In an interview with the Daily Bell that just
came my way, Antal Fekete writes about Blowing
Up Modern Austrian Economics ... in a Good Way.
Background on Velocity
To understand the interview discussion, one must first understand velocity. I
discussed velocity at length in Will
Prices Rise Significantly When Velocity of Money Picks Up?
The simple definition V = GDP/M where V is velocity, M is money supply, and
GDP is Gross Domestic Product.
Problems With Velocity
- The first problem is how to measure money supply (Is
Money M1, M2, or TMS? Each gives a different measure of velocity).
- The second problem with velocity is that GDP is a pretty
nebulous concept given that government spending (no matter how useless)
adds to GDP.
- Finally, I do not believe prices can be accurately
measured.
Interview Snips
I post snips of the interview below, followed by my own comments. Sometimes I
agree, and sometimes disagree with Fekete.
Daily Bell: Please define deflation and disinflation from both a
monetary and price standpoint.
Antal Fekete: Deflation is clearly not the same as a falling price
level. Technological improvements in production cause a gently falling price
level under sound money that is no deflation. Defining deflation as a
contraction of the stock of money is plainly wrong. We have a vastly
expanding money supply, yet a lot of economists (including myself) hold that
we are in the midst of deflation. I prefer the definition of deflation as a
pathological slowing in the velocity of money.
Mish: I agree with Fekete that "price deflation" is a
natural occurrence based on technology and productivity improvements. I also
concur that deflationary forces are huge. However, I disagree with his
definition of deflation based on velocity. Given the clear and expanding
bubbles in asset prices, I believe we are in a state of inflation.
Nonetheless, I do expect another round of credit and asset deflation (my
definition of deflation).
Daily Bell: We think monetary deflation over a long period of time is
difficult to accomplish in a central bank , money-printing economy. Comments?
Antal Fekete: "Accomplish" is not the word. No one wants
deflation any more than wanting a pathological condition in one's own body.
"Occur" may be a better word. I disagree with your assumption that
central banks' money printing is antithetical to deflation. I am in a
minority of one in suggesting that just the opposite is the case: expansion
of the money supply through open market purchases of government bonds by the
central bank is the direct cause of deflation. I know this is
counter-intuitive, yet true nevertheless.
Mish: It's not counter-intuitive at all. The Fed prints more money
than consumers and businesses want to borrow, so the money sits as excess
reserves. Velocity drops. Fekete's definition states that falling velocity is
deflation, so in that sense, the Fed does indeed "cause" deflation.
It's simply a truism based on Fekete's definition. That said, he's not a
minority of one. By sponsoring asset inflation, the Fed will indeed cause
deflation. Our difference is he calls the present environment deflation,
whereas I say a very destructive asset deflation will eventually result from
current Fed policies.
Daily Bell: Along with Rothbard , as we understand it, asset inflation
itself leads to what seems to be deflation and disinflation. Money volume
must go up to go down. Truth to this?
Antal Fekete: I would modify language slightly: money velocity must go
up first so that it could come down.
Mish: Velocity does not need to do anything. It can go up or down or
sideways. Asset inflation to the point of creating bubbles is another thing.
The busting of bubbles would be a deflation event in my model and I would
expect velocity to drop constituting deflation in Fekete's model as well.
Daily Bell: If third-party credit facilities like American Express
collapse, does this constitute monetary deflation?
Antal Fekete: The collapse of any firm is a symptom of deflation, with
a vengeance. It activates the 'domino effect'. Deflation breeds more
deflation. The velocity of money spirals down.
Mish: His symptom is part of my definition. My definition is part of
his symptom. But we are not saying the same thing entirely. I would say it's
clear we are in a state of inflation right now even though I believe
deflationary forces will soon override that inflation.The reason I see
inflation is simple: asset bubbles are expanding, and that is a clear symptom
of inflation by any rational measure.
Daily Bell: When central banks keep interest rates low, does this lead
to disinflation and deflation? How so?
