I think the following topic is a long overdue post. I’ve frequently bashed the Federal Reserve’s performance in this bailout but have always alluded to my preference that the Fed not exist in the first place. Many people believe the Federal Reserve is this prestigious institution, which keeps our system afloat with complicated monetary management. Over time, this has evolved into a misconception that the Fed can solve any economic woes during the bad times and is essential to maintain stability during the good times. This could not be further from the truth, so I intend to present my concerns in the most simple way possible. Let me get a little more detailed…
The History of Inflation
In understanding the current depression (Yes, I’m officially using this word going forward), the most important concept to understand is inflation. There is a widespread misunderstanding of what this term’s definition should truly be and what implications it has on the populace. First, let’s start with the misconceptions. The Federal Reserve, media, and even economic textbooks have coined this term to describe a general rise in prices. When the price of food, oil, IPods, etc increase households feel difficulty because their purchasing power has decreased. While certain items may increase in price while other decrease, inflation lumps everything together into increasing or decreasing trends. The government uses the CPI as a measurement of general price levels (or in their mind, inflation). Take a look at this chart to get a sense of this measurement…
Source: Charting Stocks
I purposely looked for a chart ending at 2007 because the CPI has made a major shift as of late. A few things to observe from this chart. First, price inflation was almost non-existent until1907 when the Federal Reserve was created. It didn’t truly begin to spike until 1971 when President Nixon removed the dollar from the Gold Standard. At the same time, the Fed was able to manipulate currency for its own agenda rather than tying it to the stable market value of gold.
With this in mind, let’s take a step back to the definition of inflation. Many would argue that price increases were the definition of inflation. Instead, I’d make a much different argument…
Instead, let’s examine the total currency in circulation and notice how similar the graph is to the first one. Logically, you could conclude that as more money enters circulation, prices begin to increase. Again, after the gold standard was removed and the Fed asserted control of the money supply, dollars in circulation and prices shot up at incredible rates. Now let’s examine this same measurement with a focus on the last 5 years…
What is Inflation?
Notice how at the start of the financial crisis, the money supply decreased. Keep in mind, this isn’t the total dollars available but the total dollars in circulation. Despite the Fed’s best efforts with printing money and re-inflating the economy, these dollars aren’t making it into circulation. The reason? Credit! Credit is being destroyed at such a rapid rate that the Fed’s money creation cannot keep pace. The net effect of this is lower prices across the board. You can see this at any level: housing prices, commodities, food, retail, wholesale, services, etc. In both cases, the inflation or deflation is a direct result of money supply, while prices will closely follow. Thus, let’s define inflation: inflation should be the net expansion of money and credit, while deflation is a contraction of money and credit. In the last two years, the money supply hasn’t necessarily decreased but credit has contracted at record rates.
Why should we focus on this definition? When the government talks about inflation, they generally see it as a positive economic trend so long as it’s controlled. In reality, inflation is a terrible thing and solely derived from the Federal Reserve. Imagine a world where the dollar is tied to the value of gold and the Federal Reserve cannot expand or contract the money supply. In this case, there should be a constant amount of money available to purchase society’s scarce resources. Prices may increase but it’d be a reflection of the country’s greater wealth rather than turning on the printing presses. As national income increases, people’s demand and capacity to supply goods/services will increase, thus increasing their value. When these incomes increase, everyone in society is better off for price increases… it means we are able to afford more as a society and realize better revenues in international trade. We produce and purchase higher quality goods because incomes naturally support this phenomenon. This type of price increase is a positive on the economy. Now let’s look at our current reality. Over the last 40 years, the Fed has controlled when prices are allowed to increase. Looking at the chart above, prices increased far beyond what our national income allowed for. This is because the Fed is in the business of constantly expanding the money supply.
Judging the Fed’s Policies
Is this a good or bad thing? I don’t see much argument for this being a positive economic indicator. When prices and assets increase, the value of cash savings are pushed downward. Those responsibly saving for education, retirement, or creating a family safety net are seeing their net worth being stolen from them. Inflation also hurts the middle/lower class. Just because prices begin to increase doesn’t necessarily mean incomes keep pace. In fact, the minimum wage and income disparity proves wages have trailed the price inflation. The wealthy, meanwhile, actually benefit from inflation because home prices, stocks, and resources appreciate in value. This helps the wealthy much more than the average American. When the prices of basic living expenses increase, however, life becomes much less affordable. If you want the core cause of the income gap between rich and poor, look no further than the government policy of inflation.
If inflation is such a detrimental policy for most, why does the government promote it? Inflation allows the government to spend money like they’ve done over the last 25 years. As long as the government keeps expanding the money supply, they can take credit for an expanding economy and spend an unlimited amount. Eventually this catches up, as the economy isn’t necessarily expanding so much… it’s just an illusion of cheap credit and more dollars in circulation. Think of the Ponzi Scheme publicized by Bernie Madoff. As money is created, the consumer’s assets can increase. The public demands more credit because some are richer through asset appreciation, while other need credit to fund basic living expenses. The Federal Reserve pushes that easy credit policy along by promoting excess liquidity through artificially low interest rates and lending exponentially higher than bank deposit reserves. Over time, people can buy lots of stuff and feel much richer… but are they really? No, because you cannot maintain this forever when it dramatically outpaces true productivity and income growth. Like any Ponzi scheme, it works until it becomes so big that it can no longer sustain itself.
