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Letter
to a critic of my deflation theory
Dear Mr. East,
Thank you for your letter and for your interest in
my work. You challenge my conclusion that rising bond prices may eventually
force commodity prices to fall. We are talking about the mechanism of
"linkage" here, the phenomenon that the price level and the
interest-rate structure are linked, that is to say, apart from leads and lags
they rise and fall together. This is a subject on which I have been writing
for many years. Please allow me to repeat my argument in support of linkage.
My theory is in terms of the dynamics of money-flows
from one market to another. In particular, I consider inflows/outflows of
money to/from the bond market and the commodity market. I define deflation as
the net flow of money from the commodity market to the bond market. This
doesn't preclude money from flowing to the commodity market causing prices to
rise even under deflation. But since on balance more money flows to the bond
market, bond prices rise more, and the corresponding fall in the rate of
interest is the dominant fact of the economy, not the rise in commodity
prices, however conspicuous the latter may be. Price indices may or may not
catch the effect of the net outflow of money from the commodity market. Inflation
is defined mutatis mutandis.
Now it is my contention that, as a result of the
manner in which the central bank injects new money into the economy, and also
as a result of Keynesian contra-cyclical monetary policy whereby the central
bank combats falling prices, as well as rising interest rates, through open
market purchases of bonds, there are two instances of bias, breaking the
symmetry of speculation and thereby distorting the economy.
First, there is bias favoring
bond speculation vis-à-vis commodity speculation. The symmetry
between the two markets breaks down because whenever the central bank
intervenes, it is always in the bond market, never in the commodity market. Speculators
know this, and take advantage of it. They can reduce the risks in bond speculation,
or even eliminate it altogether through adroitly forestalling central bank
intervention, that is to say, buying bonds just before the central bank does.
Even small-time speculators who cannot hope to
fine-tune their purchases to forestall the central bank, prefer the bond to
the commodity market where they feel sheltered in the shadow of that powerful
operator whose moves they can, as a copy-cat, mechanically follow. This
explains why speculative activity in bonds and interest-rate derivatives has
been snow-balling for the past 35 years. There was no organized bond
speculation before 1971 while the dollar was on the gold exchange standard. Speculators
want to have a free ride and they've got it in bonds. There is no free ride
in the commodity market because, as we have seen, there is no central bank
intervention there. Of course, this does not mean that speculators abandon
the commodity market en bloc in favor of
bonds. Scarcity and oversupply still occur and continue to offer profit
opportunities to the nimble speculator. He will calculate the risk-reward
factor and place his bets accordingly on the long or short side of the
commodity market. But it will not be a free ride. It is the speculator who
must bear the full burden of risk. Less nimble speculators will congregate in
the bond market where they can get away without bearing the full burden of
risk.
Second, there is bias favoring
bull speculators in the bond market vis-à-vis the bears. Speculation in
the bond market is far from symmetric. This is so because the central bank is
on the long side of the bond market most of the time. Its visits to the short
side are rare and hurried, mainly for window-dressing purposes and, horribile dictu,
to deceive the market. All the basic operations such as the periodic
augmentation of the money supply, combating falling prices or rising interest
rates (the two major threats to the economy as seen by the central bank)
involve purchases of bonds in the open market, not sales. The playing field
is not level. The bulls are helped by open market operations of the central
bank at the expense of the bears. The behavior of
speculators reflects this bias. They buy bonds whenever the central bank
buys, but refrain from selling when the central bank sells. If they sell, it
is for profit-taking. They hardly ever go naked short. It would be suicidal
to defy the central bank in shorting the bond market.
Combining these two instances of bias, which break
the symmetry of speculation thereby distorting its role in the economy, we
could schematize data as follows. There are four basic position that a
speculator can take:
- Long in bonds
- Short in bonds
- Long in commodities
- Short in commodities
The odds that the speculator take
any one of these basic positions should ceteris paribus be the same. But
because of the bias introduced by open market operations of the central bank,
the odds favor position number one: long in bonds. In
equilibrium speculative money will still flow, namely, it flows into bonds. There
is a prejudice favoring lower interest rates.
The managers of the regime of irredeemable currency
are either unaware of or tend to ignore the bias they have themselves
introduced into speculation. As a consequence, central bank intervention in
the bond market tends to be counter-productive. For example, in trying to
combat falling prices the central bank buys bonds, hoping that the new money
will flow to the commodity market and stem the price slide. But speculators
have a better idea. They take the new money to the bond market where they buy
in tandem with the central bank. As a result interest rates fall, and linkage
will cause commodity prices to fall further. The central bank's intervention
has made deflation worse, not better. An example is Japan where
enormous increases in the money supply, designed to combat falling prices,
has only caused prices to fall more. How could the central bank make such a
colossal blunder? Because it is ignorant of linkage, and of the bias that its
own open market operations create in speculation.
