*

As to what’s coming, I think it will be bad, but not quite the “YIKES!” Laffer has in mind. A fair chunk of the new money was dished out via the TARP etc loans and equity purchases. When the banks pay the loans back they will do so in that money, which the Fed can just park. I don’t think that would require much in the way of nads, just people making a bit of noise about retaining Fed independence. Many banks have already indicated that they want to make repayment, too. Likewise when people spend money to buy corporate equity back from the government. If all that proceeds normally then for the most part what we’ll see is a magnified version of the Y2K spike/dip cycle, less what differences arise in the prices of the stocks traded.

What concerns me more is the cash that was dished out as FDIC payments and the like. That was a direct issue of property and does not have matching liabilities – there is no non-theft means of permanently retiring the cash because there is no debt to take repayment on. This is where Fractional Reserve Banking comes into it. The pre-failure deposits were fiduciary media, which the failures plus FDIC payouts have converted to notes and coins. That’s a main element of that game of musical chairs. When the finance world returns to normal and reserve ratios fall back to recent historical norms, it is the cash from this source that’s going to be multiplied up by the gigadollar into more M1 and M3, via the FRB process, as people’s and banks’ respective demands for cash recede. I don’t know enough to put figures on how much and when.

The only ways to make the cash flow one-way out of circulation is either far higher taxation or interest rates as you note, or more intervention by way of mandating higher reserve ratios. The govt can’t raises taxes or the Fed raise interest rates high enough without causing enormous revolt, so the third would be the least undesirable – but also the least likely because that would see the banks getting hammered for ‘withholding credit from needy borrowers’ and then made victims of a repeat of King Charles I’s raid on merchants’ deposits in the Tower of London in 1640. Thus, get ready for CPI increases PLUS higher taxation and interest rates.

JJM

I remember back to the mid-70′s, and wondering when and if all those layoffs and monster mortgage rates would hit my family; fortunately, my parents were more than halfway through paying off a fixed-rate mortgage that began in 1966 (inflation actually ended up doing them a favor there), and my dad had just enough seniority at his factory job to make it to retirement in the mid 90′s.

I have heard it said from a few sources that there was indeed a deflationary period during the period of 2004-2008 that you mention — but the CPI never reflected that. I’d be interested in knowing what M3 or my concept of “total dollars” was doing during that time. I suspect that in the same manner that demand destruction is masking inflation now, the growing real estate bubble and the consequent (false) “wealth effect” were masking the (tiny) deflation then.

If I recall correctly, the Fed did actually try to bleed off excess dollars from the post 9/11 surge (the base interest rate was raised to 5% or so). That they did so at too slow a rate to matter indicates why I expect them not to retrieve this surge either. If they lacked the nads to do it when times were ostensibly good and with an unpopular sitting president, they surely won’t do it when times are bad and Obama is in the White House.

Lastly, an additional point I’d like to bring up, is that ” a dollar is a dollar”; when new dollars commingle with old ones in trade, the dilution is a fait accompli, because once that happens, the dollars are now real wealth to someone (pending the subtraction from ALL dollars in circulation as a result of inflation.) This is a big reason why it’s hard to undo money supply increases. Suppose that the Fed gave you $1000 in new money, and you bought a bigscreen TV with it, putting it into circulation. Do you think the store is going to give that money up if the Fed came knocking? Who is supposed to give up their *earned* dollars in order to shrink the money supply? Once spent, the dollars have value, and retrieving them is outright theft of real wealth (of the TV in this case), by the exact same mechanism as with counterfeit money.

The Fed could try to get it back from you, but that effectively makes it a loan. If you spent the money, now you have a debt of $1000 to the Fed which you can only pay from current or future earnings (wealth creation). This is why I don’t accept credit expansion as necessarily inflationary; the $1000 apparently bump in the supply is eventually drawn down by the repayment. The apparent demand created by the credit, is eventually matched by a drop thereof when you repay the loan.

The only difference between this hypothetical Fed loan and a normal bank loan is that the bank normally makes loans out of real wealth (deposits) lent to it by others who have earned it. That’s not inflationary either. This even remains true to the extent that the bank borrows from the government, so long as the government dollars come out of theft (taxation) or from borrowing.

