Why Isn't QE Causing Inflation?

Our monetary czars lecture us to be unconcerned about their unprecedented expansions in base money and the money supply, since there has been little sign of inflation in the economy.  For the purposes of this essay, we will assume that there has been no inflation, although John Williams at www.shadowstats.com and anyone who tries to make ends meet on the same money income will tell you a different story.  Our purpose is to explain the theory behind the price level and how theory can explain the so-called miracle/mystery of an increase in monetary aggregates with little or no inflation.

There is no miracle or mystery as to why prices have not gone significantly higher.  Our monetary authorities have not found the magic formula that allows the government to engage in noninflationary spending sprees, funded neither by an increase in taxes nor an increase in interest rates.  Our monetary masters remind me of the story of the man who jumps off the Empire State Building.  As he is passing a floor on the way down, an office worker leans out a window and asks him how he's doing.  He replies: so far, so good!

What determines the price level

On page 505 of his magnum opus, Capitalism: A Treatise on Economics, George Reisman defines the price level as a formula: P = Dc/Sc.  P is the price level.  The numerator Dc represents demand for goods as manifested in a definite total expenditure of money.  The denominator Sc represents the supply of goods as manifested in a definite total quantity of goods produced and sold.  Notice the importance not of the total supply of money but of that portion of the supply actually spent.  A Scrooge McDuck swimming in his supply of money in his basement does not affect the price level until he actually spends some of his money.  Similarly, if the money supply increases but remains

unspent, it will have no effect on the price level.  In fact, if the demand to hold money exceeds the growth of the money supply, prices actually will fall.  Likewise, notice the importance of the supply of goods as that portion of production actually sold.  For example, inventory accumulation does not affect the price level.  The goods must be both offered on the market and sold at some market clearing price for them to affect the price level.

Therefore, two events, or a combination thereof, can cause prices to rise--an increase in sales expressed in money terms, independent of whether or not the supply of money has increased, or a decrease in supply sold on the market, even if increased production goes into inventory accumulation.  The opposite of these two events, of course, will cause prices to fall.

We easily see from this simple yet powerful explanation that a falling price level need not be of concern, if it is the result of an increase in the supply of goods offered on the market.  As John Stuart Mill explained over two hundred years ago, the purpose of production is consumption.  Goods are produced to satisfy human wants.  The Keynesian view that digging holes and filling them up again adds to the general welfare of an economy is nonsense.  Jean Baptist Say explained that increased production becomes the means by which increased sales are realized.  Again, man produces for the purpose of consumption, and his production becomes the means by which he consumes via market exchange expressed in money terms.  Digging and refilling holes does not represent anything that would be valued on the market.  Neither would printing money and giving it to welfare recipients to spend.

OK, but what would cause an increase in the demand to hold money that would suppress the price level?  And is this increase in money demand something that we can rely upon to hold down the price level forever?

Mises' Three Phases of Inflation that Lead to Money Destruction

Ludwig von Mises explained that there are three phases to monetary destruction.  Murray N. Rothbard summarizes Mises' explanation in his Mystery of Banking, Chapter V  (The Demand for Money), pages 68 through 72.

In phase one the monetary authorities inflate the currency, but the public expects that prices will not rise or may actually fall, so they withhold their spending, which is the same thing as saying that they increase their demand to hold money.  Prices may actually drop during this period of monetary inflation, which seems paradoxical but actually is explained by proper theory.  The demand to hold money rises faster than the supply printed by the monetary authorities.  The people believe that whatever crisis causes an increase in money will end and prices will fall to pre-crisis levels or even lower.  They are long accustomed to lower prices or even a gently falling price level.  Therefore, their firmly held belief in lower prices becomes self-fulfilling, at least for awhile, because their increase in demand to hold money brings about this very situation.

