Inflationistas at the Helm
Print it! Money, that is. The Fed’s implicit pledge to crank out as many new dollars as needed to stave off deflation makes foreign currencies and inflation-protected Treasury notes all the more attractive. Paul Kasriel wonders how creditors of the world’s largest net debtor nation might react.
"World’s largest debtor [U.S.] pledges to pay you back in cheaper dollars." In effect, this is what one of the rookie members of the Federal Reserve Board, Ben Bernanke, announced to the world on November 21. He said that the Fed had the tools, and the talent, to borrow a line from that cinema classic, "Ghostbusters," to print unlimited supplies of U.S. dollars. So fear not deflation. The Fed has implicitly pledged, to its dying breath, that it will crank up the currency printing presses to prevent it.
Now, I find it remarkable that a representative of the central bank to the world’s largest net debtor nation would publicly make such a pledge. I don’t, however, find it remarkable that this central bank would privately harbor such thoughts. After all, isn’t a little (or maybe, a lot) of inflation what debtors want to bail them out of their financial obligations? Doesn’t it imply less of a cut in your standard of living if you can pay back some unsuspecting sap in dollars that buy less?
As a nation of net debtors, we want inflation. And this Fed, unlike the one guided by an "old era" central banker, William McChesney Martin, aims to please its domestic constituency. If inflation is what it wants, inflation is what it will get. (Incidentally, Japan is a net creditor nation. Creditors, especially those whose credits have little default risk, generally would opt for falling prices of goods and services rather than rising prices. Might this have something to do with the rest of the world being in a tizzy over Japan’s falling CPI, while the Japanese citizenry is less concerned?)
Currently in the U.S., you can earn about 1&3/8% on three- month "wholesale" bank deposits. The October reading on the year-over-year change in the U.S. CPI was 2.0%. So,an investor is receiving a negative "real" return on this investment to the tune of 60 basis points. A global investor could do better by holding comparable paper denominated in other currencies. For example, at the beginning of this week, three-month money denominated in pound sterling was yielding 1.64% after subtracting the U.K. October inflation rate. That’s an inflation-adjusted pickup of 229 basis points over a three-month U.S. investment.
Heck, even in Japan, where three-month rates are hovering just above zero, you can earn a deflation-adjusted return of 0.76% – a 141 basis-point pickup over dollar-denominated money. And if Governor Bernanke has anything to say about this, the odds are, in the next 12 months, that inflation- adjusted returns on money market investments will favor those denominated in foreign currencies over those in U.S. dollars. If global investors need to "park" funds, it would appear that there are better currencies in the world to do it in than the dollar. And, if, at the margin, more parking of funds is done abroad, then the dollar will depreciate, raising the U.S. inflation rate all the more.
Currently, the spread between the Treasury note maturing on 2/15/11 and the inflation-protected Treasury note maturing on 1/15/11 is about 1.45 percentage points. These inflation-protected notes preserve an investor’s return against a rising CPI. With the October CPI year-over-year change standing at 2.03% and with Governor Bernanke implying that the Fed would crank up the dollar printing presses even more than it already is doing if the CPI’s growth should start to weaken, why not buy the inflation- protected note and short the unprotected one? Isn’t the current spread between the two likely to widen with inflationistas in control at the Fed?
The rest of the world advances the U.S. about $1.5 billion a day. Back in the 1990s, when we also were getting relatively large advances from the rest of the world, we were using these advances for things that had the prospect of making our future non-inflationary economic growth rate higher. If things had worked out, our standard of living also would have grown faster. This would have enabled us to pay interest and dividends on these advancements to the rest of the world – perhaps even pay back a little principal – without enduring a decline in our standard of living. Indeed, because global investors thought we were using their advancements of funds in a way that would increase the probability of payments to them of principal, interest, and dividends in "honest "dollars, they were more than happy to keep investing in America.
