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Road to
Hyperinflation is paved with Market Accommodating
Monetary Policy
By
Henry C.K. Liu
Part I: A Crisis the Fed Helped
to Create but Helpless to Cure
Part II: Central
Banking
History of Failing to Stabilize Markets
Part III: Inflation Targeting
Milton Friedman, the 1976 Nobel laureate
in economics,
identified through an exhaustive analysis of historical data the
potential role
of monetary policy as a key factor in shaping the course of inflation
and
business cycles, with the counterfactual conclusion that the Great
Depression
of the 1930s could have been avoided with appropriate Fed monetary
easing to
counteract destructive market forces. Friedman’s counterfactual
conjecture,
though not provable, has been accepted by central bankers as a magic
monetary
formula to rid capitalism of the curse of business cycles. It underpins
the Greenspan-led Fed’s “when in doubt, ease” approach of the past 2
decades which
had led to serial debt bubbles, each one biggest the previous one.
Macroeconomists,
including current Fed Chairman Ben Bernanke, focus their
attention on
the structure, systemic performance and behavioral interactions of the
component
parts of the economy. While they defend the merits of market
fundamentalism,
most neoclassical macroeconomists subscribe to the debt-deflation view
of the
Great Depression in which the collateral used to secure loans or as in
the
current situation, the backing behind their derivative
instruments will
eventually decrease in value, creating losses to borrowers, lenders and
investors, leading to the need to restructure the loan terms or even
loan
recalls. When that happens,
macroeconomists believe that government intervention is necessary to
keep the
market from failing.
The term debt-deflation was coined by Irving Fisher in 1933,
and refers to the way debt and deflation destabilizes each other.
De-stability
arises because the relation runs both ways: deflation causes financial
distress, and financial distress in turn exacerbates deflation. This
debt-deflation cycle is highly toxic in a debt-infested economy.
Hyman Minsky in The
Financial-Instability Hypothesis: Capitalist processes and the behavior
of the
economy (1982) elaborated the debt-deflation concept to incorporate
its
effect on the asset market. He recognized that distress selling reduces
asset
prices, causing losses to agents with maturing debts. This reinforces
more
distress selling and reduces consumption and investment spending which
deepen
deflation.
Bernanke wrote in 1983 that debt-deflation generates
wide-spread bankruptcy, impairing the process of credit intermediation.
The
resultant credit contraction depresses aggregate demand. Yet in a later
paper: Should Central Banks Respond to Movements in
Asset Prices? (2002) coauthored with Mark Gertler, Bernanke
concludes that
inflation-targeting central banks need not respond to asset prices,
except
insofar as they affect the inflation forecast. The paper refers to a
1982 paper
by Oliver Blanchard and Mark Watson: Bubbles,
Rational Expectations, and Financial Markets with the general
conclusion
that bubbles, in many markets, are consistent with rationality, that
phenomena
such as runaway asset prices and market crashes are consistent with
rational
bubbles.
Friedman’s conjecture on the effect of monetary policy on
economic cycles drew on the ideas of neoclassical welfare economist
Arthus
Cecil Pigou (1877-1959) who asserts that governments can, via a mixture
of
taxes and subsidies, correct market failures such as debt-deflation by
“internalizing the externalities” without direct intervention in
markets. Pigou
also proposes “sin taxes” on cigarettes and alcohol and environmental
pollution. However, Pigou’s Theory of Unemployment (1933)
was challenged conceptually three years after publication by
his personal friend John Maynard Keynes in the latter’s highly
influential
classic: General Theory of Employment,
Interest and Money (1936). Keynes advocated direct government
interventionist policies through countercyclical fiscal and monetary
measures
of demand management, i.e. full employment.
Macroeconomists
are also influenced by the work of Irving Fisher (1867-1947): Nature
of
Capital and Income (1906) and elaborated on in The Rate of
Interest
(1907 and 1930), and his theory of the price level according to the
Quantity
Theory of Money as express by an equation of exchange: MV=PT
;
where M=stock of money, P=price level, T=amount
of
transactions carried out using money, and V= the velocity of
circulation
of money. Fisher’s most significant theoretical contribution is the
insight
that total investment equals total savings (I=S), a truism that all
debt
bubbles violate.
The 1990s appeared to be a replay of many
aspects of the
1920s when consumers and businesses relied on cheap and easy credit in
a
deregulated market to fuel an extended debt-driven boom which became
toxic when
an inevitable debt crisis caused asset price deflation. Federal Reserve
banking
regulations to prevent panics were ineffective and widespread debt
defaults led
to the contraction of the money supply. In the face of bad loans and
worsening
future prospects, banks abruptly became belatedly conservative in their
lending
while they scrambled to seek additional capital reserves which
intensified
deflationary pressures. The vicious cycle caused an accelerating
downward
spiral, turning an abrupt recession into a severe depression.
Bernanke points out in his Essays on the
Great Depression
(Princeton University Press, 2000) that Friedman argues in his
influential Monetary History of the United States
that the Great Depression was caused by monetary contraction which was
the
consequence of the Fed’s failure to address the escalating crises in
the
banking system by adding needed liquidity. One
of the reasons for the Fed’s inaction was
that it had reached the legal limit on the amount of credit it could
issue in
the form of a gold-backed specie dollar by the gold in its possession.
Today,
the Fed has no such limitation on a fiat dollar, a condition that
permits
Bernanke to suggest the metaphor of dropping money from helicopters on
the
market to fight deflation caused by a liquidity crunch. Free from a
gold-backed
dollar, the Fed is now armed with a printing machine the ink for which
is
hyperinflation to fight deflation.
Yet in the popular press, Friedman was known
also for his
advocacy of deregulated free market as the best options for sustaining
economic
growth, which raises the question of the need for central banking
intervention
to replace specie money of constant value with fiat currency of
flexible
elasticity. A free money market under a central banking regime is an
oxymoron.
Betting on Fed interest moves is the biggest speculative force in the
market.
Friedman apparently did not extend his love for free trade to the money
market.
The Friedman compromise was to manage the structural contradiction with
a
proposed a steady expansion of the money supply at around 2%.
Still, Friedman’s love of free markets does
not change that
fact that totally free markets always lead to market failure. Free
markets need
regulation to remain free. Free market capitalism, the faith-based
mantra of
Larry Kudlow notwithstanding, is not the best path to prosperity; it is
the
shortest path to market failure.