Antal Fekete: The word "disinflation," which suggests that
the Fed can turn the spigot on and off, is not in my dictionary. In fact, the
Fed has no such power. It can certainly turn the spigot on, but we have never
seen the Fed turning it off. Worse still, it has absolutely no control over
how people will be using the extra money spewed from spigots or dropped from
helicopters. Well, the smart ones would buy bonds, not commodities as the Fed
hoped. They knew they could always dump them on the Fed in the open market
with a hefty markup. Risk free. To answer your question, the central bank
does not "keep" interest rates low. In fact, it "pushes"
them low through open market purchases of government debt, which increases
the bond price. The other side of the coin is the simultaneous decrease of
the rate of interest. Of course, the purpose of the exercise, on a Quantity
Theory argument, is the fomenting of inflation, not deflation. The trouble is
that the central bank does not know what it is doing. It sows inflation but
reaps deflation. Its monetary policy is counterproductive, to put it
politely.
Mish: I disagree with Fekete's notion the Fed wants to push commodity
prices higher. I would say the Fed wants businesses to expand, wages to rise,
credit to expand, and consumer prices to rise, most likely in that
order. Higher commodity prices would be a very distant 5th, at best. However,
I do like Fekete's explanation that the Fed does not keep rates low, it
pushes them low with asset purchases. And I concur that the Fed has no idea
what it is doing. Specifically, the Fed can print money but has no control over
how it is spent (or if it is spent at all). Right now money sits as excess
reserves and not spent. That is deflation in Fekete's book, but not mine.
Fekete ignores asset prices (stocks, junk bonds, housing prices). While
bubbles are inflating, we have inflation. In simple terms, expansion of asset
bubbles is sufficient proof of inflation. The bursting of asset bubbles would
typically lead to deflation, but I look at asset prices and the implied value
of credit marked to market to make a determination.
Daily Bell: If central banks are keeping interest rates artificially
low, how does this contribute to monetary deflation? What do the bond traders
do that makes monetary inflation into a deflationary phenomenon?
Antal Fekete: It is not low interest rates that creates deflation but
falling interest rates. The process is triggered by the central bank's open
market purchases of bonds in an effort to pursue its inane policy of QE,
eliciting the copycat action of bond speculators. A chain reaction is activated:
bond purchases of the central bank alternating with bond purchases of the
speculators. The central bank announces its time table for its bond buying
program. Speculators preempt the central bank in buying first, dumping the
bonds into the lap of the central bank while pocketing risk free profits
afterwards. The expectation of the central bank, price inflation, does not
materialize. It is frustrated by the bond speculators who hijack the freshly
printed money on its way to the commodity market. Not to be deterred, the
central bank prints more. To do that it has to go to the open market and buy
more bonds, prompting speculators to preempt. The cycle now repeats and a
vicious spiral is engaged. The upshot is a prolonged fall of interest rates
that destroys capital across the board.
Mish: I agree with Fekete's front-running of bonds thesis. To that I
would add "realization" that capital was destroyed happens during
the bust. It cannot be prevented.
Daily Bell: Do you believe in the Misesian business cycle ? Does it
have validity, in your view?
Antal Fekete: Certainly, with some reservations. It does not assign a
very high IQ to businessmen in the field. Why don't they learn from
experience and factor into their calculations the distortion in the rate of
interest due to monetary policy? I improve on the business cycle of Mises,
pointing an accusing finger to bond speculation motivated by risk free
profits. Businessmen are the brightest people we have. They are being
victimized through the insane monetary policy of the Fed.
Mish: Banks take risk-free profits for three reasons: They are capital
impaired and cannot lend, creditworthy businesses do not want to
expand, risk-free profits exceed expected profits from risk-taking. As far as
victims go, everyone but those with first access to money are victimized by
the monetary policies of the Fed.
Daily Bell: Was the Great Depression a deflationary depression? We
note that junior mining prices apparently went UP during the Great
Depression.
Antal Fekete: Most certainly it was. It is axiomatic that gold mining
shares go up during a depression. Depression is just another name for capital
destruction, and gold is the only form of capital that is immune to
destruction. If you consolidate all balance sheets in a country (including
that of the national treasury), then all liquid assets will be wiped out,
with the sole exception of gold. Gold is the only asset that is not
duplicated as a liability in the balance sheet of someone else.
