The Monetization of Everything
What the Federal Reserve System can do and what it will do are two different things.
The Federal Reserve System can monetize anything. It can create digital money and buy any asset it chooses to buy. There are no legal restrictions on what it is allowed to monetize.
If it were to do this, and it continued to do this, the dollar would fall to zero value. This would produce hyperinflation. The result would be the destruction of all dollar-based creditors. Debtors could pay off their loans with the sale of an egg or a pack of cigarettes. This is what farmers did in 1923 in Germany and Austria.
The economists who advise the Federal Reserve System know this. The bankers who run the banks that own the shares of the 12 regional FED banks know this. Bernanke knows this.
The day will come when the decision-makers on the Federal Open Market Committee will have to fish or cut bait. They will have to decide: mass inflation (20%) or hyperinflation (QEx). They will have to decide: recession or hyperinflation.
Will they see that it's really Great Depression 2 vs. hyperinflation? I don't think so. They have been able to manipulate the economy for over 90 years between recessions and booms. Only once did it become a depression: 1930-40. That depression became deflationary, 1931-34, because the Federal Deposit Insurance Corporation (1934) did not exist. Depositors took their money out and did not redeposit it. That created monetary deflation through the bankruptcy of banks. The fractional reserve process imploded.
The FED inflated the monetary base in order to prevent this, contrary to the account by Friedman and Schwartz in their famous book, "A Monetary History of the United States" (1963). Depositors thwarted the FED, 1931-33. A chart produced by a senior official at the St. Louis FED should forever silence those economists who think that Friedman and Schwartz proved the case of FED "complacency." It won't, of course. The Friedman/Schwartz story is just too convenient for pressuring the FED to inflate. Friedman and Schwartz wrote the single most important book favoring FED inflation ever written, because it is universally believed in academia. The only section of the book ever cited by mainstream economists is the section on the FED in the early 1930s. That story is analytical and historical bunk. Here are the facts.
Today, depositors could do it again. If the FDIC were not backed up by a $600 billion line of credit from Congress, we might see it happen again. But there is a line of credit. That calms depositors.
The creditor Congress is the world's biggest debtor. Congress is running a $1.2 trillion deficit each year. But it has central banks to cover the debt: Japan's, China's, America's. So, the depositors believe that Congress can save the FDIC, which will save the banks. They leave their money in banks. If they pull money out of bank A, they deposit it in bank B. The system does not lose deposits. There is no deflation. The fractional reserve system survives.
The system has worked for a long time. The day of ultimate reckoning has been delayed. I think this has given central bankers a sense of confidence. They will think that one more refusal to go to hyperinflation will succeed. They will not believe that the refusal to pump new digital money into the system will bring on Great Depression 2. They will believe in their ability to manipulate the system one more time.
The system overcame the collapse of Lehman Brothers. They will assume that credit liquidation will be orderly. If it isn't, they can intervene one more time.
Deferring the Day of Reckoning
The leader of Europe's central bank has for months verbally played the deferral game, while inflating wildly. Mario Draghi has kept saying that the ECB will not monetize PIIGS's debts, but it has done so indirectly by allowing national central banks and commercial banks to buy PIIGS's bonds, and then use these bonds as collateral for ECB loans. It has been a version of Angela Merkel's verbal assurances that she will not sell out her nation to the Eurocrats, and then selling out her nation to the Eurocrats every time. "Her lips say no-no, but her eyes say yes-yes."
On July 26, Draghi gave a speech in London. He finally let his rhetoric catch up with the ECB's actual practices. He said the following. "Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough. To the extent that the size of the sovereign premia [borrowing costs] hamper the functioning of the monetary policy transmission channels, they come within our mandate."
World stock markets rose by at least 1% within minutes. Spain's stock market rose a huge 6% in hours.
What he said was in fact a cry of desperation. He does not know what to do, other than to inflate. He knows he must break the Maastricht treaty that created the EU, but he does not have any choice. He has defined out of existence the treaty's limits on the ECB. He defines his mandate broadly. He knows that Spain is close to default. The ECB must buy Spain's bonds, or else provide funds for some other agencies to buy Spain's bonds. The weekend summit meeting less than a month ago has already broken down. Spain's ten-year bond rate went above the failsafe 7% figure.
The European banking system is being propped up by monetary inflation. There are signs that this cannot go on much longer, but the central bankers have enormous self-confidence. They believe that fiat money can delay any major crisis. They believe that fiat money is the ultimate ace in the hole. So do Keynesians. So do politicians. They really do believe that the exclusive government monopoly authority to supervise the creation of digits is the basis of prosperity.