But now, we are using a much lower percentage of foreign advancements for nonresidential fixed investment. Rather, we are using the $1.5 billion a day from the rest of the world to buy bigger cars, bigger houses, and cruise missiles. Bigger cars, bigger houses, and cruise missiles are not the stuff of productivity growth, and, thus, future growth in our standard of living. How might we try to service our foreign debt – debt denominated in U.S. dollars – without enduring a decline in our standard of living? Enter Governor Bernanke.
We might put pressure on him to crank up the dollar printing press. And what will foreign investors, who already own about 24% of America, do if they begin to sense they are going to be paid back in "dishonest "dollars?
They will flee from dollar-denominated investments.
for The Daily Reckoning
December 10, 2002
Editor’s note: Paul Kasriel is Senior Vice President and Chief Economist at Northern Trust Co and a former Fed officer and university lecturer. Mr. Kasriel is a frequent contributor Apogee Research and the Daily Reckoning. This essay was originally published by Apogee Research.
Our mouths hang open, almost dumbstruck.
Some people watch the markets for profits. We watch them chiefly for entertainment and moral instruction. Yesterday, we felt like we were watching Gone with the Wind and The Ten Commandments at the same time.
Not that anything particular happened yesterday. Stocks went down…people said things they should be ashamed of… gold eased off…the dollar fell…it was a day like any other.
But the tension is building. Fed governor Bernanke has said the most amazing thing – that the Fed stands ready to destroy the dollar in order to save the economy. How in the world will this story turn out, we wonder?
Ours is a consumer economy. It is driven, or so it is believed, by people who buy things. The more they buy, the stronger the economy. In a slump, Fed policy is simple – make sure consumers have the ‘money’ to keep buying.
The Fed has no money, of course. It only has credit. So it makes more and more credit available to people, who mistake it for ‘money’ and pass it off to shopkeepers, who in turn spread the counterfeit cash around the economy as if it were manure in a vegetable patch.
But what is this strange ‘money’ that the Fed creates?
Bernanke tells us that the "U.S. government has a technology, called a printing press" and that it can print as much money as it wants. What kind of money is it whose supply – like air or water – is infinite?
In fact, little paper is actually printed. Most of the ‘money’ the Fed creates is only electronic – it is only information.
Since WWII to the mid-’90s, America’s consumer economy required roughly $1.40 in new credit to produce $1 in extra GDP. But the more of this strange ‘money’ you put into the system, the less impact it has. Since ’98, the Fed has created $9.1 trillion in new credit, which has produced only $2 trillion more of GDP. So, now it takes $4.50 to produce an extra dollar of output.
Where is all this extra credit going? Since the middle of 2000, it seems to be going mainly into consumer gee-gaws made in China and housing prices made in America. The gee- gaws get cheaper, while the houses get more expensive. So, the consumer feels comfortable borrowing and spending more money…because his main asset, his house, is increasing in value. His own money supply, he figures, is the price he thinks he could get for his house.
What if, suddenly, he notices that his neighbors are having trouble selling their houses? What if his money supply goes down 10%? What good is the Fed’s printing press then? How many trillions of hot new credit would it have to produce to offset the clammy cold of a decline in house prices?
What would happen to the dollar? The economy? Stock prices? Gold? The post-Bretton Woods, post-Nixon managed currency monetary system? Life as we have known it?
We don’t know. But we’re on the edge of our chairs, waiting to find out.
Over to our man on the street…Wall Street, Eric Fry:
Eric Fry writing from the islet of Manhattan…
– Hey, what happened to the new bull market?…The Dow dropped 172 points yesterday to 8,473, while the Nasdaq tumbled nearly 4% to 1,367…Repeat after me: "It’s just a healthy correction."
– The dollar also continued to slide, sinking deeper below parity with the euro. It now costs $1.01 to buy one euro. Gold dipped 60 cents to $326.50 an ounce.
– The higher stocks climbed throughout October and November, the more Wall Street urged investors to buy them. "Surely, the market has fallen far enough," they said. "And besides, the economy is recovering." If those weren’t reasons enough to enter a buy order, the Wall Street crowd would say, "Look! Corporate profits are rebounding!"
