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The
corner-stone of my deflation theory is the observation that there is a
double-bias caused by the central bank's open market operations as it removes
risks from bond (but not from commodity) speculation, and rewards bond bulls
(while punishing the bears) [4]. This double-bias distorts the economy in favor of deflation. It is palpable only when deflation is
present in the economy in the first place, in which case it is made worse
than it need be by prompting speculators to buy bonds in tandem with the central
bank. Interest rates fall and through the mechanism of linkage prices fall,
too, as the flow of money from commodities to bonds accelerates. In the
worst-case scenario a vicious circle is activated and the economy plunges
into depression.
The
question arises why mainstream economists didn't discover the deflationary
bias and alert central bankers to mend their ways. The answer is that they
did. However, they had to proceed gingerly. The bridge of the gold standard
leading back to monetary sanity and rectitude had already been burnt. They
were looking at the incurable congenital disease of the regime of
irredeemable currency. Mainstream economists could not talk openly about the
dangers of snowballing bond speculation without exposing the fatal inner contradictions
of their monetary regime. The diagnosis therefore had to be couched in the
language of the liquidity trap.
The
term originated with Keynes himself who, in the second half of the 1930's,
noted that his contra-cyclical prescription to inject new money in the
economy through central-bank purchases of bonds in order to combat falling
prices wasn't working. In fact, it produced just the opposite effect of what
he had hoped. Deflation got worse, not better. As always, Keynes was ready
with the explanation. The disease was so advanced that the patient didn't
readily react to medication as it was supposed to. The first dose of
money-injection administered by doctors from the central bank could not
spread through the diseased organism but, instead, accumulated in a
"liquidity-trap". Nevertheless, Keynes was for continuing the
money-injection therapy. He was confident that, ultimately, prices would move
higher, as they had to according to the Quantity Theory of Money. Of course,
Keynes would not admit that the main cause of the malady was the surgical
removal of the gold standard at his instigation earlier in the decade.
Pallas
Athena born in full armor
As the
ownership of monetary gold was made illegal in 1933, the only competitor to
government bonds was removed from the arena. Owners of monetary gold were
forced by the strong arm of the government to invest in government bonds -
not a very pretty sight in itself, even if the
matter ended there. But the matter did not end there. As holders of gold were
competing for the limited supply of government bonds, which rightly or
wrongly they considered as the safest thing to have second only to gold, bond
prices were driven to unprecedented heights and interest rates were plunged
to unprecedented depths. The federal funds rate even went negative. Member
banks were actually paid a premium for taking money overnight from the
Federal Reserve banks.
At that
point in time bond speculation was still unknown in the United States.
But just as Pallas Athena was born in full armor
when she sprang from the skull of Zeus after her father's bizarre pregnancy
ended in a splitting headache, so did bond speculators, a whole army of them,
spring from the skull of Keynes in a remarkable replay of the mythological
story. The speculators did not need any training. They were ready. They did
not need any capital either. It was made superfluous by the forcible removal
of gold as a competitor of government bonds. Speculators (read: the banks)
were literally paid by the Fed to take the money to buy the bonds. Thereafter
their only worry was to keep writing up their assets month-after-month,
quarter-after-quarter. Why should the banks risk their money by lending it to
ailing business on their way to recovery, if they could invest it in steadily
appreciating bonds, risk-free? The world had never seen anything like that
before: banks betraying their mission to finance business and shepherding
their resources into bond speculation. And why not? Not only did the
continuous injection of irredeemable currency into the economy by the Fed
make bond speculation risk-free, it actually guaranteed capital gains on
their bond portfolio, on the top of the interest-income. The
stock-market craze of the Roaring Twenties was nothing in comparison. The
largest speculative orgy in history was on. It was in the 1930's, and it was
in the bond market.
Of
course, the theory of liquidity traps does not mention bond speculation. The
s-word is taboo. It talks about liquidity being mysteriously siphoned off and
trapped. As the central bank fighting recession drove interest rates close to
zero, the fruits of any further monetary expansion would be stuck away in
mattresses and cooky jars where they could do
nothing for the economy. The process is described in detail in the first
edition of Samuelson's textbook published in 1948 used in training Keynesian
economists.
Truth
be told, the "fruit" is not put in mattresses and cooky-jars. It is taken by the speculators to the bond
market where the miraculous multiplication of money is taking place. But you
are not supposed to utter the s-word as it would conjure up the fatal flaw of
the regime of irredeemable currency.
The
chapter on the liquidity trap did not stay in Samuelson's textbook for long. It
was deleted from subsequent editions. Interest rates were edging up, and the
author didn't think that there was a danger for them ever to come down again
to the vicinity of zero. Surely inflation would see to that. The Fed
convincingly demonstrated its power in ending recession after recession. There
seemed no reason to doubt that it could always do so whenever needed [1].
The
regime of irredeemable currency was firmly implanted in the economy, and the
central bank could control practically everything with the possible exception
of the weather.
