Deflation Vigilantes

Standing ready to head off any hint of sub-par inflation, the Fed’s Ben Bernanke catalogs a series of dollar-creating moves that should put a scare, says Jim Grant, into government bond market bulls who accept tiny yields without qualm.

The imaginary scene is the festive Christmas party of the Federal Reserve Board. "Do you realize," one of the distinguished governors says late in the evening, his words slightly running together, "how much more money we could print if we cut down just one minor national forest? We could paper the whole damn world with C-notes." The others laugh till they cry.

Essentially, this was the theme of the talk given by Fed governor Ben S. Bernanke, one of Alan Greenspan’s new hires, at the National Economists Club in Washington on November 21. Bernanke, a leading monetary scholar, called attention to a potent anti-deflationary technology. Using a device called a "printing press," he said, the government can "produce as many U.S. dollars as it wishes at essentially no cost." The accuracy of that observation is indisputable. The question is why a sitting Federal Reserve official would choose to make it. The United States is a substantial net debtor to the rest of the world. The enviable American standard of living depends on the willingness of foreign creditors to regard the dollar as more than a piece of paper that can be printed "at essentially no cost."

What was Bernanke thinking about? What should we be thinking about? Answers – partial answers, at least – to follow.

Deflation is the monetary flavor of the week, the month and the cycle. With goods prices falling and the rate of rise in services prices abating, overall inflation rates are the lowest in decades. Government yields are the lowest since the Kennedy administration. To those who hope that deflation will push them even lower, Bernanke had a word of warning. He called the chances "remote." The Fed will not settle for no inflation, he insisted, as he inventoried the currency-debasing tools available.

Bernanke isn’t running the Federal Open Market Committee, and he doesn’t speak for the man who does. However, he brings as much academic wattage as anyone in Washington to monetary questions. When he promises that the Fed will debase the currency, if it should come to that, creditors should pay attention.

As recently as the 1980s, investors prayed for "price stability." Inflation, most believed, was endemic, embedded and irreversible. Now the faithful are coming to regret that they have received approximately what they wished for. Prices are falling in Japan and China. They are barely rising in the U.S. and Germany. There’s excess productive capacity worldwide. Highly leveraged businesses and consumers are struggling. As a rule, for debtors, that money is best which depreciates fastest.

Two days before Bernanke’s Christmas party address, Mervyn King, deputy governor of the Bank of England (and the newly designated successor to Sir Edward George as chief of the Bank of England), tried to put a London audience at ease about the same monetary worry. No question, he said, it is a worry. "If significant numbers of debtors have little net worth – recent first-time house buyers with high debt-to- value ratios are a prime example – then an unanticipated deflation could cause a sharp fall in aggregate consumption spending."

Fortunately, King noted, deflation is a rarity in the modern world. "And I am confident," he added, Bernanke- like, "that all central banks will do their best to prevent the sample size of countries suffering from serious deflation from increasing." To handicap the odds of deflation, King used Bernanke’s word, "remote." It isn’t remote to the Japanese.

Bulls believe, as we do not, that the page has been turned on the Age of Inflation. They interpret the persistence of deflationary symptoms – 99-cent Whoppers, free cell phones and $500 PCs – as evidence of a new phase of our price history. According to the historian David Hackett Fischer, grand cycles of inflation and deflation carry everything before them. They are more powerful even than central banks.

Whether or not they know Fischer or subscribe to his theories, bond bulls have accepted lower and lower yields. They have surrendered a margin of safety. They have ignored a constellation of omens that, in years gone by, would have ruined their sleep.

They recently settled for less than 4% on a 10-year note despite war, a rising federal deficit and percolating money-supply growth. And now, with Bernanke, they have been warned that the Fed can – and if duty called, would – wreck their bull market without remorse.

We admit we simplify. Not every debtor needs or wants inflation to lighten his load (economic growth is what generates the income that services interest expense, and inflation tends to stunt growth, rather than promote it). And it is not necessarily true that a bet on the Bernanke reflation program is a bet on falling bond prices.