Unregulated markets in goods have a structural
tendency
towards monopolistic market power to reduce price competition to inch
towards
rising inflation. On the other side of the coin, unregulated money
markets can
lead to liquidity crises that cause deflation. The fundamental
contradiction
about central banking is that the central bank is both a market
regulator and a
market participant. It sets the rules of the money market game while it
pretends to help market to remain free by distorting the very same
rules
through the use of its monopolistic market power as a market
participant not
driven by profit motive. The Fed is a believer of free markets who at
the same
time does not trust free markets. The response by ingenious market
participants
to the Fed’s schizophrenia is to set up a parallel game in the arena of
structured finance in which the Fed is increasingly reduced to the role
of a
mere passive spectator.
Rational Expectations
Robert Lucas, the 1995 Nobel laureate
economist, also made
fundamental contributions to the study of money, inflation, and
business
cycles, through the application of modern mathematics. Lucas formed
what came
to be known as the “rational expectations” theory. In essence, the
theory asserts
that expectations about the future can influence economic decisions by
individuals, households and companies. Using complex mathematical
models, Lucas
showed statistically that individual market participants would
anticipate and
thus could easily counteract and undermine the impact of government
economic
policies and regulations. Rational expectations theory was embraced by
the
Reagan White House during its first term, but the doctrine worked
against the
Reagan “voodoo economics” instead of with it.
Inflation Targeting
In a debt bubble, an escalating rate of
inflation to devalue
the accumulated debt is needed to sustain the bubble. Thus conventional
wisdom
moves toward the view that the overriding purpose of monetary policy is
to keep
market expectations of price inflation anchored at a relatively benign
rate to
ward off hyperinflation. This approach is known in policy circles as
inflation
targeting on which Fed Chairman Ben Bernanke is an acknowledged
academic
authority and for which he had been a forceful advocate before coming
to the
Fed.
In May 2003, Pimco, the nation’s largest bond
fund headed by
Bill Gross, having earlier pronounced a critical view on the
unrealistically
low yield of General Electric bonds in the face of expected inflation,
came out
in support of inflation targeting. Fed economist Thomas Laubach, a
recognized
inflation targeting advocate, estimates in a paper that every
additional $100
million increase in projected Federal annual fiscal budget deficit adds
one
quarter percentage point to the yield on 10-year Treasury bonds, albeit
that
this estimate has been rendered inoperative since the 1990s by dollar
hegemony
through which the US trade deficit is used to finance the US capital
account
surplus, reducing the impact of US fiscal deficits on long-term dollar
interest
rates. Global wage arbitrage also kept US
inflation uncharacteristically low, albeit at a price of hollowing out
the US
manufacturing core.
Laubach was part of the Princeton
gang that included John Taylor of the celebrated Taylor Rule, and Ben
Bernanke,
the money printer of late at the Fed. (Inflation
Targeting: Lessons from the International Experience by Ben S.
Bernanke,
Thomas Laubach, Frederic S. Mishkin and Adam S. Posen; Princeton
University
Press 2001). The Fed’s long-held position is that Federal budget
deficits raise
long-term interest rates, over which Fed monetary policy as currently
constituted has little control.
The Taylor Rule
Economist John
Taylor was the editor for Monetary Policy
Rules (National Bureau of Economic Research Studies in Income and
Wealth –
University of Chicago Press 1999) in which he put forth the Taylor Rule.
The Taylor Rule states: if inflation is one
percentage point
above the Fed’s goal, short-term interest rate should rise by 1.5
percentage
points to contain it. And if an economy’s total output is one
percentage point below
its full capacity, rates should fall by half a percentage point to
compensate
for it. The
rule was designed to provide
“recommendations” for how a central bank should set short-term interest
rates
as economic conditions change to achieve both its short-run goal for
stabilizing the economy and its long-run goal for fighting inflation.
Specifically, the rule states that the “real”
short-term
interest rate (that is, the interest rate adjusted for inflation)
should be
determined according to three factors: (1) where actual inflation is
relative
to the targeted level that the Fed wishes to achieve, (2) how far
economic
activity is above or below its “full employment” level, and (3) what
the level
of the short-term interest rate is that would be consistent with full
employment.
The rule “recommends” a relatively high
interest rate (a
“tight” monetary policy) when inflation is above its target (normally
below 2%)
or when the economy is above its full employment level (normally
defined as 4%
unemployment, but this figure has risen in recent years to 6%), and a
relatively low interest rate (a “loose” monetary policy) in the
opposite
situations. Under stagflation when inflation may be above the Fed
target when
the economy is below full employment, the rule provides guidance to
policy
makers on how to balance these competing considerations in setting an
appropriate level for the interest rate. The answer is a neutral
interest rate.
Yet as a practical matter, the only way to counter stagflation is to
lean on
the anti-inflation bias as Paul Volcker did during the Carter years
because a
neutral interest rate may extend stagflation longer than necessary.
Although the Fed does not explicitly follow
the rule,
analyses show that the rule does a fairly accurate job of describing how
monetary policy actually has been conducted during the past decade
under
Chairman Greenspan. This is in fact one of the criticisms of the Taylor
Rule in
that it tends to reflect Fed action rather than to guide it. On the
question
whether the Fed should have leaned against accelerating home prices
during
2003-2005, Taylor rule
simulations
suggest that the Fed should perhaps have been thinking of itself as one
important
cause of that phenomenon in the first place.
The Mystery of
Neutral Interest Rates
Journalist Greg Ip of the Wall Street Journal
reported on
December 5, 2005 that in a written response to a letter from Rep. Jim
Saxton
(R- NJ), chairman of Joint Economic Committee of Congress, about the
meaning of
a neutral interest rate as invoked by Fed Chairman Greenspan’s
testimony,
Greenspan says that definitions of neutral vary, as do methods of
calculating
them and that neutral levels change with economic conditions.
Thus the concept of a neutral rate is made
useless by
practical difficulties. This of course
was a standard Greenspan position of all economic concepts as the
wizard of
bubbleland always drove by the seat of his pants, doing the opposite of
his
obscure official pronouncements. With the Fed widely expected to raise
the FFR
target to 4.25% the following week in a continuation of the traditional
policy
of “measured pace”, up from its low of 1% in June 2004, and with the
10-year
yield at 4.5%, the yield curve was approaching flat, and an inversion
soon if
the Fed, as expected, continued its interest rate raising policy. Historically, a flat yield curve signals
future slow growth and an inverse yield curve signals future recession.
But Greenpsan, invoking rational expectations
theory,
dismissed the historical pattern by arguing that lenders were likely to
accept
low long-term rates because of their expectation of future low
inflation, and
this would stimulate future economic activities. So
stop worrying about the inverse yield
curve. It was an attitude that continued when an inverse yield curve
emerged
again in the early 2000s.
There is no denying that the US
economy, as well as the global economy, had been plagued with
persistent
overcapacity. And if low inflation, as defined by the Fed, is the
result of
slow wage increases, where in the world can the future expansion of
demand come
from? Many analysts, particularly in the bond markets, have sharply
criticized
the Fed for keeping interest rates too low for too long and ignoring
signs of
incipient and insipid inflation.