To recapitulate, there is a fundamental deflationary
effect in the economy caused by central bank open market operations favoring, as it does, (1) bond as opposed to commodity
speculation, (2) the long as opposed to the short side of the bond market. This
effect reinforces deflation in the economy whenever it occurs. The net inflow
of money to the bond market from the commodity market is expanded as risks in
bond speculation on the long side of the market are reduced or eliminated. There
is no corresponding effect to reinforce inflation, the net outflow of money
from the bond market to the commodity market is not expanded, and risks in
bond speculation on the short side, and in commodity
speculation on the long side are not reduced. As a result, in a deflation
(but not in an inflation) bond prices tend to be
higher, and interest rates lower, than justified by economic conditions. This
is what baffles the Bond King, and this is the "conundrum" of King
Al. Be that as it may, this effect ought to be taken into account in reading
deflationary signals, or in searching for inflationary signals.
Now let's turn to linkage, the phenomenon of
commodity prices and interest rates moving together subject to leads and
lags. We want to see how this is a consequence of the bias, breaking the
symmetry between bond and commodity speculation, and between bull and bear
speculation in bonds. The proposition that high and increasing prices cause
higher (and low and decreasing prices cause lower) interest rates is not
controversial as it is accepted by most economists. Therefore I shall focus
attention on the case of interest rates being (1) low and falling, (2) high
and rising.
In the first case bond prices are high and rising,
as they would be in deflation. If there was no bias, then speculators would
resist the rise and take profit in selling the bonds. But bias is introduced
by the central bank's buying of bonds in an effort to combat deflation. Therefore
speculators will let their profits ride. What is more, they will pyramid. Rather
than opposing the central bank, they will join its buying spree with all what
they have and finance their bond pyramiding through liquidating their
holdings of commodities, causing prices to fall.
In the second case bond prices are low and falling as
they would be in inflation. If there was no bias, then speculators would
resist the fall and buy the bonds. But they find the risks unacceptable. They
already have worrisome paper losses on their bond portfolio due to rising
interest rates. They consider the possibility that the central bank may fail
in its efforts to contain inflation. Central bank buying of bonds is their
opportunity to cut losses and exit the bond market. So they feed their bonds
to the central bank and use the proceeds to pyramid in commodities, causing
prices to rise.
This concludes my explanation of linkage. I realize
that my theory is counter-intuitive and raises eyebrows right and left. Please
remember that we have been conditioned by financial journalists and academic
observers to ignore the dynamics of the interaction between changes in the
rate of interest and price changes in terms of the underlying money-flows. They
work on the basis of the simplistic formula that a low rate of interest perks
up speculation whereas a high rate dampens it. My theory goes far deeper than
that. It takes speculation fully into account, including the choice
confronting the speculator whether he wants to deploy his capital in the
commodity market, or whether he wants to deploy it in the bond market. The
simplistic formula is flawed, as it ignores the fact that speculation itself
has a feedback-effect on interest rates.
It is unrealistic to assume, as most financial
journalists do, that speculators don't take advantage of profitable
opportunities in the bond market inadvertently created by central bank
intervention. Actually they do, and have done so since the 1930's when the
Fed first started using what has come to be known as open market operations,
in line with Keynes' contra-cyclical monetary policy prescriptions. It is
not recognized in the existing economic literature that bullish bond
speculation played a big role in prolonging and deepening the Great
Depression. Unfortunately, the deficient understanding of the Great
Depression will result in a repetition of the mistakes and may be
instrumental in bringing about a Second Great Depression, worse even than the
first.
My critics suggest that, as prices and interest
rates move in opposite directions, linkage has now been broken. Don't be
hasty with your conclusions. It is possible that either the price level lags
the interest rate structure, or the other way round. If either one forced the
other to follow, then they would resume marching together once more. It is an
open question whether they would march up, or they would march down. My guess
is that, unless the world plunged into a full-scale war stretching supplies
of commodities to the limit and destroying production facilities, they would
march down, after commodity prices made an 'about-face', as they did in Japan. This
guess is justified by the deflationary bias caused by central bank open
market operations as explained above, and on the dynamics predicated upon it.
The deflationary bias in the economy is quite
palpable. In spite of the reckless and record-breaking increases in the money
supply under Alan Greenspan's watch, price increases have been moderate. Without
the deflationary bias we should have had massive inflation.
Don't be fooled by Greenspan who is patting himself
on the back in taking credit for turning inflation around through monetary
policy that "cleverly mimics the gold standard". Greenspan is not
unlike the surfer on the beach boasting that it was he who turned the tide
back through skillful surfing.
A steep rise in American interest rates and the
corresponding destruction of bond values, at a time when central banks around
the globe are itching to dump the dollar, would be catastrophic. It would be
a financial earthquake measuring 9.9 on the Greenspan scale. That is strong
enough to demolish the international monetary system based on the
irredeemable dollar. Moreover, through the domino effect, reinforced by
competitive devaluations, it could wipe out the value of a lot of weaker
currencies.
Greenspan knows this. He won't allow that to happen
during the last nine months of his long tenure, if he can help it. Can he?
You bet. How? Why, through conspiring with the Bank of Japan, of course. If
they joined forces, they could mercilessly punish everybody who had the
temerity to short the dollar and bonds, be they central bankers, bond kings,
or individual speculators. But this is a topic for another letter.
Yours, etc.
March 17, 2005
Dr.
Antal E. Fekete
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