay for these purchases. In the short run, these purchases by the Fed help to keep interest rates lower than otherwise. So, the Fed, by virtue of its ability to create money, is enabling the government to borrow money at lower rates than otherwise.

However, this creation of reserves will have to be "paid" for in the future in the form of increased prices, higher interest rates, or increased taxation or a combination of all of the above.

Notice, that the dollar has been under extreme pressure and many are calling to replace the dollar as the world's de facto reserve currency. This is all in reaction to the unprecedented money creation and deficit spending being undertaken by the current regime.

Let me know if that helps and thanks for comment as always.

garret seinen said...

Actually Doug, that's what I was thinking. What they are doing is far more evil and manipulative than a first look suggests. I think the scale of the malinvestments they are unleashing could easily annihilate the dollar. Truly tragic. On that happy note, keep up the good work. I think I speak for many people when I say I love your work. gs

The Rat Cap said...


Thanks so much! Let me know if you have any other thoughts on this.


Kevin said...

Doug, why do I read this. It makes me sad. I didn't even know the fed was buying up this stuff (beyond the government debt).

Since I see no public will to accept the painful consequences of previous and current government insanity I can only assume that we will delay and defer the suffering as long as the house of cards can last.

So what do I do with my soon to be useless dollars? How long will the cards stay up? What businesses are worth holding through massive inflation? Sigh. Not the kinds of things I want to waste my time thinking about. I'd rather focus on building my current business. This kind of Govt misadventure also robs us all by forcing people like me to become financial analysts instead of doing what we do best.

The Rat Cap said...


Yes, you are right - they will defer because it is the political path of least resistance. You can make things seem good right now which helps to get you elected. That's as far as they think. It is why we need a firm constitutional separation of state and economics. Politicians will always inflate if they can since it is more palatable than raising taxes or borrowing to fund their largesse.

You can protect yourself by holding gold or other hard assets. You will not make a lot of "real" money but you will not lose in real terms either. I think this is a good time to just protect what you have. Companies that derive earnings from hard assets should do okay but that is harder to predict.

You said: "This kind of Govt misadventure also robs us all by forcing people like me to become financial analysts instead of doing what we do best."

Absolutely. I wrote a post a while back about the opportunity cost of government intervention and this is another example. While no one should profit from mindless investment, i.e., you must think, it is true that the government's machinations cause massive volatility and the boom-bust cycle's which are difficult or impossible to predict and do nothing but wreak havoc on people's wealth. It does this not only in a direct way, but in the way you are stating which is in terms of peoples investment portfolio's.

In my recent post about hyperinflation in Revolutionary France, I alluded to the idea that many turn to speculation and other schemes to profit from inflation. (Recall when doctors were quitting their professsion to day trade during the dot.com boom and others were flipping condos during real estate boom). They can't be blamed but it is a consequence of this process - many get rich from being able to speculate in currencies, hard assets, and other securities that oscillate wildly in value while others get destroyed - the market is never easy even if it were free but this adds another dimension that is truly sinister.

Furthermore, there are those like Goldman Sachs that profit from these manueveurs via political pull and their position as favored member of the Fed's court.

Unknown said...

I'm with Kevin, honestly I'm not sure what to do. My ears were actually burning reading the previous article. How many more must suffer? Why must we go through this again and again?

And of course, we all know who (and what) will be blamed. I don't even need to mention it...

The Rat Cap said...

I feel your pain but....the real death blow will not be inflation only. It will be the next logical step in the reoccuring statist progression. As prices rise, there will be calls for price controls. We saw this start to bare it's head when gas prices were rising. Controls were enacted by carter in the 70s and this admin wouldn't hesitate. Price controls are tantamount to socialism and would collapse the economy. See my discussion of The Maximum in my post on hyperinflation in France. If prices are" allowed" to rise it will be tough for the govt to continue.

What is particularly insidious presently is that because prices are not rising in absolute terms, those schooled in the flawed "inflation is rising prices" idea do not recognize the effects of the inflation of the money supply until prices do rise in absolute terms. They conflate cause and effect and so can not see that inflation has the same effects even though prices now are just going down less than otherwise.

In fact, this fact acts like a green light to the regime to create even more money - as long as prices are not rising in absolute terms

The Rat Cap said...

clarification: in my last comment, when I said: If prices are "allowed" to rise it will be tough for the govt to continue.

what I meant was that if the government does not enact price controls, it is difficult for the government to continue its inflationary policies without political repercussion. Therefore, inflation in and of itself will be unlikely to cause an all out collapse (although it certainly could).

Price controls are the next logical step for the statist mind. Price controls are the true death knell for civilization as it amounts to a de facto usurpation of property rights and requires state violence to enforce as all the true socialist countries have amply demonstrated throughout history.

Unknown said...

"Price controls are the next logical step for the statist mind. Price controls are the true death knell for civilization as it amounts to a de facto usurpation of property rights and requires state violence to enforce as all the true socialist countries have amply demonstrated throughout history."

Thanks for the response. I guess we already have some of that with the minimum wage though.