In his Monday, December 5, 2005 Congressional
testimony, Mr. Greenspan reiterated
his view that recent price increases were mainly a result of
“transitory
factors,” such as rising oil prices. True to his Keynesian past,
Greenspan also
pointed out that corporate profit had been so high that businesses had
ample
room to offer higher wages without raising prices to consumers. But of
course,
supply-side economics requires corporate profits to boost return on
capital
rather than boost demand by raising wages. And management never
voluntarily
raises wages without being pressured to by labor strikes, let alone for
the
good of the economy. To management, the only thing good for the economy
is
corporate profit.
The surprisingly tentative tone of Greenspan’s
residual
Keynesian outlook contrasted with the more extended attempt in his
testimony on
the following Tuesday to buttress his view that core inflation, which
excludes
volatile areas like food and energy prices, is likely to remain below
2%
through the end of next year. But
despite his optimism about inflation remaining under wraps, Greenspan
cautioned
investors against thinking that the Fed might feel less constrained in
unwinding its cheap-money policies of the last three years from 2001 to
2004.
In the June 30, 2004 Congressional hearing, Greenspan
carefully dodged an opening
question from Senator Richard C. Shelby, Republican of Alabama and the
chairman
of the Senate Banking Committee, on whether the Fed would raise the
federal
funds rate another quarter-point at its August 2004 meeting. Greenspan
also
refused to be pinned down on what was in many ways the most basic
question:
What constitutes a ''neutral'' interest rate that Greenspan claims he
tries to
follow that neither provokes inflation nor slows down the economy?
Many economists have suggested that a
“neutral'” fed funds
rate -- the rate charged on overnight loans between banks and the key
policy
tool the Fed relies on to guide the economy -- is between 4 to 5%. That
would
have been a big increase from the June 30, 2004 fed funds rate level of 1.25%.
Like the famous description of pornography
from Supreme
Court Justice Potter Stewart, Greenspan said people would know the rate
when it
arrived. “You can tell whether you're below or above, but until you're
there,
you're not quite sure you are there,” he said. “And we know at this
stage, at
one and a quarter percent federal funds rate; that we are below
neutral. When
we arrive at neutral, we will know it.”
Economists have highlighted numerous
difficulties in
estimating the neutral federal funds rate in real time, including data
and
model uncertainty, which can result in estimates that are off by a
couple of
percentage points. These difficulties add to the challenge of
conducting
monetary policy, especially when the fed funds target is near the
neutral rate,
because policymakers must make their decisions without the benefit of
reliable
data. Therefore, policymakers will be especially attentive at this
stage to
incoming data. And, until research finds a solution to the difficulties
of
estimating the neutral rate, the conduct of policy will remain both a
science
and an art.
Market Expectations
Undermine Inflation Targeting
The problem is that according to “rational
expectations”
theory, market expectation can undermine the Fed’s inflation targeting
policy
to push tolerance for inflation increasingly higher until it reaches
hyperinflation. Inflation targeting advocates therefore argue that
inflation
targeting should encompass a dual objective of holding down inflation
as well
as preventing deflation.
The financial press, grasping at straws in the
wind to
anticipate Fed policy, highlighted Fed Chairman Bernanke’s January 10,
2008
speech at the Women in Housing and Finance and Exchequer Club Joint
Luncheon in
Washington, D.C. on Financial Markets, the
Economic Outlook, and
Monetary Policy as signal of
the Fed standing “ready to take
substantive
additional action as needed to support growth and to provide adequate
insurance
against downside risks.”
Yet Bernanke also said:
“any tendency of
inflation expectations to
become unmoored or for the Fed’s inflation-fighting credibility to be
eroded
could greatly complicate the task of sustaining price stability and
reduce the
central bank’s policy flexibility to counter shortfalls in growth in
the future. Accordingly,
in the
months ahead we will be closely monitoring the inflation situation,
particularly as regards to inflation expectations.”
Thus the Fed is restrained in its
interest rate action not only by actual incoming inflation data, but
also by
data on inflation expectations. This means that when the market expects
the Fed
to cut interest rates, it actually limits the ability of the Fed to cut
rates.
After the Fed’s January 2008
unprecedented and drastic interest rate cuts, the market has been
anticipating
that the European Central Bank (ECB) would need to follow the Fed’s
lead to
lower euro rates significantly. Yet
while the ECB faces similar dilemma as the Fed with regard to
simultaneous
vigorous inflation and slowing growth, the ECB is limited by its
singular
mandate of restraining inflation, unlike the Fed’s dual mandate of
price
stability and support for growth and employment. Jean-Claude
Trichet, head of the ECB,
testified in front of the European Parliament that inflation remains
the ECB’s
prime focus to “solidly anchor inflation expectations.”
The euro zone economies are saddled
with a less flexible structure of wage volatility that cannot adjust
quickly to
price changes as in the US because most European wage contracts are indexed to
inflation
but not to deflation. Unlike their US counterparts, European companies cannot layoff
workers as
easily, or adopt a two-tier wage and benefit regime for new workers.
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Market expectation is focused on the
inevitability of a euro-zone slowdown form the financial market turmoil
that
had originated from the US in August 2007 and on the prospect of euro interest
rate
reduction in the face of asset price correction despite a strong euro
against
the dollar. Yet European politics will not allow political leaders to
be
complacent about a strong euro buoyant by a flight from a deteriorating
dollar
while euro economies face a decline from global depression caused by a
slowdown
in the US economy. In the current
global trade regime, the depreciation of the dollar will bring down the
value
of all other currencies. Exchange rate fluctuations only reflect
temporary
differentials in the rate of decline in the purchasing power of
different
currencies. Even as the euro falls against the dollar, it continues to
lose
real purchasing power.
Democrat-Controlled
Congress Wants Employment Targeting
As early as February 19, 2007, half a year before the August
emergence of the credit
crisis, Representative Barney Frank of the 4th Congressional District
of
Massachusetts, the Democratic chairman of the House Financial Services
Committee, told The Financial Times
it would be a “terrible mistake” for the Fed to adopt inflation
targeting to
guide its interest rate decisions. Frank,
whose committee is the House
counterpart of the Senate committee
charged with oversight of the US
central bank, said such targeting “would come at the expense of equal
consideration of the [the Fed’s] other main goal, that is employment.”
By that Frank meant inflation targeting could
be used to
keep inflation down at the expense of full employment. His comments
came as Fed
policymakers entered the final stages of a far-reaching strategy review
that
included detailed debate over the merits of adopting an inflation
target. What
Frank opposed was the prospect that the Fed would fight inflation by
keeping
interest rate above that needed to produce low unemployment.