But if the bank fall short and the government falls short (watch that bond market, and taxes!) and the Fed prints up the missing amount… it’s inflationary again. As I understand it, fractional reserve banking simply increases the risk of default, and therefore of the Fed creating dollars to shore up banks and/or replacing destroyed deposits after a collapse via the FDIC.

In all cases, no matter how byzantine the path that the new dollars take or how long the delay before the new dollars circulate, or in what context they circulate, or how they fudge the numbers…. inflation can only come from the central bank. Changes in the price level from market factors (such as oil prices) is just ordinary supply and demand, and cannot be “inflationary”; inflation and deflation pertain solely to specific monetary causes of such effects.

I just wish I’d bought up gold when I first began to suspect a repeating pattern in 2004, with the Iraq War and Medicare part D echoing Vietnam and the Great Society.

By extension I thought that by denying us having been in a deflationary period you were implying that fiduciary media weren’t part of the money supply and only notes and coins were. Notes and coins have indeed been in an inflationary mode for decades non-stop other than for a dip that offset the Y2K-related spike in demand for money, but fiduciary media have moved differently. I took what you opened with to mean that we “haven’t been in a deflationary period *at all* recently”, but if your real point was that “we were but aren’t any more, despite what the mainstream economists say” then I do apologise.

***

Using economic terminology, in essence what you’re claiming has happened is that total money has still been increasing but its velocity has collapsed because the overall economic demand for money has increased via a convoluted game of musical chairs involving who owns what money and who’s doing what with it. That game was made possible by malinvestment becoming manifest (which is the destruction of real wealth as you write about) and government responses to this such as the disastrous mark-to-market edict (more destruction), FDIC payouts and bank bailouts (yet more destruction). Demand for money is high because the banks are holding on to the cash – they aren’t lending as high a proportion of these reserves as they use to because of concerns about asset prices and that damn edict. For that reason prices and quantities sold have fallen accordingly, which is your retail-level demand-destruction causing price-reductions, which via that damn edict turned into a vicious cycle that the Fed responded to by further jacking up the quantity of notes and coins.

Additionally, since the vicious cycle may have abated, the exact nature of that game of musical chairs presents a coming problem because when velocity rises back to normal levels (ie as banks lend and people spend) it will also be accompanied by a catastrophic increase the money supply through falls in reserve ratios, unless the Fed claws back that increase in the money supply either by pulling a huge amount of notes and coins back out of use or mandating reserve ratios higher than they had previously been. You (and Laffer, and I) then doubt the Fed’s and current administration’s willingness or ability to do that. I’m just old enough to remember the anguish of the early 80′s, and I expect worse than that coming.

I’m in perfect agreement with that as an explanation (and again, thank you for specifying it), leaving only the questions of what you meant by us not being in a deflationary period and in turn whether your claim about the money supply actually not decreasing is in fact true. According to the St Louis Fed, M1 had been flat or slightly down-trending since Nov 2004 and only increasing after Sep 2008 just as Laffer noted. That’s a nearly-four-year (just barely) deflationary period ending less than 12 months ago. I also apologise for how a quibble like that has turned into a considerable exposition.

JJM

“You are implying that money is *only* the notes and coins in circulation, be they either proper banknotes and real gold coins or irredeemable Reserve notes and junk Treasury coins. That is debatable.”

I don’t see where I did that, but I do not consider the money supply as being restricted to physical currency. I here mean “money” as any and all things that exist as dollars, including time deposits etc. M3 is the closest approach to what I mean.

The trick here is that money can exist and be created “inside the system” separate from the econopmy. The Fed could “give” every bank a trillion dollars today, and take it away tomorrow, and we would not experience price rises as a result.

The problem is that I have several reasons to believe that the Fed will not be able to un-create that money.

The first, is that it is being used to fill the holes on bank balance sheets — holes caused by the destruction of real wealth. When the bank forcloses a $300k mortgage on a house now worth only $150k, and nonetheless isn’t selling, the bank is out that $300k — $150k lost in a depreciating asset, and the other $150k frozen.

The actual $300k in dollarsthat was originally lent, however, still exists — in the account of the original seller. Therefore, contrary to the mainstream view, those dollars were not lost — but real wealth WAS lost — or to be more precise, that additional $150k of “value” in the house was an illusion.

