Alarm bells ring at Fed (deflation alert)

It was a conference to mark Milton Friedman's 90th birthday last month, and who should give the toast to the world's most famous monetarist? A governor from the US Federal Reserve, naturally.

The man from the Fed, a monetary expert in his own right, Ben Bernanke, delivered a dense, 10-page tribute to Friedman's contribution to modern economics, then this punchline: "Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton ... regarding the Great Depression: You're right, we did it.

A couple of weeks later, seemingly following through on this pledge, Bernanke delivered an unprecedented speech in Washington DC. The title: "Deflation: Making sure it doesn't happen here."

It was the Fed's emergency plan, the economic equivalent of the The Worst-Case Scenario Survival Handbook

Bernanke laid out the extraordinary measures the Fed could take - including buying assets from private companies - if the US economy fell into that condition people associate most closely with the Great Depression - deflation, a fall in the general level of prices, the opposite of inflation.

If inflation is too much money chasing too few goods, then deflation is too little money chasing too many goods.

Fed chairman Alan Greenspan told anxious members of Congress in October that "we are not close to the deflationary cliff". But how good are his forecasting skills? The Fed, by its own admission, utterly failed to foresee Japan's slide into deflation seven years ago.

And a solid core of serious analysts now believes it to be a very real risk. The Fed's own behaviour betrays a distinct unease. A month ago it cut the key official interest rate by an aggressively large increment - from 1.75 per cent, already the lowest in over 40 years, to 1.25 per cent.

Fed officials have called that move insurance. Although the financial markets think there is little chance that the Fed will cut rates again at its policy meeting this week, "the Fed is, I won't say panicked", says Steve Roach, economist for the investment bank Morgan Stanley, "but it is very much on alert".

The decision by President George Bush to replace his economic team last week is another indicator that American officialdom is alert to the need for decisive action to keep the economy from quicksand.

As the Fed's Bernanke says: "Sustained deflation can be highly destructive to a modern economy and should be strongly resisted."

The broadest measure of price pressures in the US economy - the gross domestic product deflator - is barely above zero. In the year to the end of September, it was up by 0.83 per cent, its feeblest in half a century.

"The essence of deflation is that business leaders know they do not have pricing power," the ability to raise the price of their products, points out Wayne Angell, a former governor of the Fed and chief economist for the Wall Street investment bank Bear Stearns.

And the prices received by US firms overall have declined in each of the past five quarters, the longest run in more than 50 years. For the latest quarter, they were down 1.3 per cent.

At first, and sometimes for years, executives think that this lack of pricing power is temporary, due to a downturn in the business cycle, Angell says.

"They expect that pricing power will return with recovery." With deflation, it doesn't. "This is precisely what is happening in the US economy today."

Consumer prices in the US are still rising - by 1 to 2 per cent a year, depending on the measure. But David Rosenberg, an economist in the Canadian office of the US investment bank Merrill Lynch, points out that the price of 40 per cent of the hundreds of items that go into the basket to make up the consumer price index are falling.

Indeed, all the inflation in US consumer prices is coming from only five areas that make up a quarter of the index - housing, tobacco, car insurance premiums, hospital services and tuition.

"There's a compelling case for deflation," says Morgan Stanley's Roach. "We are in a rarefied and highly dangerous period."

The two top-most international finance officials in Japan last week took the warning even further. They declared that it was not just a danger facing the US - it was a risk to the entire world economy.

In an unorthodox move, the Vice-Minister for International Affairs at Japan's Ministry of Finance, Haruhiko Kuroda, and his deputy, Masahiro Kawai, put their case starkly.

"Monetary policymakers around the word are still fighting the old enemy of inflation, not the new foe of deflation," they wrote in the Financial Times.

"There is an urgent need to switch to global reflation in order to avoid a deflationary spiral." They called on the Europeans, Americans and Chinese to join Tokyo in heading off a global deflation. And the Japanese know something about contemporary deflation - they pioneered it.

The mainstream of US forecasters does not foresee deflation in the US. But then again, the mainstream does not have such an enviable record of forecasting - the consensus of US economists conspicuously failed to foresee the length of America's boom of the 1990s, and completely missed its 2000 bust.

What of Milton Friedman's school, the monetarists, whose believe that the supply of money is the key to inflation and deflation?

A respected US monetarist, Allan Meltzer, professor of political economy at Carnegie Mellon University and author of a new book, A History of the Federal Reserve, dismisses the possibility of deflation as nonsense.