Fed Chairman Bernanke believes that the
central bank would
be better off with a relatively flexible inflation target – one that
would be
achieved on average, rather than within a specific time frame, giving
maximum
latitude to respond to exogenous output shocks. Critics point out that
this
could lead to the Fed alternatively overshooting and undershooting in
the short
term, creating undesirable volatility in the market. This is because
incoming
economic data are known to be unreliable and need subsequent revision.
Further, in order to make any such policy
change, Bernanke
would need at least the tacit consent of key figures in Congress.
Frank’s
unequivocal statements against inflation targeting as it impacts even
short-term unemployment suggest this consent will still be difficult to
secure
even after generally favorable congressional hearings. Frank told The Financial Times that Bernanke “has a
statutory mandate for stable prices and low unemployment. If you target
one of
them, and not the other, it seems to me that will inevitably be
favored.” The
reality could be that neither stable prices nor low unemployment can be
achieved by short-term flexible inflation targeting.
Advocates of an inflation target at the Fed
say it is
important to distinguish between the relatively rigid form of targeting
as used
by the Bank of England, and the relatively flexible form favored by
Bernanke.
Frank, however, said he would not support even a flexible target
“without equal
attention to unemployment also.” What
Frank
wants is a low unemployment target to link to a low inflation target.
The fear
is stagflation with high unemployment accompanied by high inflation.
Inflation Expectation
around the World
Inflation expectation has been rising
everywhere in the
world, driven in part by rational expectation on the part of market
participants. Beyond price data on oil and food, US
core inflation in the 2.2 - 2.3% range since April 2006 has been above
the
central bank’s stated comfort level of 1.6% to 1.9% for some time.
Further, the
“core rate” is designed to sooth the financial markets and to distract
market
participants from the reality of rising inflation. The core rate does
not exist
anywhere in the real economy. It is a fictional notion designed to
disguise
inflation to justify perpetual real negative interest rates. And
negative real
interest rates have an upward spiral effect on inflation trends.
And in the euro-zone, even a rising euro has
not stopped
inflation from rising to 3% in November 2007, largely due to rising
price of
dollar-denominated imports, such as oil, outpacing the rise in exchange
value
of the euro. Evidence of second-round inflationary effects are already
visible,
with Europeans workers, most vocal in France and Germany, demanding
wage
increases to compensate for a loss of purchasing power beyond the
acceptable
range of accepted inflation and productivity targets. Member of the
British
police held a mass protest over pay in central London
on January 23, 2008,
angered by a 2.5% pay rise being backdated to only December 1, 2007 for member
officers in England,
Wales
and Northern Ireland.
Long-term inflation expectations in the
euro-zone, as
expressed by interest rate futures, are running at nearly 2.5%, a
robust 25
basis points above official ECB target of “close to but below 2%”.
Forecasters
expect euro-zone inflation to slow in 2008 but nobody is predicting
that it
will fall below target, let alone turn negative for the rest of the
year,
particularly if the dollar continues to decline in purchasing power.
Responding
to a declining dollar, oil and other key commodities prices denominated
in
dollars can be expected to rise in adjustment, causing inflationary
pressure
worldwide.
Global inflation outlook for 2008 does not
justify an
accommodating monetary policy stance for any central bank. Risk of a
recession
in the US
looms
larger by the day from the collapse of the debt bubble, yet monetary
policy is
not an effective tool to prevent that prospect. A debt bubble will
eventually
have to burst to allow overblown asset prices to self-correct. If a
central
bank, as Greenspan claims, should not and cannot intervene on asset
prices on
the way up, but starts to target them on the way down, it fuels
inflationary
expectations. Low interest rates had caused the price bubble; and
resorting to
lowering interest rates to keep prices up after the bubble burst risks
hyperinflation.
If higher inflation to the level needed to
sustain the
expanding debt bubble is tolerated, serious convulsions in global bond
markets
and the foreign exchange market and serious disruption to the global
flows of
funds can be expected. If high inflation is not tolerated, a violent
burst of
the debt bubble may be the outcome. While the market pushes the Fed to
allow
inflation to moderate price correction, it is far from clear that the
damage to
the global economy from inflation will be less than that from market
price
correction.
Inflation
Expectations in Emerging markets
Measuring inflation expectations in emerging
markets
requires different methods since competition for export market share
has
neutralized wage-price spirals common for the developed economies. This
is so
despite the fact that food and energy account for a much larger share
of total
spending in poorer countries than in rich ones, making it harder for
workers to
absorb price increases without demanding higher wages to compensate.
The core
rate of inflation, excluding food and energy, is moderate in most parts
of the
world and strikingly low in some of the fastest-growing economies in
the world,
including Saudi Arabia
and even China,
where core inflation was just 1.1% in October, 2007. Headline inflation
in China
was 6.5% in August, 2007 with food prices leading the rise.
Food prices increase was exacerbated by an
outbreak of
porcine reproductive and respiratory syndrome (“blue-ear” disease) that
has
affected pig supplies, pushing the year-on-year increase in meat and
poultry
product prices to 49% in August. 2007. Pork alone accounts for around
4% of the
basket used for the consumer price index, so movements in its price
have a
direct feed-through into inflation. The cost of eggs rose by 23.6% year
on year
in August, moderating from a peak of 34.8% in June. Vegetable prices
were up
22.5% over a year ago. Aquatic-product prices are also gaining
momentum. Food
accounted for 37% of the average total spending of a Chinese urban
household in
2005.
The Fed and Global
Stagflation
While inflation expectations remain locked at
moderate
rates, food and energy prices will continue rising above-average rates
because
of anticipated decline in the purchasing power of the dollar, causing
overall
inflation to escalate globally as the global economy slows. The Fed is
betting
on its aggressive rate cutting moves to turn 1970s-style “stagflation”
into
mere inflation.
Until the end of 2007, many financial
executives, market
participants, influential commentators and government policymakers had
insisted
publicly that last summer’s credit squeeze would prove short-lived and
containable. Suddenly, in the course of a few weeks, bankers and
regulators
have been forced to face reality and to admit that the shock that began
in
August was merely the first sign of widespread financial collapse that
would
take years to unwind.
Sharp Fall Off of
Market Confidence
Market confidence fell abruptly off a cliff,
with banks wary
of lending to each other while investors stop buying new securitized
debt
instruments. Borrowing costs in the money markets rose dramatically to
put
pressure on corporate borrowers, private equity acquisition and
commercial real
estate finance.
Fear has spread to the entire global market,
partly due to
lack of transparency behind the credit crisis that began in the US.
Projected losses continue to rise with no end in sight. The problem is
made
worse by the self-inflicted loss of credibility on the part of top
government
officials and leading financial executives.