Amazingly – you will rub your eyes when you read it – the professor-governor threatens a reversion to the old Truman- era "peg." It was under this system that the Fed fixed not only money rates but also bond yields, the latter at 2 & 1/2%. Would this go down well in a world of freely floating capital and lightly regulated markets? Bernanke didn’t speculate. But we try not to forget that the 1920-46 bull bond market survived both the New Deal and the Second World War.

Treasury coupons of 3% or less were standard fare from the early 1930s through the late 1940s. "Deflation" means many things. To us, it connotes a comprehensive shrinkage in prices, incomes, wages and profits. It is more than falling prices. For that matter, to reinforce the point, inflation is more than rising prices.

In the United States, in World War II, too much money chased too few goods. However, the CPI rose by only a little (in 1944 by 1.74%, in 1945 by 2. 28%). Prices were controlled, and inflation was repressed. Similarly, too, with deflation in Japan today. Bank credit is contracting, but the government has partially compensated with infusions of public credit. From year-end 1997 through October 2002, the CPI has fallen by an average of just 0.42% a year. Japanese deflation (if deflation is what it is) is being repressed.

Maybe prices are falling not because of the contraction of credit, but because of the march of progress. If, thanks to a genuine worldwide boom in productivity growth, the prices of goods and services broadly declined, we would not call it "deflation." We would call it "falling prices." Bernanke has his own ideas.

"Deflation is in almost all cases a side effect of a collapse in aggregate demand," he said in his speech – "a drop in spending so severe that producers must cut prices on an ongoing basis in order to find buyers."

Borrowing from Milton Friedman, people are always ready to say, "Inflation is a monetary phenomenon." And they sometimes add, "Deflation is also a monetary phenomenon." We would make a distinction. Inflation is a monetary phenomenon. Deflation is a credit phenomenon. The causes and consequences of deflation are directly concerned with credit, i.e., with lending and borrowing. An excess of credit formation leads to misallocation of capital, overcapacity, price competition, bankruptcy and joblessness. The root cause of inflation is money creation. The root cause of deflation is credit destruction.

Any central bank can print paper money. It’s less clear that any central bank can, by conventional means in a deflationary setting, foster more lending and borrowing than would otherwise occur. Bernanke’s contribution to the financial discussion is to demonstrate just how much the Fed could do via unconventional means. Many have thought that is what he said. His claim to fame is that he said it.

Bernanke fears and loathes deflation, and the damage it could do to this economy. In the 1980s, Ed Yardeni, the always-interesting financial economist, proposed that inflation was done for, because, at the first sign of rising prices, the "bond market vigilantes "would cause rising interest rates. Now, in Bernanke – the former Howard Harrison and Gabrielle Snyder Beck Professor of Economics and Public Affairs at Princeton University – we have a real live deflation vigilante. At the first sign of a sub-par inflation rate, Bernanke will press for monetary countermeasures. We didn’t need to read his text to believe that any central bank could reverse any deflation (under the pure paper standard). Now, we really believe it.

The catalog of these countermeasures ought to put a scare into the people who happily settle for tiny yields on the theory that a new bout of inflation is technically unfeasible. Bernanke would like you to know that nothing is impossible if you try. Not that such heroic efforts will even be necessary. Why? The flexibility of the financial system armors the United States against such travails as beset Japan. And then there’s the determination of the government. "I am confident," said Bernanke, "that the Fed would take whatever means necessary to prevent significant deflation in the United States and, moreover, that the U.S. central bank, in cooperation with other parts of the government as needed, has sufficient policy instruments to ensure that any deflation that might occur would be both mild and brief."

Some worry that, at a 0% funds rate, the Fed would have no ammunition. Bernanke has news for these defeatists. "[U]nder a fiat (that is, paper) money system," he said, "a government (in practice, the central bank in cooperation with other agencies) should always be able to generate increased nominal spending and inflation, even when the short-term nominal interest rate is zero."

It is at this point in the text that Bernanke brings up the printing press (a phrase which, in the bear-market year of 1981, might have catapulted bond yields to 25% from 15%). "By increasing the number of dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation."