– Markets make opinions, as the saying goes, and the bear market rally that started in early October made most opinions bullish. Unfortunately, out in the real world, nothing much has changed since October 9th, when the bear market rally began.
– Stocks are higher than they were two months ago, but so is unemployment. Meanwhile, corporations are still struggling to make money; which means they are in no hurry to invest in either new capital equipment or new personnel. We seem to be in the midst of what John Mauldin calls the "muddle-through economy."
– "Less bad economic data are not the same thing as strong economic data," observes Andrew Kashdan of Apogee Research. "And yet, a stock market selling for 49 times the S&P’s estimated ‘core’ earnings for the 12 months ended in June would seem to be discounting super strong economic data." Kashdan points out that the "strong" 4% GDP growth in the third quarter was conspicuously light on profits. In fact, the entire so-called recovery has been profits-lite. And as last week’s dismal employment report shows, the recovery is also jobs-lite.
– "Profits are the lifeblood of sustainable stock market rallies," says Kashdan, "and the GDP data are very enlightening on this point – bearishly enlightening. The jump in third-quarter GDP, to a 4% annualized growth rate from 1.3% in the second quarter, sounds pretty good – until you look more closely at its components…Profits from current production fell $14.1 billion, after a drop of $12.6 billion in the second period. Current-production cash flow, the internal funds available for investment, fell $12.2 billion…Which means, we think, that it’s far too early to declare that a healthy expansion is under way."
– If profits did not power the third quarter’s aesthetically pleasing GDP number, you ask, what did? Consumption…the great American pastime. Out of the third quarter’s 4% annualized growth, 2.9% came from personal consumption expenditures.
– "If consumption were self-perpetuating," Kashdan winds up, "this breakdown wouldn’t be so bad. Unfortunately, at some point, you’ve got to make money to spend it…Profitless ‘strength’ is not the stuff of sustainable bull markets."
– Here’s another interesting tidbit from Kashdan: "’Greed is good,’ Gordon Gekko proclaimed in the 1987 movie ‘Wall Street.’ Now comes The Economist to proclaim that war is better. The British magazine joins the chorus of those trumpeting the most dangerous myth of all. "[M]ost wars in America’s history have – thanks to massive government spending on defense – tended to stimulate the economy," it says. "All we can do is implore you not to believe everything you read in the [financial press] – and ask yourself, perhaps, why we haven’t heard economists propose what would seem to be the obvious all-season remedy: perpetual war for perpetual growth." [For more of Kashdan’s insights, see: Apogee Research]
– Last week, your editors at the Daily Reckoning exchanged some of our intermittent banter about deflation and inflation. While we may disagree about the probable near- term direction of US consumer prices – Bill favors deflation, while I’m partial to inflation – we do agree that the "whole inflation/deflation discussion is a waste of time"…almost.
– Strictly speaking, engaging in sex that does not propagate the species is a waste of time. Some of us bother with it anyway. Debating deflation versus inflation may not be quite as much fun, but it is at least good theatre. Furthermore, the process of debating this issue probably yields a useful insight or two from time to time.
– Even if the conclusions are utterly unknowable, the debate itself is worthwhile. Stay tuned for more useless opinions about inflation… below…
Back in Paris…
*** Well, nothing much new here. The weather has turned very cold and gray. But the city feels more and more Christmasy.
Yesterday, on the subway, we noticed shoppers with wrapping paper and ribbon sticking out of their bags. Holiday lights festoon many streets and stores. If only it would snow!
*** Your editor is on his way to London this morning. Last year at this time, he made the mistake of ordering a ‘bespoke’ jacket from a tailor on Saville Row. The thing cost a bloody fortune, but his wife insisted. Your editor may be weak, but he is no fool. He always keeps the women in his family right where they want him.
He has since realized that you amortize the cost of a Saville Row tailor over the period in which he makes the coat, not the period that you wear it. It has been a year since the measurements were taken. During the wait, you are able to say to your friends that you need to visit your tailor in London. Each time you say that costs you about $200. Finally, after numerous visits, the coat should be ready. We will let you know how it turned out.