For example, Fed Chairman Bernanke first
suggested that the
subprime mortgage crisis would result in a manageable $50 billion in
losses.
Less than three months later, he tripled the projected loss to $150
billion but
still denying any threat of systemic contagion. Speaking after the
February 9
meeting of Group of Seven finance ministers, Peer Steinbrück of
Germany said
the G7 now feared that write-offs of losses on securities linked to US
subprime
mortgages could reach $400 billion, sharply higher than the $150
billion credit
losses that the Fed, Wall Street banks and other institutions have
revealed in
recent weeks. The latest panic-stricken Fed interest rate cuts are
telling
market participants to expect losses that could amount to trillions.
AIG, The world’s biggest insurance company by
assets, sent
tremors through the markets on February 12 when the insurance company
raised
its estimate of losses in October and November from insuring
mortgage-related
instruments from about $1 billion to $5 billion. AIG
shares tumbled 11%, wiping $14 billion
off its market value. AIG has written $78 billion of credit default
swaps on
CDOs,
which protect the purchaser from a CDO’s failure to pay. The primary
providers
of the hedges are bond insurers such as MBIA and Ambac, whose ability
to pay
claims is causing deep anxiety in global markets. These have written
about $125
billion of protection on “senior tranches” of CDOs. Catherine Seifert,
analyst
at Standard & Poor’s, was quoted in the Financial Times that AIG
would
“have an extremely difficult time regaining investor confidence”.
How many times can public figures be shown
wrong by
subsequent unfolding events before losing total credibility? The
overused
truism is now flooding the media: that credibility is like virginity –
much
easier to lose than to get it back. Like the resourceful pimp who
promotes the
virgin-like freshness of his prostitute by claiming that it is only her
second
sexual encounter, the “good fundamentals” of the economy is touted over
and
over again by influential public figures in the face of deepening
systemic
collapse and dwindling confidence. Gratuitous advice that the market
was
temporarily oversold and that every decline session presents a “buying
opportunity” continues to be standard pronouncement by those who are in
the
position to know better.
The faith-based Larry Kudlow & Company
program on CNBC,
where participants are asked to declare with solemn piety: “I believe
free
market capitalism is the best route to prosperity” as an article of
faith, is
increasing attracting viewers for its entertainment value rather than
for the
quality of its analysis, particularly when the host continues to repeat
with a
straight face his tiresome mantra that goldilocks economy is alive and
well in
the face of serious systemic financial disaster.
Losses Exceeding $1
Trillion
Back in the real world, Goldman Sachs analysts
estimate that
the total final loss on US subprime mortgages would exceed 80% of its
March
2007 face value of $1.3 trillion, even if the meltdown does not spread
throughout the $20 trillion total residential mortgage outstanding and
beyond
the housing sector into commercial real estate and corporate finance.
The bulk of this loss will ultimately be borne
by pension
funds whence the average worker around the world expects to receive
money to
fund his/her retirement needs. Market forces can resolve the financial
crisis
with a sharp and quick price correction from bubble levels but the
politically
sensitive Fed and Treasury are trying to engineering a “soft landing”
by
extending the debt bubble, the penalty for which would be a decade or
more of
stagflation. Pathetically, supply-side market fundamentalists are
clamoring for
more government bail out of the market, with “damn the economy” frenzy.
It is
the equivalent of the God-fearing faithful asking the Devil for help in
easing
the ordeal of faith.
Dollar Hegemony and
Loose Monetary Policy
The benefits of a loose monetary policy are by
now proving
to be dramatically short of what their advocates have claimed. A
protracted
policy bias towards low interest rates led the economy into its current
debt
quagmire, particularly when the unearned profit of the debt-driven boom
has
gone to a select manipulating few, leaving the masses with debts
unsustainable
by income. More low interest rates will perhaps help the wayward
financial
institutions delay inevitable insolvency but will not get the economy
out of
its debt crisis without pain. The argument that subprime mortgages
helped
expand homeownership is false. Such mortgages only put buyers into
homes they
cannot otherwise afford by distorting the happy American dream into an
unneeded
financial nightmare.
Easy money has been one of the most tempting
monetary
fallacies for all governments all through civilization. It has brought
down the
mightiest of empires, from Rome
to dynastic China. But the one basic requirement for sustaining the
value
of money
is that it must not be easy to come by without equivalent input of
value.
In the
current international architecture based on fiat money, governments of
trading
nations justifies inflationary monetary policy with the need to lower
currency
exchange rates to compete for market share in international trade.
Inflation is
driven by global trade.
The Bernanke Fed seems to have followed
Greenspan’s pattern
of adopting traditional gradualism only when interest rates are on the
way up
to retrain inflation, but always abandoning gradualism on the way down
to
stimulate growth, thus introducing a long-term structural bias in favor
of
inflation. The Fed then frequently finds itself behind the curve in
fighting
inflation expectation and overshooting to combat deflation expectation.
This
unbalanced proclivity has contributed to the long-term decline of the
purchasing power of the dollar on top of the fiscal and current account
twin
deficits. Yet the US
has been the privileged beneficiary of this easy fiat money fallacy
through
dollar hegemony since 1971 when President Nixon abandoned the Bretton
Woods
fixed exchange rate regime based on a gold-backed dollar. And this
fallacy of
the benefits of easy fiat money is about to be exposed by hard data for
even
the printer of the fiat dollar.
The Age of Worker
Capitalism
There was a time in the past under industrial
capitalism
when in a class war between capitalists and workers, moderate inflation
could
help workers keep their jobs by keeping the economy expanding and make
it
easier for them to pay off their debts to capitalists. But nowadays,
under
finance capitalism when capital comes mostly not from capitalists, but
from
enforced savings held by worker pension funds, inflation robs workers
of their
retirement resources while stagflation lays them off from their current
jobs.
Capital has been manipulated as a notional
value on which
derivative transactions are calculated and profit and loss are
realized.
Finance capitalism, through income disparity condoned by supply-side
ideology
of keeping profit for the rich in the name of capital formation and
letting the
working poor be taken care of through trickling down from the rich, has
constructed a financial infrastructure that channel profits to a few
and
assigns losses to the many. The inequity
is mind-boggling. At least the capitalists of industrial capitalism
used their
own money. In finance capitalism, the retirement funds of workers are
manipulated by financiers to exploit workers.
A Flawed
International Finance Architecture
In April 2002, the term dollar hegemony
was
put forth by me in Asia Times on Line
in a critical analysis of a post-Cold-War geopolitical phenomenon in
which the
US dollar, a fiat currency, continues to assume the status of primary
reserve
currency in the international finance architecture that finances global
trade.
Architecture is an art the aesthetics of which is based on moral
goodness, of
which the current international finance architecture is visibly
deficient.