Bernanke has a way of promising you he won’t say something and then saying it anyway. "Of course," he proceeded, "the U.S. government is not going to print money and distribute it willy-nilly," a thought he qualified by an immediately following parenthetical phrase, "(although as we shall see later, there are practical policies that approximate this behavior)." He left no doubt that the Fed could debase the dollar, even at a 0% federal funds rate.

That is certainly a comforting thought, except to the holders of Treasury securities, but Bernanke didn’t leave it at that. He expounded on the techniques by which the Fed might intervene in the world’s freest and most liquid capital market to depreciate the currency in which America’s titanic external debts are denominated (a privilege accorded to no other country but the one that prints the dollar). For example, the Fed could revert to the bad old days before the Treasury-Federal Reserve accord of 1951, when bond yields were "pegged" to suit the political and financial agenda of the Truman administration. Not such a bad idea, Bernanke suggested. The Fed scrunched yields down to the floor.

Is there an objection heard that, in a real credit contraction, the Fed finds no traction but only "pushes on a string"? As banks won’t lend, the Fed can’t reflate. Bernanke is not so easily discouraged. Another "policy option," he said, "complementary to operating in the markets for Treasury and agency debt, would be for the Fed to offer fixed-term loans to banks at low or zero interest, with a wide range of private assets (including, among others, corporate bonds, commercial paper, bank loans and mortgages) deemed eligible as collateral." And the Fed has "considerable leeway" to determine which assets to accept.

"For example," he continued, "the Fed might make 90-day or 180-day zero-interest loans to banks, taking corporate commercial paper of the same maturity as collateral. Pursued aggressively, such a program could significantly reduce liquidity and term premiums on the assets used as collateral." Nor would even that radical intervention empty the Fed’s tool bag. Why, the central bank could buy, or "monetize," foreign debt. "Potentially," said Bernanke, "this class of assets offers huge scope for Fed operations, as the quantity of foreign assets eligible for purchase by the Fed is several times the stock of U.S. government debt."

Had he just suggested that it could be expedient to depreciate the foreign-exchange value of the dollar?

Bernanke caught himself: this isn’t the Fed’s bailiwick; it’s the Treasury’s. The last thing he wanted to do was to advocate, or to forecast, a lower dollar exchange rate. Yet, he added in the next breath: "[I]t’s worth noting that there have been times when exchange rate policy has been an effective weapon against deflation. A striking example from U.S. history is Franklin Roosevelt’s 40% devaluation of the dollar against gold in 1933-34, enforced by a program of gold purchases and domestic money creation. The devaluation and the rapid increase in money supply it permitted ended the U.S. deflation remarkably quickly. Indeed, consumer price inflation in the United States, year on year, went from -10. 3% in 1932 to -5. 1% in 1933 to 3. 4% in 1934. The economy grew strongly, and by the way, 1934 was one of the best years of the century for the stock market. If nothing else, the episode illustrates that monetary actions can have powerful effects on the economy, even when the nominal interest rate is at or near zero, as was the case at the time of Roosevelt’s devaluation."

Here’s what wasn’t the case at the time of Roosevelt’s devaluation: the United States wasn’t the world’s greatest debtor nation; the dollar wasn’t the world’s reserve currency; the public wasn’t heavily exposed to floating- rate debt, including Libor-based, "interest-only" mortgages.

Bernanke, leaving nothing to the imagination, may or may not go down as a brilliant monetary statesman. But he may be just the fellow to lead the upcoming global reflation program. If any economist knows where to find the "on" switch of a high-speed printing press, he does.


James Grant,
December 30, 2002

"Uh oh…there’s a bull on the cover of Fortune magazine," writes Dan Ferris. "You know what that means."

The financial media is making predictions for the year to come. Investor’s Intelligence reports that twice as many advisors are bullish as bearish. They’ve almost all been wrong for the last 3 years. But that doesn’t stop them. People such as Abbey Cohen and Ed Yardeni seem to have no sense of dignity or shame. Cohen expects the Dow will end 2003 at 10,800 – a nice 27% rise. Yardeni puts it at 10,500.