Phase one may last a long time, but eventually the demand to hold money abates and prices start to rise, gently at first but more robustly as time progresses.  In this second phase the people come to believe that prices are not going to fall and that they actually will continue to rise.  Therefore, they begin spending more to purchase goods before the inevitable increase in prices.  In this phase, even if the monetary authorities shrink the money supply, prices still can rise, because the people's demand to hold money is falling too fast.  Again, the people's belief that prices will continue to rise becomes self-fulfilling.  Price increases in phase two come faster and faster, as more and more people accelerate their spending to thwart the falling purchasing power of their money.

Phase two morphs into phase three, when people lose all confidence in the future purchasing power of their money and demand to hold money goes to zero.  In this final phase the monetary authorities are unsuccessful in stopping the loss of monetary confidence even if they take drastic action to curb monetary inflation.  People wish to exchange their money for any vendible commodity.  The panic feeds on itself.  This is what Mises calls the "crackup boom", because there is a flurry of buying as everyone tries to exchange his money for whatever he can.

The Cantillon Effect and Boom/Bust Business Cycle

Not only do our monetary masters fail to understand the real danger of monetary destruction that they have unleashed with their zero interest rate and quantitative easing policies, they do not understand the true nature of money as part and parcel of the market.  For example, they fail to understand that money is not neutral.  Its expansion does not fall upon the economy equally, perhaps raising the price level but not disturbing its underlying structure.  In his eighteenth century book, An Essay on Economic Theory, Richard Cantillon first observed that money enters the economy in certain places, enriching the early receivers of new money at the expense of later receivers.  Money expansion transfers wealth within society, benefiting the politically connected and harming the true engines of progress, the savers.  This is the Cantillon Effect of the non-neutrality of money.  In his first great book, The Theory of Money and Credit, Ludwig von Mises went even further and corrected a major deficiency of the classical economists by integrating money into general economic theory that governs all economic processes.  For example, money is just as much subject to the law of diminishing marginal utility as all other goods and services.  Our monetary masters admit as much when they muse that more recent quantitative easing measures have had less effect on their favored monetary metrics than earlier ones.  What they do not understand is that the economy was not helped by increases in money.  Quite the contrary.

At the conclusion of The Theory of Money and Credit, Mises introduced another great contribution to economic theory: that bank credit expansion is the source of the boom/bust business cycle.  Money and GDP aggregates fail to identify the capital destruction set in motion by monetary interventions.  GDP may indeed increase but only due only to the Keynesian fascination with monetary aggregates.  The capital structure of production is set in disequilibrium, sending too much capital to the earlier, long term stages of production which eventually cannot be completed due to the fact that there never were enough resources in the economy for their profitable completion.  Mises termed such misallocation "malinvestment".

No one can predict when people will begin to lose confidence in the purchasing power of the dollar.  Each new dollar that the Fed creates is like one more strand of straw laid on a mountain of straw.  The real question is "Is this next strand of straw going to be the one that breaks the camel's back?"

I thought Germany was replacing coal with wind and solar...

Re: Steag starts coal-fired power plant

I thought that Germany was going to lead the world to a new era of electricity generated by wind mills and solar panels instead of dirty old coal.  What happened?

Of course, we know what happened.  Reality intervened.  Coal is cheaper, for one thing, and neither wind nor solar can ever produce enough power to meet the needs of a modern, industrial economy.  Furthermore, I doubt that the Germans would allow a new coal fired power plant to begin operations if it didn't meet the already stringent environmental standards.

My letter to the NY Times re: Ms. Yellen can't have it both ways

Re: Message from Yellen is full speed ahead on the stimulus

Dear Sirs:
If Ms. Yellen "does not believe that the trillions in stimulus money the Fed has injected into the financial system...had created a bubble...", then why is she "saying that the Fed will not take its foot off the gas..."?  Either the stimulus is propping up a bubble or it isn't.  If it isn't, as Ms. Yellen claims, then end it.  But we know this won't happen, because Ms. Yellen isn't telling the truth.  She knows that the stimulus has created a bubble; she just doesn't want to be the Fed chairman who says so.  If she said so, then she would have to end the stimulus and accept the inevitable (and necessary) recession, which would reveal to all that, once again, the Fed's manipulation of markets has destroyed even more capital.
 