"It's just bad thinking by badly trained Wall Street economists," Meltzer says. "I don't think any competent economist can make the case for deflation with M2 [the base money supply] growing at 8 per cent year on year and the economy expanding.

"You hear it from that Morgan Stanley guy, and his policy is being able to say, if something goes wrong, 'See, I told you so!', and he hopes that people forget the 800 times he was wrong."

"I don't want to call a guy like Allan Meltzer simplistic ... but he's pretty consistent with his monetarist framework.

"With all due respect to him, the money supply may be growing, but there's no guarantee that it will go into consumption or prices. It's a circuitous route, at best - especially in an overindebted economy.

"Money can go into debt or saving; if you print enough of the stuff it will eventually spill over, but it's a long and arduous path."

It should also be pointed out that Roach's forecasting record is quite good, and better than most.

But even if you disbelieve the case for deflation, the most persuasive case for vigilance comes from the Fed itself.

An important research paper by 13 Fed staff economists, titled Preventing Deflation: Lessons from Japan's Experience in the 1990s, says: "Japan's deflationary slump was not anticipated. This was true not only of the Japanese policymakers themselves, but also of private-sector and foreign observers, including Federal Reserve staff economists.

"Moreover, financial markets had no better handle on the economy's prospects ... The failure of economists and financial markets to forecast Japan's deflationary slump in the early 1990s poses a cautionary note for other policymakers in similar circumstances: deflation can be very difficult to predict in advance.

"In consequence, as interest rates and inflation rates move closer to zero, monetary policy perhaps should respond ... to the special downside risks - in particular, the possibility of deflation."

Deflation is not necessarily a bad thing. The world economy has enjoyed booms while prices were falling, during the 1920s, for example.

But it looks malign at the moment for two main reasons. First, there is a kind of good deflation that happens when productivity is high and the economy is robust. This is not that kind of deflation. Today's deflationary pressures come from excess supply of goods and industrial capacity.

Second, deflation is especially dangerous now because the US has unprecedented proportions of debt. Why does this matter?

In an inflation, money loses value, so the inflation-adjusted value of debt shrinks as the years go by. So inflation is kind to borrowers.

But in a deflation, the opposite holds. Because prices are falling, the real value of money goes up in a deflation. So the value of debt actually rises, and borrowers are punished.

This can create a debt trap, forcing firms and families into a spiral of cutbacks to service a growing burden of debt - even though they're not borrowing a cent more. This pattern of retrenchment and bankruptcy can create recession and depression.

"We've already got debt deflation stories - we do have quite a large number of firms that are facing those kinds of pressures from unexpected sort of deflation already," says former Fed governor and leading forecaster Larry Meyer.

"And, as slack builds up in the economy, we're likely to see inflation fall below the implicit target" of the Federal Reserve, says Meyer.

"And, we know in those situations, again, following the lessons of Japan, that the policy authorities have to be particularly even more aggressive about pushing inflation back [up] to its target."

The Fed's contingency plan includes drastic options. If the key official interest rate should hit zero and the Fed loses its ability to stimulate the economy in the customary way - the current rate is already at 1.25 per cent - it could

buy up masses of government debt, even private corporate debt and private real estate, as a way of pumping liquidity into the economy. Fed governor Bernanke also points out that big devaluations of the US dollar have helped defeat deflation in the past.

Ultimately, "the US government has a technology, called a printing press ... that allows it to produce as many US dollars as it wishes at essentially no cost ... Sufficient injections of money will always reverse a deflation", he says.

Morgan Stanley's Roach says that the Fed's speech and its actions "are all very carefully orchestrated; they are shaping policies as if deflation is going to happen - and that's a good thing, because it is such a dangerous time".

Perhaps you are correct, but the combination of all 5 of your factors for a currency will inevitably lead to liquidity crisises.

Consider that the new hypothetical island nation of Surin might have 1,000 ounces of gold to use for its new gold coin currency. Surin's treasury issues 1,000 1 oz gold coins, and citizens engage freely in commerce.

All is right with the world until Surin wants to build a bridge to a large trading partner. The bridge will enable vast amounts of new, profitable commerce to be transacted, so all of Surin is excited about it.

However, the only contractor who can do the job requires 1,500 Surinese gold coins paid up front so that it can use those coins to purchase the minimum amount of the first stage of construction materials.

Even if all of Surin pooled their resources, the new amount of needed currency can not be injected into this scenario in time for Surin to get its bridge built before its competitor nation of Siam finishes its own competing project, gaining critical marketshare and signing long-term contracts that doom Surin to second-rate status for a generation.