Thus dollar hegemony is objectionable not only
because the
dollar, as a fiat currency, usurps a role it does not deserve, thus
distorting
the effects of trade, but also because its impact on the world
community is
devoid of moral goodness, because it destroys the ability of sovereign
governments beside the US to use sovereign credit to finance the
development
their domestic economies, and forces them to export to earn dollar
reserves to
maintain the exchange value of their own currencies. Exporting
economies are forced
to accumulate dollars that cannot be spent domestically without severe
monetary
penalty and must reinvest these dollars back into the dollar economy.
The Bretton Woods II
Theory Fallacy
In 2003, economists Michael Dooley, David
Folkerts-Landau
and Peter Garber proposed what has since become known as the Bretton
Woods II
theory. The theory turns dollar hegemony from the destructive monetary
scam
that it is into an assenting fantasy by applauding it as a happy
win-win
arrangement in which newly industrialized countries peg their
currencies to the
fiat dollar at an undervalued exchange rate in pursuit of export-led
growth;
and in return, they reinvest their trade surplus dollars back into the
US,
which acts as an economic anchor and consumer of last resort. This
warped
theory fed the illusion that the US
trade deficit can be reversed by merely forcing trade surplus partners
to
upward revalue their currencies. The 1985 Plaza Accord succeeded in
pushing the
Japanese yen up against the dollar and threw Japan
into a two-decade-long recession without reversing the US
trade deficit.
By 2006, the US
was running a current account deficit in excess of 6% of its gross
domestic
product, a level that would normally be considered excessive and
unsustainable
while the capital starved exporting economies in Asia
were holding large amounts of US
debt. The Bretton Woods II theory says that this state of affairs is
both
desirable and sustainable, a dubious claim clearly disproved by facts
by now.
There may still be some who argue that dollar hegemony is desirable but
no one
can deny it is clearly unsustainable. If this currency abuse is
practiced by
any other government, the International Monetary Fund (IMF), a creation
of the
Bretton Woods regime, would impose austere “conditionalities”
on its fiscal budget to restore the exchange value of the currency.
With dollar
hegemony, the US,
the nation with the longest continuous current account deficit in
history and
the world largest debtor, is exempt from such IMF imposed austerity
discipline
on its fiscal budget.
Dollar Hegemony
Engenders US Protectionism
The net result of the injurious effects of
dollar hegemony
is the emergence of anti-trade protectionism even within the US,
the supposedly lead beneficiary of the Bretton Woods II regime,
particularly
the segment of the US
population that has unevenly borne the pain of free trade. For the
exporting
economies, there are growing signs that political leaders are beginning
to
realize that export-led growth is not the panacea that neoliberal
market
fundamentalism has made it out to be. Exporting for dollars that cannot
be
invested at home has left all exporting economies starved for capital
for
domestic development, with serious disparity of income and wealth, and
political instability resulting from unbalance development. While much
of
domestic politics in the exporting countries is distorted by uneven
power held
by special interests of the export sector, a collapse in global trade
will
shift the balance of political power back towards the domestic sector.
The circular fund flow from US
current account deficit back into US
capital account surplus appeared to have come to a sudden halt in the
summer of
2007. The US Treasury International Capital System (TICS) data show a
massive
drop in net foreign purchases of US long-term securities since the end
of June,
dropping from $99.9 billion to $19.5 billion in July and to a negative
$70.6
billion in August, bouncing back to a positive $26.4 billion in
September. All the while, US
current account deficit has been running about $80 billion a month.
Dollar Hegemony Feeds
the Debt Bubble
What dollar hegemony does over time is to feed
the US debt
bubble and steadily weaken the value of the dollar while it hollows out
the US
industrial core, as US policymakers in both the Clinton and Bush
administrations tirelessly assert that a strong dollar is the national
interest. Whenever the dollar debt bubble burst in the last two
decades, as it
again did in August 2007, and the Fed had been forced into the fad of a
monetary easing mode, i.e. lowering dollar interest rates not just
temporarily
but kept it low for long periods. The effect has been to force the
purchasing
power of the dollar to fall which then induced other central banks to
let their
currencies fall as well to protect their competive export market shares
and to
preserve the value of their dollar holdings in local currency terms. A
competitive currency devaluation war will eventually unravel dollar
hegemony in
a disorderly fashion into a spiral of global hyperinflation. That
eventuality
appears to be at hand in 2008.
The collapse of dollar hegemony can accelerate
the emergence
of an Asian regional currency regime, along the lines of what happened
in Europe
after the collapse of the Bretton Woods regime in 1971. There has been
a lot of
talk for a long time about Asian monetary union, with little progress
so far.
See my July 12, 2002
article on The case for an Asian Monetary Fund
in Asia Times on Line.
Prisoners Dilemma for
Foreign Central Banks with Massive Dollar Holdings
The Triffin dilemma,
name after Belgian-American economist Robert Triffin who first
identified it in
1960, is the problem of fundamental currency imbalances in the
Bretton
Woods regime. With dollars flowing overseas through the Marshall Plan, US
military spending and US
citizens buying foreign goods and US
tourists spending aboard, the amount of euro-dollars in circulation
soon
exceeded the amount of gold backing them. By the early 1960s, an ounce
of gold
could be exchanged for $40 in London,
even though the official price in the US
remained $35 by law. This difference showed that the market knew the
dollar was
overvalued and that time for gold-backed dollar was running out.
The solution was to reduce the amount of
dollars in
circulation by cutting the US
balance of payments deficit and raising dollar interest rates to
attract
dollars back into the country. But these moves would drag the US
economy into recession, a prospect President John F. Kennedy found
politically
unacceptable. This was posed as the famous Triffin dilemma to Congress
as an
explanation why the Bretton Woods regime had to collapse inevitably.
Triffin noted
that there was a fundamental liquidity dilemma when one country’s
national fiat
currency was used as a global reserve currency for trade. The very
structural
advantage would cause that country to lose any resolve to maintain the
value of
its fiat currency.
As the post-war world economy grew, more
dollars were needed
to finance it. To supply global dollar liquidity, the US
must run a deficit, as no other government could produce dollars. But
to
maintain credibility of its currency, the US
must not run a deficit. That was the fundamental dilemma. In the end,
the US
opted to continue to run a balance of payments deficit, which led to
the loss
of credibility and the collapse of the Bretton Woods regime in 1971.
However, if the United
States
stopped running balance of payments deficits, the global economy would
lose its
largest source to monetary reserves. The resulting shortage of
liquidity could
pull the world economy into a contracting spiral, leading to economic,
social
and political instability.