That’s the point I made here: that the “deflation” we are seeing is a consequence of the fact that the loss in the house was of real wealth — that is, the house buyer traded $300k *earned* dollars, whether it was his own or a bank’s.

This destruction of real wealth is what is dropping prices. Not “deflation”.

Now here’s why I don’t believe that the Fed can or will retrieve those dollars: to the extent that the government is replacing those dollars lost in foreclosures — representing what was real wealth — with new dollars that represent nothing, they are necessarily increasing the money supply relative to the available goods.

We don’t see the effect yet, because the loss of wealth in housing — and the ripple effects thereof, including the recession and the huge drop in available credit — is the dominant factor by far in the overall economy. Those big profits from house sales and home equity loans are gone.

But nonetheless, in particular if you bank at Bank of America or at any of the failed banks over the last two years, some of those new dollars were the ones that were used to insure your checking account. So some of the new money is already leaking into the conomy now, and will not be retrieved.

Eventually, once the economy adjusts to the demand destruction, by cutting inventories, shutting factories and closing stores, prices will rebalance to previous levels. Except now, there will be the false extra “demand” from the new money that has leaked into the economy to date — pursuing a supply of goods reduced to accomodate the recession.

What happens next depends on how much of the new “inside” money has already escaped. IF a lot of it is out, the inflation will be big and sharp; if it leaks out more slowly, it will run longer. Either way, I do not expect to see much, if any, “soaking up” by the Fed, simply because that would be actual deflation — and so long as people insist on seeing deflation where there isn’t any, adding actual deflation to the mix — or ramming up interest rates in the Paul Volcker approach — just won’t be politically feasible.

After all, it took a decade of this sort of thing before we were ready for Volcker. You won’t see it during an Obama term, that is for certain.

Rob,

The futures market deals in contracts, not shares. It is impossible for there to be counterfeit contracts in the futures market. It takes two parties to make a contract, so for every seller there has to be a buyer.

Investopedia has a good introduction to futures here:

http://www.investopedia.com/university/futures/

You are implying that money is *only* the notes and coins in circulation, be they either proper banknotes and real gold coins or irredeemable Reserve notes and junk Treasury coins. That is debatable.

When fractional reserve banking exists (I’m not looking for yet another argument about the virtues or otherwise of *that*) there is also what von Mises called “fiduciary media”, consisting of bank accounts out of which one can issue cheques or make direct transfers from without using notes and coins. The amount of fiduciary media can fall as a result of increases in reserve ratios or the destruction of deposits through bank failures, independently of changes in the base money supply. I argue that fiduciary media are part of the money supply – technically, that “M1″ is the best conceptual measure of it.

Equally debatable then is whether an increase in fiduciary media constitutes a type of inflation and a decrease a deflation. I’d argue that when government controls the base money and is giving support to banks et al then yes, they are. If no such government support existed then no, they wouldn’t be. Without government intervention there would be just the normal market forces in relation to credit and risk-management.

We’ve had both increases in reserve ratios and spates of bank failures recently, so I don’t think recent prices history comes from destruction of demand for goods alone. This means the mainstream economists you cite are partly right on that score. That being said, your post was a good explanation of a real monetary phenomenon and which does warrant thorough consideration. Thank-you for that.

JJM

I’m in Las Vegas now, and spent the weekend house-browsing…. the available bargains here are just shocking (especially by contrast of coming here from California). Were it for sale, I could probably buy the same house I bought here in 2001, for less than I paid in 2001.

Another destructive effect of Inflation is on the company inventories which is evident once the inflation is stopped or slows down. Inflation which encourages spending of cash to buy more inventory for sales fueled by excessive cash.

Once the interest rates rise and the sales slowdown, it reveals widespread losses in form of unproductive inventory invetments.
(source: Treatise of Capitalism, Reisman)

Daniel, you’re correct, assuming that there aren’t counterfeit shares floating around out there, introduced to the market by means of naked short selling. But since there are, I would be wary.

The lesson to be learned here it to get leveraged with futures and options. Spend $2000 on gold today, and you control about 2 ounces of gold. Deposit $2000 with an online broker like thinkorswim, and you can control about 32 ounces of gold.

You could also short treasury security futures, since they are very sensitive to interest rates.