Of the 8 seers to whom Barron’s posed the question, 6 said stocks would go up in the year ahead. Only one expected them to go down – a modest decrease to 7572. Richard Bernstein of Merrill Lynch said they would stay about where they are.

Where’s the surprise, we ask ourselves? That the Dow will fall? Or that it will fall much more than anyone expects?

Stocks are still preposterously high…with the S&P trading at near 30 times earnings. The late, great bull market was the biggest ever…shouldn’t the following bear market be equally impressive?

Profit margins are the thinnest since the Great Depression. And debts are the fattest they’ve been in many decades…perhaps ever. In the manufacturing sector, interest expense has risen from just 23% of profits in 1997 to almost 100% today.

It was in 1949, if we recall correctly, that stocks recorded their lowest-ever P/E, below 6. If the Dow were to fall to ’49-style P/Es, it would have to sink to below 2,000.

Not that we’re predicting anything. We’re just wondering…

We’re still wondering where the surprise will come from. Mr. Market always seems to come up with something astonishing.

Maybe it will be the dollar. The dollar is now at a 6-year low against gold…and a 3-year low against the euro. Many economists expected a lower dollar…and many in the Bush Administration were hoping for one. But all expected a moderate decline.

So far, the dollar’s decline has been as soft as toilet tissue. But we can’t help but wonder…perhaps it is headed in the same direction, down the tubes? Once it gets caught in the whirling flush of investor panic…what will hold it back?

A foreign investor in U.S. dollar assets, Dow stocks for example, lost 16% on his stocks in 2002…and another 12% on the dollar itself.

He consoles himself with the knowledge that he might have done worse. European stocks are down an average of 33%…with German stocks down 42%. Equities in Argentina and Brazil were nearly cut in half.

On the other hand, gold rose 25% so far in 2002. He can’t help but notice.

Eric…over to you:


Eric Fry in New York…

– The Christmas holidays brought very little yuletide cheer to Wall Street last week. The Dow slid 207 on the week to 8,304, while the Nasdaq fell about 1% to 1,348. But while stocks stumbled, gold sparkled. The yellow metal continued its winning ways by gaining $8.70 to $349.20.

– An unbiased macroeconomic observer would have to admit that things aren’t looking too good in the U.S. financial markets. Stocks are falling and commodities are rallying. That’s not the picture most investors like to see. And yet, this picture is unlikely to change any time soon. The Fed is doing its best to rekindle inflation and the economy, meanwhile, is idling in neutral – a victim of the post- bubble blues.

– A big part of the problem for both Wall Street and Main Street is that consumers lack the wherewithal to consume. What has become of us free-spending Americans? Suddenly, we aren’t buying as many of the things we don’t need with the money we don’t have. But if we Americans don’t borrow and spend, who’s going to do it for us? We’re the world’s "growth engine."

– Unfortunately, the engine is sputtering a bit. Our borrow-and-spend nation is becoming a scrimp-and-save nation. Thriftiness hasn’t been this fashionable since John Winthrop governed the Massachusetts Bay Colony. This new thrift craze is probably just a temporary thing…unlikely to last more than a decade or two. But it’s putting a serious dent in our economic growth prospects.

– During the bubble years, Americans spent freely, knowing that the stock market would faithfully replenish the chalice of disposable income. Almost mystically, the chalice never ran dry – the more money Americans spent, the more they had to spend. Surely, the seven wonders of the Ancient world could not compare to this one, stupendous wonder of the modern world. Best thing of all, the chalice of disposable income would forever run over. That’s because the stock market forever runneth higher. Dow 64,000-and- beyond seemed a sure thing, thanks to the Internet and other technological marvels.

– But we all know what happened next. The stock market entered a bear market, while class-action lawsuits entered a bull market. During the bubble years, stocks "ruled" and stockbrokers "rocked." But in the post-bubble era, recrimination rules and plaintiff attorneys rock. A recent Wall Street Journal story recounts the saga of Ms. Maria Walker, who in 1999 became a widow at the age of 33. "Ms. Walker’s money was in the hands of her late husband’s friend, a Merrill Lynch & Co. broker named Brian Randall," the Journal relates. "Through the magic of high-tech stocks Ms. Walker’s…inheritance soared by 50% in less than a year, exceeding half a million dollars…`You rock!’ she told Mr. Randall again and again."