How Long will Foreign
Central Banks subsidize Dollar Hegemony
Some argue that it is not the business of
central banks to
maximize the return on their exchange reserve portfolio, but to protect
and
enhance the stability of domestic financial markets and, in the case of
central
banks of large economies, global financial stability. In other words,
foreign
central banks that hold of massive dollar reserves from trade surplus
are
expected to pay the price of exchange rate losses to sustain the
current
international global financial infrastructure based on the fiat dollar.
Yet the
profit made from the exchange rate losses sustained by the foreign
central
banks went disproportionately to the international financial elite,
causing
income disparity everywhere that held back consumption demand which
became a
critical structural problem when the global economy moved into an
overcapacity
mode.
Whether and for how much longer this counter
salutary
arrangement can be sustained depends on the degree and rate of decline
of the
dollar and the disproportionately low purchasing power of workers in
the US
and the rest of the world. Foreign central banks may become convinced
that the US
has neither the intention nor the resolve to keep the dollars strong
beyond
rhetoric, or the ideology to let domestic and foreign workers have a
larger
share of global corporate earnings. When that happens, the incentive
for
foreign central banks to hold onto the dollar in hope of an eventual
reversal
of its declining value may vanish very suddenly either as a result of
financial
logic or political pressure.
Credit Rating Fiasco
Shortly after the outbreak the credit crisis
of August 2007,
as the supposedly low-risk instruments became victims of unanticipated
risk
swelling from below, the monetary policy establishment began looking
for a
scapegoat and found it in the failure of the rating agencies to account
properly for the complexity of the securitized instruments, relying
overly on
faulty mathematical models to override conventional prudent risk
management.
It is true that rating agencies operate under
a conflict of
interest, their fees being paid by the issuers of the debt instrument
they
rate. Yet the underlying logic of the rating agencies’ permissive
blessing
rested on a reasoned assumption: that the explosive growth in credit
derivatives and collateralized debt obligations (CDO) of recent years
around
the world had been enabled, if not caused, by US-led monetary policy
under the
leadership of Alan Greenspan at the Fed and Robert Rubin at the
Treasury, and
that this monetary policy of easy money would continue forever. Dollar
hegemony, though unavoidably
presenting a long-term threat to the US-controlled international
finance
architecture, was as close to a free lunch in monetary economics as one
could
get.
The Destructiveness
of Dollar Hegemony
Dollar hegemony allowed the US
to soak up the world’s wealth with persistent negative real interest
rates to finance
US spending. After Clinton,
the
Bush tax cuts, with the help of Greenspan’s loose monetary policy,
sustained
the global debt bubble with reflation, the act of stimulating the
economy
artificially by increasing the money supply during stagnant growth and
by
regressive tax reduction during periods of rising fiscal deficits.
Global broad marketing of securitized debt
instruments has
shifted credit monitoring from direct lender knowledge of the credit
history of
individual borrowers to aggregate credit rating based on statistical
probabilities constructed from theoretical borrower profiles and
behavior
patterns, much like the fundamental assumption of the rational economic
man by
neoclassical economics. More and more
mortgages were written on the assumption of home prices continuing to
rise,
thus reducing concern for borrower credit rating to near zero. The safety of mortgage-back securities
depended entirely on expected rising prices of homes and not on the
credit
worthiness of the borrower. In fact, a subprime borrower is more likely
to
refinance regularly to siphon rising home value into bank profits than
a prime
borrower.
As house price stopped rising and began to
fall,
irresponsible borrower behavior surprised the risk models.
Many borrowers stopped mortgage payments not
because they were cash strapped, but because they did not want to feed
a
mortgage that would soon exceed the market value of their houses. The abnormally rapid rise of distressed
mortgages upset the statistical credit hierarchy of the mathematical
models and
caused a sudden credit squeeze. As the credit squeeze persists, ratings
agencies were being forced to downgrade hundreds of thousands of debt
securities, after failing to foresee the on-coming waves of defaults
initialized by subprime borrowers.
For example, on the last Wednesday night in
January 2008
alone, Standard & Poor’s reportedly downgraded more than 8,000
residential
mortgage-related securities with a market value of $534 billion. These
downgrades in turn triggered bitter recriminations, amid a wave of
losses at asset
management firms and banks. The Financial
Times quotes Wes Edens, head of Fortress Investment Group, a
leading fund
with over $40 billion in assets under management: “Much of the money
lost has
been held by people who held AAA securities [that were downgraded].
That has
caused a tremendous loss of confidence.”
At the root of the rating collapse was the
reliance on risk
management models that assume human behavior to remain unchanged in
times of
financial distress as during times of financial euphoria. Delinquency
rates on
home mortgages jumped much more abruptly than historical trends, with
many
subprime borrowers stopping payment on their home mortgages before halting payments on
their credit cards or automotive loans – turning the traditional
delinquency
pattern on its head. As a result, mortgage lenders face losses at a
much
earlier stage in a credit crisis than in the past and within much
shorter time
frames.
This is partly because many subprime
mortgagees were first
time homeowners who had little or no equity in their new homes and did
not
particularly consider keeping their new home as a top priority,
rendering the
assumed risk profiles inoperative when house prices fell. Unlike home
buyer of
previous times who bought a house to have a home, many in this new
group of
house buyers in the debt bubble tends to view their houses as vehicles
of
investment driven by financial calculation with little or no emotional
attachment. Many bought and sold a house every year, each time moving
into a
bigger house the payments for which have no relationship to their
income.
Bank data show that a large number of current
mortgage
defaults are not linked to temporary cash flow shortfalls but to
borrowers
having bought houses at prices their income could not carry. These
borrowers
depend on refinancing at rising home value to handle their mortgage
payments.
Mortgage delinquencies started to surge as soon as house prices started
to
fall, which prevented overstretched households with unaffordable loans
from
refinancing their way out of trouble. These buyers were a key factor in
turbo-charging the rise in home prices during the debt-driven boom;
they are a
key factor in turbo-charging in the rise of defaults when the boom
busts.
Borrowers with high loan-to-value mortgages or
negative
equity have no incentive to maintain payments when house prices started
to fall
below the value of the mortgage even if they were able to. No one likes
to feed
a dead horse.
Borrowers appear to favor their cars more than
their houses
in which they had no equity stake. IMF data show delinquency rates on
prime
loans made in 2006 and 2007, too late to benefit from house price gains
before
the debt bubble burst, rose more quickly than delinquencies on similar
prime
loans made in 2003 or 2004.
With a presidential election on the horizon,
official
attention has been focused on the problem of payment “resets” which
allegedly
pushed subprime borrowers with loans at initial, ultra-low “teaser”
rates to
default. The Bush administration brokered a plan to freeze resets while
Treasury officials privately admitted that the scheme is not a “silver
bullet”
because recent mortgage data show a surprisingly weak correlation
between rate
resets and delinquencies. The main factor remains borrower attitude and
behavior
distorted by massive debt with reduced punitive consequence for the
borrower
from default.
