Mish Response:
Those four points above are perfectly expressed. In conjunction with secular changes in consumer attitudes, they form the very heart of the deflation argument.
In spite of Bernanke's heroic efforts, banks are still capital constrained. The Fed can create reserves at will. It cannot create capital.
Very few understand those alleged "excess reserves" are a mirage. They don't exist. More importantly, fewer still understand that reserves are not an issue at all and in reality, lending precedes creation of reserves.
I discussed those concepts at length in Fictional Reserve Lending And The Myth Of Excess Reserves
Lending Comes First, Reserves Second
• Australian economist Steve Keen has made a strong case that lending comes first and reserves later in Roving Cavaliers of Credit. I discussed that at length in Fiat World Mathematical Model.
• That point alone should seal the hash of the debate but it keeps coming up over and over. So let's try one more time.
• Inquiring minds are reading BIS Working Papers No 292, Unconventional monetary policies: an appraisal.
• Note: The above link is a lengthy and complex read, recommended only for those with a good understanding of monetary issues. It is not light reading.
The article addresses two fallacies
• Proposition #1: an expansion of bank reserves endows banks with additional resources to extend loans
• Proposition #2: There is something uniquely inflationary about bank reserves financing
Simply put, anyone who thinks those "excess reserves" are going to produce haunting inflation simply has no idea how the credit system even works.
What about the "Liquidity Trap"?
My only point of contention in the above section by Levy is in regards to the alleged "liquidity trap".
The "liquidity trap" concept is a Keynesian artifact that presumes something needs to be done about falling prices and lack of credit expansion.
The reality is falling prices are a good thing (they are only bad in the construct of a credit bubble bust where banks can't be paid back and the Fed feels obliged to steal from taxpayers to increase bank profits to make up for their losses).
What causes asset bubbles?
Why inflation of monetary supply and credit of course.
A depression is a necessary aftermath of a credit boom. Japan attempted to fight deflation for 20 years and all they have to show for it is debt to GDP ratios of 200% and an enormous demographic problem staring them square in the face.
Ad Hoc Policy of Inflation
My friend "HB" aka Pater Tenebarum discusses the Fed's misguided policy The Ad Hoc Policy of Inflation:
Contrary to Bullard's hypothesis that rising prices are desirable, we tend to think that most consumers would probably be quite happy to see falling prices. Note here that producers need not suffer either from a fall in prices. What is important for producer profits are relative prices. If their input costs fall to the same extent as their sales prices, they will continue to be profitable.
Bullard's error is the widely held belief that falling prices are synonymous with economic depression. We already mentioned in the past that this view can neither be supported theoretically nor empirically. The fastest period of real economic growth in US history of the past 150 years occurred before the Fed was founded, and coincided with steadily falling prices. Since Bullard does simply not say anywhere why he thinks the price level should always be rising, he seems to assume that this is self-evident. However, it is not. If falling prices were bad for an industry, the computer industry would not be an engine of economic growth, but would always be in depression. Until Bullard explains how such an 'exception to the rule' can not only exist, but actually thrive, we fail to follow his argument in favor of more inflation.
Also note, as I pointed out above, the Fed cannot control where liquidity flows or if it does at all. The housing bubble is proof enough. Thus, the idea that +2% CPI inflation is a good thing is doubly stupid.
Levy:
4. The Rapid Increase In Public Debt Is Not Likely to End in Disaster
Although public debt issuance is massive at present and will continue to be so, total debt issuance— public plus private—is much smaller than it has been in recent years, and it will remain depressed. Public debt growth may have accelerated to roughly $2 trillion annual rate, but net private debt issuance will likely be minimal or negative for many years as the private sector delevers; private debt growth had been running at about $4 trillion annual rate in recent years but has shifted into reverse, becoming negative (chart 4). Thus, although the federal debt is rising rapidly, the total debt level in the economy is not.