Oh well, at least the Surinese can take their portable and fungible gold coins over to Siam. Pitty the poor Surin businesses who aren't granted permits to operate in the new location of Siam, however.

Grin!

The point is that NUMEROUS such gold-based economies have been tried over the millenia, and they ALL bump up against a recurring problem: a lack of the instant ability to meet all demands for currency.

You can't just mint new gold coins out of thin air.

But what you are MISSING is that even if you are a citizen of the paper-based system in Siam, you can still BUY all of the gold that you want with the Siamese paper currency.

Thus, you get the best of both worlds. You can have as much portable, fungible, limited-supply material as you desire, yet the economy isn't crippled by a lack of liquidity.

In other words, if you think that Gold is so grand, then exercise your own personal freedom and go buy all the gold that you want, rather than forcing at gunpoint all citizens to be constrained to operate under an innefficient gold-based economy.

Go buy your gold. You are free to do so, and no one is stopping you (just don't try to force the rest of us to have to use it).

I haven't said anything about gold, Southack.

You raise an interesting point, how does an advancing society finance a project which exceeds the purchasing power of their accumulated wealth?

Since money, at its core, is simply contractual relationships between people, the ideal currency would never limit collaborative activity.

However, all such activity involves risk and so there must be some mechanism that keeps risk, responsibility and profit in balance. Our current system privitizes profit while socializing risk, a receipe for disaster.

I'm tempted to say that deflation should be the norm in an advancing society, such that the purchasing power of accumulated wealth increases as the economy advances. This would solve the liquidity problem in a modestly advancing society. However what about large discontinuities in the system such as your bridge example? I would simply issue bonds and stock that entitled the owners to the future profits of the bridge. In this way, risk, reward and responsibility would be balanced.

Am I missing something?

No I don't think you've missed too much. I've read this exchange since the beginning and while disagreeing completely with Southack in regards to his monetary theory, found it interesting nonetheless. The fact of the matter is: when people who espouse the classical liberal gold standard of the 19th and very early 20th century mention GOLD today, we really mean a commodity money as determined BY THE MARKET. The fact is, the gold commodity standard was exceptionally stable, mildly deflationary in fact, except when the government would tinker with it thus causing large economic downturns and runs on the banking system. If you want proof just go back and look at the panic of 1819, the post Civil War Greenback period, and the panics of the late 1870's when the government tried to fix the gold-silver exchange rates. I don't really care if it's gold, silver, platinum, or paperclips that the market decides on; the point is people, trading freely amongst themselves, determine the best commodity as their medium of exchange.

"I would simply issue bonds and stock that entitled the owners to the future profits of the bridge. In this way, risk, reward and responsibility would be balanced."

Well, that's my point; when such a demand for extra liquidity exists, an economy naturally goes for a fiat currency (i.e. paper bonds and paper stocks ARE fiat currencies at some level - bonds can certainly be defaulted on and stocks have certainly become worthless in the past).

So why not face the inevitable up front by always having a fiat currency in the first place? Better still, how about using a hybrid currency that permits unlimited liquidity yet limits the urge to print excessive amounts of a currency?

But, all of this is mere window-dressing. The economic problems of the world do NOT revolve around currencies. Currencies are only a minor part of the whole scheme. Currencies provide a useful, efficient medium of exchange, and currencies provide a convenient way to store wealth (with the option that anyone can use even paper-based currencies to BUY any other form of wealth-storage that they desire, such as gold, land, or oil).

So why get all worked up about a few esoteric details regarding the implementation of various forms of currencies? It's not like you are going to substantially improve any system simply by switching currencies (a few minor efficiency enhancements, sure, but nothing really dramatic).

With that said, it just seems as though your time and efforts would have a better chance for a more profitable return if you focused on other, currently less efficient, areas of our economy.

Nice to meet you, welcome to Free Republic.

Southack's one the brighter guys here when he's not accusing people of harboring gloomy or doomy thoughts.

He does always find the bright side of the status quo. Sometimes in ways I have failed to appreciate.

If you really want to see us hiss at each other, change the subject to Fannie Mae.

THE MOUNTING CASE FOR PRIVATIZING FANNIE MAE AND FREDDIE MAC

When it comes to designing/making useful, nuts-and-bolts necessities, we leave that to the less elite cultures.

Boy, you got that right. I find that same attitude within the U.S., too. People like me who know how to design and build things are looked down upon by the symbol-manipulators that make up the bulk of the American economy these days. We're condidered mere "workmen", less deserving of respect than...say...a teacher or an office worker.