Mish: Actually, a stockpile of any valuable commodity owned free and
clear is an asset with no liability elsewhere. I do not believe it is
axiomatic that gold mining shares rise in deflation, but I would expect gold
to do well.
Daily Bell: Are we in a deflationary depression? Or are we in a kind
of stagflation?
Antal Fekete: We are in a deflation that is metastasizing into a
depression. The monster word "stagflation" does not appear in my
dictionary.
Mish: Stagflation should have ended Keynesian theory right then and
there. Keynes believed it was impossible to have a recession and inflation at
the same time. The 1980s is a testament to the absurdity of Keynesian theory.
Daily Bell: Has money volume increased in the US and Europe? Have
prices increased in response?
Antal Fekete: As I hinted a while ago, increasing the volume of money
does not necessarily cause an increase in the price level. The Quantity
Theory of Money is a false theory. In spite of an eightfold increase in
the stock of money in America the price of crude oil was cut in half and the
price of iron, copper and a number of other metals showed steep declines,
thought impossible only a few months ago. If this is not deflation, then let
me ask: How much farther do prices have to fall before we are allowed to use
the D-word?
Mish: The Quantity
Theory of Money says "money supply has a direct, proportional
relationship with the price level." Fekete points to falling prices
and says "If this is not deflation, then let me ask: How much farther
do prices have to fall before we are allowed to use the D-word?" By
Fekete's own definition, falling prices do not constitute deflation. I
believe he is speaking from the reference of what most economists believe
(that falling prices constitutes deflation). Unfortunately, most believe that
constitutes deflation. I call it brainwashing by the Fed and academia.
Regardless, Fekete also misses the boat on the theory. Prices have gone up,
just not commodities. The bubble is in assets (equities, housing, junk
bonds), things that are impossible to measure precisely. I call that
inflation. Fekete calls it deflation. But we both seem to agree that a big
deflationary bust is coming.
Daily Bell: Oil has apparently been manipulated down. Does this
constitute price deflation nonetheless, or is it simply a kind of
manipulation?
Antal Fekete: The manipulation theory was invented by those who are
afraid to face the facts squarely. We should know better: no valorization
scheme ever works for any significant length of time for any commodity. It is
another matter that foreign policy makers in Washington may have stolen a
ride on the back of spontaneously collapsing crude oil to punish Putin.
Mish: I am in perfect agreement on this point. Commodity price
declines are about the slowing global economy, not oil price manipulation.
There is more to the interview, and inquiring minds may wish to read further.
Let's stop here and look at a few charts of velocity.
M1 Velocity
M2 Velocity
As you can see, velocity depends on how one measures money, and even
Austrians do not agree how to do that.
Mish Definition
My definition of inflation is expansion of money supply and credit with
credit marked to market. My definition of deflation is contraction of money
supply and credit, with credit marked to market.
Both Fekete and I have definitions that differ from the pure Austrian concept
of expansion of money. And we have been in the same boat in one sense.
Neither of us thought the expansion of money would lead to huge "price
inflation" and it didn't.
- The problem with defining inflation as an increase in
consumer prices is that it ignores asset bubbles.
- Fekete's definition also ignores expanding asset
bubbles.
- Judging inflation solely on the basis of money supply
would cause one to believe we were nearly always in a state of
inflation, even in states where banks, asset prices, and consumer prices
simultaneously collapsed.
Numerous Austrians who relied on money supply alone believed for years on end
we were on the verge of high inflation or even hyperinflation. It did not
happen. Fekete and I both got that correct.
From a practical standpoint, I believe my definition explains the real world
better than other definitions.
In my model, and called for in advance, the US experienced deflation from
late 2007 until March of 2009. At that point Bernanke managed to reignite
demand for credit and the stock market took off.
I expect another round of deflation when various asset bubbles pop.
Meanwhile, and as long as asset bubbles are expanding, I do not believe
deflation is the best word to describe current events. However, I would
describe the current setup as highly deflationary looking ahead.
Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