Mish Response:
Levy was kind enough to produce a larger more up-to-date version of the above mentioned chart. Here it is:
Note that net credit has been in contraction for 5 quarters!
In spite of huge government deficits, private credit is contracting faster. Given that "excess reserves" just sitting don't do a damn thing, and given that TMS1 - True Money Supply is barely growing we have a rock solid case for saying deflation is here and now.
True Money Supply
For more on TMS1 and TMS2 please see:
True Money Supply (TMS) vs. Austrian Money Supply (AMS or M Prime) Update
Money Supply Divergence - TMS1 vs. TMS2 vs. M2 - What does it Mean?
We Are In Deflation Here and Now
Rising prices do not constitute inflation, they are at best a symptom of rising inflation.
If you have not yet done so, please read Are we "Trending Towards Deflation" or in It?
There is plenty of information in that article about how to spot inflation and deflation by looking at symptoms of inflation and deflation.
Nearly every condition one would expect to see in deflation is happening, right now. The few that aren't are close at hand and likely. If all or nearly all the conditions one would expect to see in deflation are happening (the scorecard is close to unanimous), I suggest that those who say we are not in deflation have the wrong definition of the word.
Inflation and Deflation Defined
Bear in mind my definition of inflation is a net expansion of money supply and credit, with credit marked-to-market. Deflation is a net contraction of money supply and credit, with credit marked-to-market.
Unfortunately, the Fed and the FASB have conspired to prevent mark-to-market accounting.
However, it is relatively easy based on market reaction, credit expansion/contraction, and moves in interest rates to state that deflation started in 2007, continued through 2008, was interrupted in 2009, and we are back in it now, simply by looking at action in treasury yields in conjunction will all of the other indicator mentioned in the article.
The reason I use "mark-to-market" accounting of credit in my definition is twofold.
1. From a practical standpoint "mark-to-market" accounting better explains what is happening and why.
2. The model is predictive. Note the Levy chart for 2008 and 2009. Asset prices crashed in 2008 and rose in 2009 although total credit fell in both years. Why? The massive bailout of banks by the Fed and Congress hugely lifted the value of credit on the books of banks. In turn, asset prices rose, as did treasury yields, even though the real economy stagnated.
One could not have predicted recent events (even in hindsight) simply by looking at the Levy chart. The Levy chart shows 2008 to be an inflationary year and 2009 a deflationary year.
One could also not have predicted what would happen to treasury yields without an understanding of what collapsing credit would do.
Time to Short Treasuries?
Flashback January 20, 2008: Time To Short Treasuries?
Kass: Inflation is still an issue. Despite the Bureau of Labor Statistics' readings, inflation remains elevated and is not reflected in the current level of interest rates. The expected fiscal and monetary stimulation in the upcoming months will only serve to exacerbate inflationary pressures.
Mish: Before we can have a debate about whether or not inflation is a problem, we need to agree on what inflation is. Credit is being destroyed far faster than any monetary printing. Currently, Money Supply Trends Are Deflationary. In context of understanding what inflation is, treasury yields this low seem reasonable.
With rising unemployment will come still more foreclosures on both residential and commercial property. This will further impair bank balance sheets and any presumed recovery from this so called $150 billion "stimulus". It will likely take months, before that money gets into consumer hands and perhaps a year before Congress figures out it is meaningless.
Virtually no one, including Bernake thinks deflation can happen in the US. My position is that Things That "Can't" Happen are about to. The result will be Deflation American Style.
There is no bubble in treasuries if you look closely at the fundamental issues. Those who want to see how low treasury yields can get and stay there, need to look at Japan. Yields in the US are going to go far lower and stay lower longer than nearly everyone thinks.
Note how useless the CPI and the price of oil were and still are, in predicting treasury yields.
By the way, I love that Levy chart.