– But alas, the bubble eventually burst, as bubbles tend to do, and Ms. Walker’s adulation for Mr. Walker yielded to litigation. Yes, that’s right; she sued him for doing what she had asked him to do. Ms. Walker, as is so often the case, seems to have been complicit in her own financial undoing. Nevertheless, she determined that somebody must pay for her errors.

– "Ms Walker delighted in hearing from Mr. Randall how much money she was making," the Journal says. "When she heard that another [client] had profited from IPO shares, she called the broker and asked, `What’s an IPO? If that’s making a lot of money, I want one too.’"

– Such was the wisdom that excelled during the bubble. A seemingly benign ignorance paved the road to riches. Meanwhile, many seasoned investors recoiled from the terrifying excesses of the bubble market. But fear was an expensive state of mind in those days. Timorous investors would watch helplessly as the "dumb money" racked up spectacular gains. However, the bubble eventually burst and a lot of money returned to its rightful owners, the smart money. The dumb money went back to being just plain dumb.

– "Many investors aren’t much worse off today than before the bubble," the Journal asserts. "Yet everything has changed. They’re bitter and vindictive about losing the future they thought was in their grasp. And they’re grappling with where to lay the blame." Purchasing a mirror might be the simplest way to "grapple" with blame-laying, but there’s no money in that. So hiring an attorney is the avenue of choice.

– But even if every plaintiff were to prevail, the $8 trillion lost in the stock market over the last three years will not be returning from money heaven. That money has passed away for good, which brings us back to the new national thrift craze.

– Folks might not be THAT much worse off, but they are worse off, nonetheless…This thrift craze might just last a while.


Back in Paris…

*** We are back in the city after an agreeable week in the countryside. We intended to work on our book, but there is far too much commotion in a country house with 5 children, a Paris art dealer and a grandmother. People kept popping in and out, a little maddened by the holidays…and Elizabeth nearly burned the house down…

*** Elizabeth is an indefatigable socializer. The children and their father could happily ignore the rest of the world. But Elizabeth insists upon so many aperitifs, teas, and dinner parties we are afraid to come downstairs.

Friday night brought the Morands…or Morais…or something like that…over for a drink. Pierre’s deceased brother’s wife, a beautiful woman in her early ’60s, remarried a retired general…a man considerably older…but not completely broken down. Well, the general was elected to the European parliament and serves, he told us, on the Foreign Affairs committee.

"Yes," he told us, "I travel almost all the time…for the purpose of developing European foreign policy…"

But your editor reads the papers and had a question: "I understood that Europe had no foreign policy. It is one of the things we like about it…" he said.

"Ah, yes…" General Morand or Morais…or was it Morelies?…"that is what makes the job so difficult. Each county in Europe has its own foreign policy. We are just trying to develop the contacts…and the institutions… that will serve for a common foreign policy in the future…"

"Uh oh…" muttered your editor, under his breath. Foreign policy is merely an invitation to trouble…

"But we will never have a foreign policy like you do in the U.S.," the general continued, admiringly. "Ours will always be modest in comparison. Europe simply has too many different peoples with too many different points of view to allow for any serious overseas meddling…"

Meanwhile, the general’s step-son Louis seemed to be enjoying himself chatting up Maria and Sophia. Louis is a handsome young man…but he looked as though he had just been in a bad bar fight – and lost. He had two very black eyes…and cuts and bruises all over his face.

"I hit a deer on Christmas eve," he explained.

Louis, it turned out, has embarked on a military career too.

"I’m in the army’s information service," he told us.

"What do you do, exactly," we pressed for an explanation.

"I’m a spy…"

Louis travels to places like Kabul, where he takes photos that are sent by satellite back to French military analysts.

"It sounds so exciting…" Maria purred. "just like James Bond."