Investors invest digits called money. They are convinced that the ability of central banks to create digits has created a failsafe for investors' digits. They believe that a prudent mixture of digit-generating investments will gain them a positive rate of return, as measured in digits, just so long as the total number of digits is always increasing. This is the key to every investment strategy that is tied to "digits invested now, more digits to invest later": an ever-increasing supply of digits.
You might think that investors would judge their success in investing by increased real income: stuff, not digits. But the vast majority of investors assume that stuff will inevitably take care of itself, if only the supply of digits is increasing. Here is the mantra of this generation: "The system of stuff production depends on a steady increase in the supply of digits."
This is why there is no resistance to central bank monetization. On the contrary, there is cheering. The journalists follow the economists. The economists have adopted the mantra of digits with the zealous commitment of any priesthood. Milton Friedman is their high priest.
Friedman, not Keynes
Keynes argued for government spending to save the system. This is universally believed by academic economists. But there is a problem with this scenario: interest rates. Governments must borrow. From whom? At what rates?
Keynes had little to say analytically about central banks, yet central banking is at the heart of government debt. Economists can intone the mantra, "government spending," but this does not answer the economist's universal question: "At what price?"
That is where Friedman enters the picture. Keynes was the prophet of government spending. Friedman was the guy with the green eyeshade in the back room. He ran the books. Without Friedman, Keynes & Company would have folded during World War II.
Keynes was the academic prophet of big government. Friedman was the high priest of big central banking. The high priest raises the money. Every prophet needs a high priest, or else the religion disappears.
Friedman argued for decades that the banking system need only create money at a rate of 3% to 5% per annum for the economy to prosper.
I never saw anyone make this observation: 5% is 66% more than 3%, so Friedman was not recommending anything like stable money. Nevertheless, the monetarists adopted his mantra. So, the free markets' best-known academic defenders universally accepted the legitimacy of a government monopoly, central banking, as well as a government-licensed cartel, fractional reserve commercial banking. Only the Austrian School economists rejected this legal arrangement, and there were few of them. None had any influence.
Keynes gets the credit as the supreme economist of the era, but Friedman was more important operationally. Keynes promoted government spending, but said little about central banking. In contrast, Friedman provided the theoretical justification for the funding of government deficits by central bank purchases of government debt.
The trouble was this: the deficits during major recessions were so large that a steady 3% to 5% increase in the money supply did not suffice. More was needed. The central bankers then took their monopoly and put it to immediate use: unlimited expansion of money. That was what the FED did in 2008.
The predictability of steady monetary inflation never was honored. Friedman's defense of central banking was well-received by the Keynesian economists. His limit of 3% to 5% was of course ignored. The central banks did not adhere to the limit, any more than the Internal Revenue Service adhered to the 1943 withholding tax law as a temporary wartime measure. Friedman provided the intellectual support for that law, too.
Once you consecrate the priesthood, you will find that the limitations which you specified are no longer taken seriously by the priesthood. Call this the Nadab and Abihu factor. Call it the sons of Eli factor. It always appears.
Friedman gave repeated theoretical justifications for the actions of the federal government, based on an official position of limited government. In the two most important areas of economic policy, income taxation and central bank legitimacy, he stood squarely behind the federal government.
Once consecrated, the government agencies paid no attention to his practical restrictions on the exercise of power. This is the curse of everyone who recommends a government policy to make government more efficient. This merely furthers the expansion of the power of government into new areas of the economy. Then the politicians and central bankers ignore the recommended practical limits that were supposed to guarantee liberty and its blessings. The camel's supposedly efficient nose becomes its entry point into the tent.
Limits to Hyperinflation
The main limit is a currency unit of zero value. The idea behind hyperinflation is for the government to be able to buy goods and services without raising visible taxes. This policy ceases to function when the monetary unit falls to zero value. At that point, the currency unit has only one practical economic function: to pay off debt.
Once the state overcomes its debts through hyperinflation, the benefits to the state of further inflation cease to exist. It can no longer buy anything of value.
The economy goes to barter before hyperinflation reaches its theoretical limit of zero purchasing power. The tax authorities cannot easily assess taxes in barter transactions. Most barter transactions are not recorded. If a business must report these transactions, it pays its taxes at the end of the tax period. By then, the purchasing power of the monetary unit has fallen. A tax bill is a debt. Hyperinflated money is excellent for paying debts.
So, the government starts over. It kills the old currency. It knocks off lots of zeroes. Then the process begins anew. But, in the meantime, the middle class was wiped out. Pension funds are gone. Bonds are worthless. The political system has had a major defeat. The government promised security and justice, and it delivered insecurity and injustice.
Western Europe experienced hyperinflation in only two nations in peacetime: Germany and Austria, 1921 through 1923. Hungary had the worst inflation ever recorded immediately after World War II. But it was not an industrial economy. Israel had hyperinflation in the mid-1980s, but pulled back short of the destruction of the shekel. Argentina had hyperinflation in the late 1980s.