Unfortunately, it is not possible to put together a chart of credit "mark-to-market". There is no such thing, on purpose. Neither the Fed, nor the banks want anyone to know true marks, and the accounting board has delayed "mark-to-market" accounting as well as rules that would require more off balance sheet transactions to be brought back onto bank balance sheets.
However we can easily deduce the trend by a number of variables. Those variables suggest we are indeed bank in deflation after a short interlude in 2009.
Levy:
As revenues strengthen and social safety net spending eases, the deficit will tend to narrow rapidly on its own. As in the late 1940s and early 1950s, the debt-to-GDP ratio is likely to fall rapidly.
Mish:
The conditions in the 1940s and 1950s have absolutely nothing in common with the conditions now. Think of the baby boomer dynamics, population growth, etc.
We now have a massive wave of boomers headed for retirement with a need to draw down savings. Unfortunately, those savings are nonexistent for a huge chunk of retirees and hugely insufficient for nearly all the rest.
The Model is Japan NOT 1940
We have a model to look at and that model is Japan. Is debt-to-GDP rising or falling in Japan? I think we all know the answer to that. No doubt many will chime in "the US is not Japan" citing Bernanke's massive reflationary effort.
Ho-hum.
Please consider Bernanke's Deflation Preventing Scorecard and my followup post Are we "Trending Towards Deflation" or in It?.
In spite of that massive effort by Bernanke the US is in deflation.
Others will claim Japan is a nation of savers. What they really mean is Japan WAS a nation of savers. The savings rate in Japan is now under 1% while the US savings rate is soaring.
Interestingly, a lack of savings in the US strengthens (not weakens) the deflation case. What cannot be paid back won't. What isn't paid back results in a collapse in credit (i.e. deflation).
So yes, we are Japan, and no, this is not 1940.
Headed For Disaster
Levy makes another error in stating "The Rapid Increase In Public Debt Is Not Likely to End in Disaster"
Assuming we stay on the same course, we are indeed headed for disaster. However, timing the disaster and the nature of it is the problem. We could be 5 years away or 10. There are too many variables to figure out, and too many ways the problem can change in the meantime.
I think Japan faces disaster first. They are one cycle ahead.
Levy:
8. Could the Economy Begin to Overheat When the Contained Depression Is Over, Leading to Rapidly Rising Inflation?
As long as the contained depression persists, and our best estimate is that it will last roughly a decade, the primary threat to price stability will remain deflation rather than inflation. Japan provides a graphic example of how an economy in contained depression — in Japan’s case, for nearly two decades — can run huge deficits, accumulate massive government debt, and still experience disinflation and deflation. The real inflation question concerns what will happen once the contained depression ends.
Although the future that far out holds many uncertainties, it appears that occasional spikes will be more likely than an ongoing upward wage-price spiral after many years of disinflation or deflation.
Mish: Levy is back on track. I too suspect the "contained depression" may last as long as a decade. If it does, there is no reason to think the deficit will shrink. Japan's didn't, so why should ours?
Interestingly, Levy hits the nail on the head with "Japan provides a graphic example of how an economy in contained depression can run huge deficits, accumulate massive government debt, and still experience disinflation and deflation" while stating something sounding way different in the preceding section.
Conclusions
I commend Levy for coming to what I believe is the correct overall conclusion. Levy did go astray on some minor issues as well as one major point, but overall I like their analysis. The report was well presented.
One problem in reading the report is that at times Levy seems to confuse "price inflation" with "inflation". It is very difficult to draw correct conclusions about what is happening and more importantly what is likely to happen, unless one figures out where money supply and credit are headed, and why.
If you have not done so, please consider Fiat World Mathematical Model.
That Levy managed to come to what I believe is the proper overall conclusion stems from Levy's rock-solid case presented in section 2: Why Aggressive Monetary Policy Isn’t Causing and Won’t Cause Inflation.
Thanks
Read more:
http://www.businessinsider.com/were-in-a-contained-depression-that-may-last-as-long-as-a-decade-2010-8#ixzz0xfjzPydb