Well, I'm perfectly willing to see who needs whom ;-)

So investing has devolved from a science to a crap shoot. In that most insidious way, the government has robbed its citizens of the ability to enjoy financial stability, and (even more abhorrent) the ability to function as an individual on a level financial playing field.

A good example is the politically-motivated continuing attack on energy-trading companies. The democRATS twisted last year's Enron bankruptcy into an attack on all energy companies, the republican party, and capitalism itself. Their purpose was (and still is) to garner electoral votes in the 2004 election out West.

...the Democratic story is simple. A bunch of crooks called Enron cut off your power and extorted your money to turn it back on. And guess what? George W. Bush let them get away with it. Wait for the thirty second spots, and see how easy it is to communicate this idea.

You can see that this propaganda really caught on in the recent California elections. It doesn't bother the RATs at all that millions of widows and orphans who had invested in "safe" utility stocks were devastated when those stocks lost up to 95% of their value. Champion of the working people, indeed.

Those energy stocks are starting to come back now that the truth is slowly leaking out: The Utility companies and energy traders did nothing (or very little) wrong. But for many of the over-50 set who had prudently invested in those stocks, they will not live long enough to recover the money they lost at the hands of the democRAT-inspired market crash.

All in all, I see America becoming more like Russia, where obtaining any kind of financial security requires one to become an outlaw.

This sounds fairly reasonable. I own silver coins, mainly because I like to collect them (Proofs and also some rolls (about 4) of Uncirculated). About the only way I see using them for my "daily commerce" is in the event of total collapse of the US economy or a war of such magnitude that we all get bombed to the Stone Age. Are these scenarios possible? Yes. Are they probable? I do not believe so.

I hope you got your questions answered.
The purchase of Treasuries on the open market is step one.
This will cause the interest rate to fall to zero, but will start to flood the market with cash, hoepfully increasing inflationary expectations and raising rates

The second major action will be to cut taxes in a huge way.This will tend to generate more Treasury borrowing which can then again be purchased by the Fed,

The final step, referred to in the article, is for the Fed to intervene by restarting trading in core investment assets. We are a long way from that.

Don't worry folks, before it gets too bad there are many others who will march to DC to fix it.

"About the only way I see using them for my "daily commerce" is in the event of total collapse of the US economy or a war of such magnitude that we all get bombed to the Stone Age."

If civilization turns to anarchy along the lines of the fall of the Roman empire and the beginning of the Dark Ages, am I really going to find someone stupid-enough to trade me his last food, water, guns, and bullets for a couple of useless discs of silver?

How long would such an idiot survive in such a scenario?

Agreed. I would not expect one who is down to his last "beans and bullets" to do so. But, even in the decline of the Roman Empire, trade and commerce continued, albeit in modified ways.

Your point is well taken. A question - where do you think one should park cash to earn better rates of return? I have been considering T-bills, which seem to have several advantages. Any suggestions are welcome. Gratias!

Of all tariffs, a raw steel one is one of the least helpful, I suspect -- yet a tariff on finished steel products, on Wal-Mart's type imported finished goods -- there you go! A good.

People yell "Unions destroyed our manufacturing"! -- I do not. The unions that destroyed and continue to do so are but half the coin, an inseperable coin. Both owners and labor together -- equal in every way in destructive effect -- cojoined the both with official regulator and litigator.

Look at one unionized biz that has avoided destruction -- that is instead booming -- the movie business. It is vital.

And without tariffs! Another might yell. Sure -- because WE dominate, American style, American English. Think man! As Adam Smith said -- pursue your advantage! Sure an open plain is advantage to all -- when all hew the same law and custom. Here China is besting us, we need a safety, or their regulated tyranny will overrun ours (much the less tyranny ours.) It is war -- as was the 30's too. the tariff weapon in the 30's may have been misused, and it is most surely misreported as all reports out of that time are suspect.

(Written also in reply to jayef's post 361 in the "U.S. manufacturing jobs fading away fast" thread.)

>>am I really going to find someone stupid-enough to trade me his last food, water, guns, and bullets for a couple of useless discs of silver?

I have been telling that exact same thing to some of my buddies who beleive that being invested in gold is the best place to be if civilization totally collapses. I tell them having ample guns and ammun ition will be much more valuable to own and for bartering purposes than some silver or gold trinkets...assuming the local grocery store is suddenly going to accepting gold as payment for a cart full of food is stretching it a bit.

For the price of a couple of ounces of gold you can have more peace of mind with a cellar full of weapons....

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