My point is this: central bankers are aware of the short-term effects of hyperinflation. These effects cause losses in production. They disrupt the banks, especially the large banks. Banks lend money; then they are repaid in money of vastly depreciated value.
The capital base of the nation is undermined. The lenders of long-term money are wiped out. They have no money to lend after the period of hyperinflation is over. If they saw it coming and bought hard assets such as real estate, as few do, then in the recessionary period after hyperinflation they have illiquid assets. If they bought foreign currencies, they are sitting pretty, but few investors buy foreign currencies.
Central bankers are trained in the basics of banking. They recognize the threat that hyperinflation poses to the banking system. The social order is threatened. Their pensions are threatened. They resist hyperinflation.
Is Hyperinflation Possible?
In the early 1970s, a debate broke out in the hard-money camp between deflationists, who argued that hyperinflation is no longer possible, and the inflationists, who said it was inevitable. Both positions have yet to be proven. Both positions still have their defenders.
In the 1970s, the positions were best represented by John Exter (deflationist) and Franz Pick (inflationist). Pick was the first person I ever heard refer to government bonds as certificates of guaranteed confiscation.
Exter argued that the financial structure is leveraged to such a degree that central bank inflation could not save it from massive de-leveraging in a panic. So, despite the attempts of central banks to re-liquify the economy, the collapsing financial structure would produce price deflation.
I do not recall that he brought up the issue of excess reserves. This may be a problem with my memory rather than Exter's analysis. But what we have seen since 2008 seems to confirm one part of his thesis, namely, the lack of effect on consumer prices of Federal Reserve monetary base inflation. But there has not been a collapse of financial asset prices. So far, his case is not proven.
He said there would be a massive run on gold in this deflation. Why? Because gold is the ultimate liquid asset. He came up with a pyramid of increasing liquidity. Gold was at the bottom. We still see this pyramid in economic analysis. You can see it here.
Yet gold fell by 25% in 2008, contrary to his prediction. This calls into question his theory of over-leveraged financial markets as the cause of deflation.
What he never showed was this: how the total money supply could contract in a world in which banks are protected from collapse by central banks. If the money supply does not fall, then there is no reason for consumer prices to fall. Asset prices could fall, but that has nothing directly to do with consumer prices.
Those of us who were anti-deflationists kept coming back to this argument. The price movements within the capital markets are not the same as price movements in the consumer goods markets.
Then there is this. The Federal Reserve is legally allowed to monetize anything. It can monetize stocks, bonds, commodities anything.
The FED can buy the S&P 500. It can buy S&P futures. It can buy individual shares. If there were ever a collapse of share prices as a result of fears over Federal Reserve deflation, the FED could monetize the entire stock market.
The FED can enter markets in a panic sell-off and buy any asset class that it chooses. It can head off the panic by serving as the buyer of last resort, not simply the lender of last resort.
There is no seller of an asset who would not take the FED's money. There is no lack of trust in the FED so great that a frightened seller of an asset will say, "Sorry, but your money's no good here." The sellers will sell for dollars.
I do not believe that hyperinflation is inevitable. I think it is unlikely. I do think that a Great Default is inevitable. Governments will default when the workers who are paying into Social Security and Medicare finally figure out that (1) this is not in their self-interest and (2) they outnumber the geezers.
Central bankers are arrogant. They really do think they have the upper hand. They really do think fiat money creation by central planners (themselves) is more powerful than free market forces (investors). They really do believe that they can find a suitable middle/muddle road between deflationary collapse and hyperinflation. So, they will not pull out all the stops. They will not hyperinflate unless Congress compels this.
Paul Volcker is the model. He reversed the policies of the ill-equipped G. William Miller, who was persuaded to resign by Carter after only 18 months in office. Volcker stuck to his guns from the fall of 1979 until August 13, 1982. By then, the public had lost its fear of inflation. It had gone through back-to-back recessions.
Volcker saved the dollar and the bond market. He let the politicians pay the price: first Carter, then Reagan. Reagan weathered the storm because the economy had turned back up by 1984. He smashed Walter Mondale.
The leverage is much greater today. The leverage of the big banks is much greater. The public still trusts Bernanke and Draghi. The investors think the central banks can save the system from a catastrophe. I don't. But I think the central banks have their choice of catastrophes: deflation/depression vs. hyperinflation/depression. I think they will try to navigate a middle ground, but when push comes to shove, they will risk a controlled deflation, with selective bailouts for the largest banks.
The central banks are not there to save the governments, which come and go. They are there to save their clients: the largest banks. They know where their bread is buttered.
But if Congress ever nationalizes the FED, then hyperinflation is a real possibility.
July 28, 2012