The
interest-targeting cabal
While
out of the textbooks, the liquidity trap was not out of the ivory towers. It
was still being discussed in the rarified
atmosphere of academia. The world center for
liquidity-trap studies and for the inflation-targeting cabal is the Woodrow Wilson
School at Princeton
University in New Jersey. Under the leadership of
department head Ben Bernanke a team consisting of
Paul Krugman, Lars Svensson,
and Mike Woodford has been busy investigating the liquidity trap and finding
ways to unplug it through inflation-targeting should it get clogged again. The
Princeton plumbers worked out esoteric
mathematical models to show that, indeed, the danger of liquidity traps was
real. Here is the verbalization of the mathematical hocus-pocus. (A less
polite expression, the title of [1], could also be used. I stay with the more
polite version. As the author points out, according to Goodwin's Law the
party that blinks first and mentions bodily wastes loses the argument.)
The
cabal turns on the concept of "potential output". It is defined as
maximum output consistent with a stable inflation-rate. (Please don't heckle
the plumbers with interjections that a stable inflation rate is an oxymoron.)
If actual output exceeds potential, then the rate of inflation will rise; if
below potential, then it will fall. In the latter the Princeton
plumbers sniff great danger. Suppose that, for whatever reasons, the economy
is operating below potential output (there is an "output-gap"). Then
the situation is no longer stable. We are staring right into the liquidity
trap. Disinflation makes inflationary expectations fade, leading to more disinflation, whereupon inflationary expectations fade
more. The vicious circle is on and pushes the economy right into the liquidity
trap. Once that happens, the central bank can pump money into the economy as
much as it wants, it will all end up in the liquidity trap. The output-gap
will worsen, leading to even lower inflation, and so on. The thing to worry
about is the spiral of declining output relative to potential, and fading
inflationary expectations [1].
Krugman adds the punchline:
"zero is not a big number whether for growth,
or whether for inflation" [2]. In plain language, if you want growth,
you had better target inflation, and target you must well above
zero. The trouble with fading inflationary expectation is that it jerks
the rug from underneath the interest-rate structure.
Please
note how the Princeton plumbers studiously
avoid any reference to bond speculation, a hard fact of the economy,
and substitute for it "fading inflationary expectations", a soft
economic euphemism.
The
Japanese bubble bursts
So when
the Japanese bubble burst, the Princeton
plumbers were ready. The Fed quickly tapped Ben Bernanke,
bringing him to Washington
and making him the heir-apparent to Greenspan. Recent rumors
have it that the threat of the Japanese sickness is so serious that Bernanke will have to be moved from Constitution Avenue
to Pennsylvania Avenue, right into the White House, to head the council of
the President's economic advisors. Well, we won't have to wait too long to
learn where upstairs the head-plumber will be kicked.
By 1996
Japan
looked an awful lot like a country in a classic liquidity trap. And that was
scary. It meant that "our grandfathers were not as stupid as we
thought" in the words of Princeton
plumber Paul Krugman, who is moonlighting as staff
writer for The New York Times. A 1930-style slump may not be that easy
to fix, after all. A disease we had thought was under control reappeared in a
form resistant to all the known antibiotics. Japan's trap was real.
But if Japan remains
stuck in that trap, who cares? Well, you should. Not
only is Japan the world's second largest economy; until recently it seemed to
be the economy of the future. Worse still, if it could happen to Japan, why
not to us? [1]
As the Princeton plumbers must not utter the s-word in public,
talking about the mechanism whereby depression can metastasize across the
Pacific is taboo, too. This mechanism is the notorious yen-carry trade, or
bond speculators doing arbitrage between the Japanese and the American bond
markets. They sell the ultra-high-priced Japanese bonds and buy the
relatively cheap American. The net effect is to push interest rates in the United States down to the unprecedented low
levels prevailing in Japan.
Can
Deflation Be Prevented?
This is
the title of an article [3] also written by Paul Krugman
six years ago when he was still at MIT, from which the following quotations
are taken. What gives it timeliness is that those six years have not solved
any of the underlying problems but, in many ways, the economy has
deteriorated in the wake of the continuing exponential growth of debt and its
symbiotic parasite, bond speculation.
"The
cover story from The Economist makes it more or less official. Deflation,
not inflation, is now the greatest concern for the world economy. Over the
past year, producer prices have fallen throughout the advanced world; consumer
prices have been falling for the last 6 months in France and Germany; in
Japan wages have actually fallen 4 percent over the the
past year...
"So
far none of these price declines looks anything like the massive deflation
that accompanied the Great Depression. But the appearance of deflation as a
widespread problem is disturbing, not only because of its immediate economic
implications, but because until recently most economists - myself included -
regarded sustained deflation as a fundamentally implausible prospect,
something that should not be a concern.
"The
point is that deflation should - or so we thought - be easy to prevent: just
print more money. And printing money is normally a pleasant experience for
governments. In fact, the idea that governments have a hard time keeping
their hands off the printing press has long been a staple of political
economy; dozens of theoretical papers have argued that the temptation to
engage in excessive money-creation causes an inherent inflationary bias in
fiat-money economies. It is largely to combat that presumed bias that most of
the world has accepted the notion that monetary policy should be conducted by
an independent central bank, insulated from political influence - and has
been written into the charters of those central banks that they should seek
price stability as their main, often only, goal.