Debt Bubble Destroys
America’s Admirable National Character
The debt bubble fed by dollar hegemony had
hollowed out more
than just America’s
industrial core; it has also hollowed out America’s
moral core and filled it with unprincipled greed. The American idea of
home
ownership as a symbol of a free society in which any citizen can earn
with
honest hard work and financial discipline a home for his/her family has
been
punctured and replaced by a vile fantasy that a home can be bought with
no
equity, with unrealistic interest and amortization payment schedules
based not
on the buyer’s current and expected future income, but on rising home
prices
made possible by the deliberate easy money policy of the Federal
Reserve,
supposedly the nation’s keeper of the value of its currency.
Some market cheerleaders continued to argue
for months after
August 2007 that the US
jobs market could stay healthy to keep the credit crisis from spreading
to the
general economy. But the job growth in recent decades has been
concentrated in
the financial service sector which cannot continue in a distressed
financial
system. By the end of 2007, even the most optimistic analysts had to
acknowledge
that December consumer spending decline signaled that the US
is slipping into recession that can result in a protracted period of
rising
unemployment. “The problems in the credit markets are spreading to the
consumer
sector – the next area of concern is auto loans and credit cards,” says
John
Thain, newly appointed chief executive of Merrill Lynch who replaced
the
discharged chief after the giant brokerage disclosed massive losses
from
subprime mortgage related investments.
Since repeal of Glass Steagall in 1999,
mega-banks have been
able to re-enact the same kinds of structural conflicts of interests
that were
endemic in the 1920s -- lending to speculators, packaging and
securitizing
debts, marketing structured financial instruments backed by bank credit
line
and extracting lucrative fees at every step along the way in blatant
conflicts
of interests. And, much of these debt instruments are even more complex
and
opaque to bank examiners than their counterparts were in the go-go
1920s. Much
of it is virtual obligation tied to the solvency of other instruments
supercharged by complex computer model of assumed variables and
relationships.
Structured finance, instead of preserving liquidity and hedging unit
risk,
turns out to be the detonator of systemic risk and liquidity draught,
exacerbated by explosively high leverage. The problem is multiplied by
the lack
of transparency.
The rise in prices destroyed the purchasing
power of wages
and government revenues, and the government responded to this by
printing money
to replace the lost revenues but left most wages relatively fixed. This
was the
beginning of a vicious circle. Each increase in the quantity of money
in
circulation brought about a further inflation of prices, reducing the
purchasing power of incomes and government revenues, and leading to
more
printing of money. In the extreme, the monetary system simply collapses
while
the economy remains technically robust.
Hyperinflation is a
State of Mind
This is the way that hyperinflation takes
root: by a self-reinforcing
vicious cycle of printing money, leading to inflation, leading to
printing more
money, and so on. Hyperinflation is not defined by merely a super high
rate of
inflation, but the general acceptance of the compounded inflationary
effect of
a vicious cycle of debt. This is one reason why incipient inflation is
feared,
that even a little inflation one year will lead to more next year, and
so on,
building exponentially by compound interest.
There is a general knee-jerk market psychology
associating
rising asset prices with economic health and falling asset prices with
economy
distress. Yet some economies have experienced steady price rises up to
50 to
100% per year without falling into a cycle of hyperinflation, if such
rise is
anchored by real economic growth. And
there has never been a hyperinflation cycle that could not have been
avoided or
broken by a simple government determination to stop the expansion of
the money
supply for speculation purposes.
Keynes Warns Against
Inflation
John Maynard Keynes who advocated deficit
financing to
counter cyclical depression, warned about the danger of inflation: “By
a
continuing process of inflation, governments can confiscate, secretly
and
unobserved, an important part of the wealth of their citizens. There is
no
subtler, no surer means of overturning the existing basis of society
than to
debauch the currency. The process engages all the hidden forces of
economic law
on the side of destruction, and does it in a manner which not one man
in a
million is able to diagnose.”
The key point is that a monetary system can
only function if
the value of the monetary unit is relatively stable so that any
increase in the
quantity of money reflects a corresponding increase in real wealth.
Monetary
elasticity should not be confused with tolerance for inflation. Hyperinflation is not just prices rising at
an extremely high rate. It means that inflation is out of control and
price
levels are detached from the value of underlying assets. Most of
all,
hyperinflation can only exist if society loses faith in itself and
accepts
further resistance of it as a lost cause.
War and
Hyperinflation
War is the mother of all inflation. Modem
democratic governments
always find it easy to borrow than to level taxes needed to pay for
war. To pay
back the mounting national debt, the temptation for inflation is
irresistible.
As the wave of inflation of the 60s and 70s which began around 1965,
was
triggered by the enormous cost of the Vietnam War, the current wave of
inflation is tied to the two wars in Afghanistan
and Iraq
and
the homeland security costs related to the global war on terrorism. As
with the
Vietnam War which failed either to contain the spread of communism in
the
Southeaster nation, or to strengthen the US
economy, the current war on terrorism will only drag down the US
economy without improving US
national security.
Rubinomics Exports Inflation
to Emerging Economies
At least the inflation of the Vietnam War was
partly caused
by the social dividend of Lyndon B. Johnson’s Great Society spending,
albeit
paid for with the inflation equivalent of a 20% capital tax on all
savings held
as cash, bonds, insurance and on pension payments and other fixed
income.
Today, under the dynamics of “Rubinomics”, the US
through dollar hegemony exports inflation to all emerging economies
that export
to the US.
The Federal Reserve for the past two decades
have not been
able to check inflation, even as it succeeded in slowing down the US
economy,
but global prices have continued to rise, pushed by the demands of the
emerging
economies. The reason is that the world’s growing population is
consuming food,
energy and basic commodities faster our market economy can produce
them,
ironically because full production capacity cannot be tapped due to
insufficient
worker income to support unmet consumption. Inflation has developed
momentum
with excess money that has flowed to those who will not spend it, but
to invest
it.
The market has lost faith that governments
will have the
political courage to adopt needed policies to remodel the antiquate
plumbing of
systemic cash flow needed to keep the economy growing without debt or
inflation. Current market forces react to fixated inflation
expectations which
in turn exacerbate inflation pressure in a self-fulfilling prophecy. The world must stop looking to the flawed
institution of central banking to bail it out of a monumental debt
crisis with
more debt. The current debt crisis presents an opportunity for a
catharsis to
reform
the greed-infected global economy away from senseless and wasteful
competition,
toward cooperative enterprise to rebuild a new world community based on
human
values, to achieve equality without conformity, with compassion for the
less
fortunate and respect for diversity. The wind of change is sweeping the
world.
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