The wealthy like inflation to prop up their homes, stock portfolios, and commodities. The government loves inflation because they can spend as much money as they’d like. The Federal Reserve clings to this power because they can manage the economy however they see fit. This is why we get treated to the following…
“The key to preventing inflation will be reversing the programs, reducing reserves, and raising interest rates in a timely fashion,” Kohn said. He emphasized the importance of inflation expectations in holding down future inflation. “If expectations are not anchored – if they vary in response to our actions or to persistent gaps between actual and potential output – inflation itself will follow,” he said.
On Friday, a survey-based forecast of one-year inflation expectations, from the University of Michigan, jumped surprisingly to 3 percent in April from 2 percent in March. Kohn said the policy-setting Federal Open Market Committee is still mulling the value of setting an explicit objective for inflation – a step further than it went earlier this year, in publishing “longer-run” inflation forecasts.
At its January meeting, the FOMC said most participants saw a long-run inflation goal of 2 percent as appropriate.
Read the rest of this article and see Paul Volcker challenge Kohn on the absurdity of maintaining a 2% target inflation rate. He wonders how it could possibly make sense to target an inflation allowance that would lead to a complete loss of purchasing power within a generation. I’d go one step further and ask why anyone would possibly want inflation in the first place. We should be targeting zero inflation to avoid the hidden consequences to the American people. In reality, two percent inflation is pure nonsense. The Fed has promoted much higher inflation rates in the past and continuing the same thing with their printing and zero interest rate policies.
Inflation In the Present
Skip to 2007 where the money supply is beginning to decrease. The Federal Reserve wants you to keep spending and banks to keep the credit machine going. The government wants credit because this is supposedly the lifeblood of our economy. They’re so worried about credit loss and an end to their inflationary policies that they’ve used $24 trillion to push lending, stimulus, and bailout programs. Little do they realize, the Ponzi scheme is up as Americans have learned their lesson. Households can no longer handle debt and have embraced better savings habits. Banks can no longer afford to push credit on anyone with a pulse. These facts will not change anytime soon, which ensures the deleveraging process will lead to a more normal level of credit.
Ok, then inflation in the future?
Many people are concerned with inflation because the government is so far in debt and continues printing money. These inflation concerns are unfounded, however, because the level of money and credit is decreasing and will continue decreasing for a long time. Many argue inflation is here because the cost of living is so expensive. The reason it’s so expensive is because incomes haven’t kept pace with the tremendous inflation over the last 30 years. Prices have already begun declining slightly but as the correction continues, prices will return to equilibrium levels. (They can no longer be supported by cheap credit and massive consumption). This correction process will take many years just as it did during the Great Depression and Japan in the 1990s. Undoubtedly, inflation will once again become a big problem if the government doesn’t get serious about its debt problems. These concerns are more of a medium term problem than anything.
The Fed’s True Economic Function
Let’s conclude with an understanding of the Fed’s role. Assume the Fed didn’t exist and we kept the monetary base constant (like we did prior to the Fed’s existance). Prices would go up and down based on their implied worth rather than the wishes of a central bank. We wouldn’t have to worry about savings being eroded. 70% of the GDP would not be consumption and easy credit never would’ve existed because the money supply would stay constant. All the bubbles and crises of the past 15 years would’ve never happened. The income gap would be at normal level rather than the explosion since the 1970s. This is all due to inflation from the Fed’s monopoly on monetary decisions.
I’d like to see a society where prices are set based on market realities. Go back to the Fed’s disagreement with HR 1207 because it would “interfere with monetary policy”. When I hear an argument like that, I assume the Fed is nervous about the public discovering the true motivations behind their policies of inflation. Inflation should be the biggest outrage of the American system and should make everyone question why the Federal Reserve even exists in the first place. We don’t need a central bank manipulating the supply and value of the dollar. If it were left to the market exchange, the frequent bubbles and prices increases would cease to exist. Few have questioned the Fed because of their untouchable status. Their operations are largely secretive but the public knows they credit themselves with various market recoveries during recessions past. People think they’re the best and brightest economists and should logically be entrusted with managing the economy. The first step in busting this myth is to understand what inflation actually is and where it comes from. People should understand what monetary policy really is. I think we’re on a great path towards developing this transparency and understanding. It’s really not as complicated as some would like you to believe…
Another good post…..read it twice. Wow Danny……you have a lot of “anarcho-capitalist” in you these days. dr. p can’t be happy with that and I know Krugman, Nobel prize winner, would not approve. It is revealing how many of our problems (government and personal), if not most, are directly related to living beyond our means.
Thank you… it’s funny how I’ve been writing for over a year yet this post sums up just about everything I’ve said during that time. I should forward it to everyone’s hero Matt Taibbi and tell him to write about this same topic. Unfortunately, he got it wrong the first time and blamed Goldman Sachs for everything wrong with the economy. Since then, Goldman has been swarmed with incredible public backlash. If only this energy could be directed at the real culprit.