"Yet
here we are, with deflation turning out to be a serious problem after all -
and with policymakers finding that it is not as easy either to prevent or to
reverse as we all thought.
"How
can this be happening? What does it imply for policy? The purpose of this
note is to argue that more or less conventional economic theory actually does
suggest some answers to these questions - but that these answers fly in the
face of conventional policy wisdom. And because the answers are so hard to
accept, deflation is indeed a real risk."
We may
skip the hocus-pocus part of the article and go directly to its conclusions.
"The
obvious answer to sustained deflationary pressures, then, is the
now-notorious proposal for 'managed inflation'... But the idea sounds
crazy, and that is a problem. How can we get finance ministers and
central bankers, who have spent their whole careers preaching the evils of
inflation and the virtues of price stability, to accept the idea that price
stability may not be an available option?
"For
if deflationary forces are as powerful as they are in Japan - and
may soon be in the rest of the world, if The Economist is right -
there is no middle ground... Attempts to find a halfway house - to aim merely
for stable prices rather than sufficiently high inflation - will be doomed to
failure.
"In
short, if you really believe that deflation is now a global threat, you
should also believe that only policies lying outside of the realm of what is
conventionally regarded as responsible will contain that threat. And because
unconventional thinking is not what one expects (or, in normal times, wants)
from finance ministers and central bankers, there is now a real risk that deflation
will indeed become a global scourge."
Thus
concludes the article. It nicely explains what has happened in the
intervening six years. The powers that be were scared by the deflationary
threat much more than they ever admitted. Without any hesitation they took
the advice of Krugman, abandoned policies
"conventionally regarded as responsible", unilaterally betrayed
their mandate, burnt the halfway house of price stability, and hit the
warpath of inflation, euphemistically calling it "inflation-targeting".
One
irresponsible monetary policy deserves another
What Krugman conveniently ignores is that inflation may not be
'manageable' like a pet dog. More like a hungry tiger smelling blood, it
could get out of hand following reckless increases in the money supply. No less than burning bridges, burning halfway houses is not a
very good idea. Mainstream economists burnt the bridge of the gold
standard making it the whipping boy for the Great Depression. Through that
bridge we could have retreated to monetary rectitude after the insane
experiments with the fiat dollar. Now they burn the halfway house of price
stability, too. Where will the Fed find shelter after the tornado of runaway
inflation has struck?
The
seriousness of the problem cannot be overstated. A steep rise in interest
rates at this juncture would be the horror of horrors. Normally higher
interest rates would strengthen the value of the currency as they attracted
foreign investors. Not this time. Apart from the problem of pricking all the
bubbles in the economy starting with the housing bubble,
and ballooning the budget deficit into outer space, there is an even larger
and more immediate problem. And that is the effect that
steeply rising interest rates have on the value of bonds, widely held
at home and abroad. The effect is inevitable and instantaneous. Higher
interest rates make bond values collapse.
You
have to be very clear in your mind about this, so I spell it out. The dollar
losing value on the foreign exchanges because of the trade gap is one thing. Dollar-bonds
losing value due to higher interest rates is another thing. Nevertheless it
is entirely possible, and right now appears highly probable, that the two
losses will be inflicted simultaneously. Losses on bonds will compound the
loss on the dollar. The compounded loss shall exceed the critical mass of
bearable losses, and will trigger a chain reaction of further losses. The
confidence in the dollar will be fatally and irreparably shaken, domestically
as well as internationally.
How
likely is that to happen? In my opinion not very likely. The Fed must have a
contingency plan to prevent a steep rise in interest rates. Krugman has convinced us that the money-managers at the
Fed have got rid of their last scruples, if they ever had any. Paraphrasing
him, if you really believe that runaway inflation is now a global threat, you
should also believe that only policies lying outside of the realm what is
conventionally regarded as responsible will contain that threat. One
irresponsible monetary policy deserves another. The contingency plan to
prevent a steep rise in interest rates will have to involve a conspiracy
between the Fed and the Bank of Japan to punish speculators short-selling the
dollar and dollar bonds. There is nothing else left in the Fed's bag of
tricks but the check-kiting scheme with the Bank of Japan that could hold
back the forces of monetary destruction waiting in the wings. Never mind that
it is "conventionally regarded" as irresponsible. Never mind that
it is illegal. Never mind that it is criminal.
Nothing
else will defer the day of reckoning.
March 21, 2005
Dr.
Antal E. Fekete
References
[1] Elephant
Shit, by Paul Krugman, May, 2003
www.pkarchive.org/economy/042203Follow5.html
[2] Zero Is
Not Enough, by Paul Krugman, May, 2003
www.pkarchive.org/economy/042203Follow4.html
[3] Can
Deflation Be Prevented? By Paul Krugman,
February, 1999
web.mit.edu/krugman/www/deflator.html
[4] Is
"Linkage" Broken? No, the Symmetry of Speculation Is, by
Antal E. Fekete, March, 2005
www.financialsense.com/editorials/fekete/2005/0313.html
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