Hyperinflation Is the Necessary, Proper, Patriotic, and Ethical Thing to Do

Hyperinflation is the complete breakdown in the demand for a currency, which means simply that no one wishes to hold it.  Everyone wants to get rid of that kind of money as fast as possible.  Prices, denominated in the hyper-inflated currency, suddenly and dramatically go through the roof.  The most famous examples, although there are many others, are Germany in the early 1920's and Zimbabwe just a few years ago.  German Reichsmarks and Zim dollars were printed in million and even trillion unit denominations.

We may scoff at such insanity and assume that America could never suffer from such an event.  We are modern.  We know too much.  Our monetary leaders are wise and have unprecedented power to prevent such an awful outcome.

Think again.

Our monetary leaders do not understand the true nature of money and banking; thus, they advocate monetary expansion as the cure for every economic ill.  The multiple quantitative easing programs perfectly illustrate this mindset.  Furthermore, our monetary leaders actually advocate a steady increase in the price level, what is popularly known as inflation.  Any perceived reduction in the inflation rate is seen as a potentially dangerous deflationary trend, which must be countered by an increase in the money supply, a reduction in interest rates, and/or quantitative easing.  So an increase in inflation will be viewed as success, which must be built upon to ensure that it continues.  This mindset will prevail even when inflation runs at extremely high rates.

Like previous hyperinflations throughout time, the actions that produce an American hyperinflation will be seen as necessary, proper, patriotic, and ethical; just as they were seen by the monetary authorities in Weimar Germany and modern Zimbabwe.  Neither the German nor the Zimbabwean monetary authorities were willing to admit that there was any alternative to their inflationist policies.  The same will happen in America; in fact it may already be happening.  Take a look at what has been done since 2008.  The vast explosion of the monetary base, bank reserves, and the money supply has been sold to us as necessary, proper, patriotic, and ethical.  Despite the fact that the American economy continues to flounder, our monetary authorities are unwilling to consider any alternative to their policies. 

The most likely trigger to hyperinflation is an increase in prices following a loss of confidence in the dollar overseas and its repatriation to our shores.  Committed to a low interest rate policy, our monetary authorities will dismiss the only legitimate option to printing more money--allowing interest rates to rise.  Only the noninflationary investment by the public in government bonds would prevent a rise in the price level, but such an action would trigger a recession.  This necessary and inevitable event will be vehemently opposed by our government, just as it has been for several years to this date.

Instead , the government will demand and the Fed will acquiesce in even further expansions to the money supply via direct purchases of these government bonds, formerly held by our overseas trading partners.  This will produce even higher levels of inflation, of course.  Then, in order to prevent the loss of purchasing power by politically connected groups, the government will print even more money to fund special payouts to these groups.  For example, government will demand that Social Security beneficiaries  get their automatic increases.  Likewise for the quarter of the population getting disability benefits.  Military and government employee pay will be increased.  Funding for government cost-plus contracts will ratchet up.  As the dollar drops in value overseas, local purchases by our overextended military will cost more in dollar terms (as the dollar buys fewer units of the local currencies), necessitating an emergency increase in funding.  Of course, such action is necessary, proper, patriotic, and ethical.

Other federal employee sectors like air traffic controllers and recently armed TSA workers will likely threaten to go on strike and block access to air terminal gates unless they get a pay increase to restore the purchasing power of their now meager salaries.

State and local governments will also be under stress to increase the pay of their public safety workers or suffer strikes which would threaten social chaos.  Not having the ability to increase taxes or print their own money, the federal government will be asked to  step in and print more money to placate the police and firemen.  Doing so will be seen as necessary, proper, patriotic, and ethical.

But at this point the fun has only begun

Each round of money printing eventually feeds back into the price system, creating demand for another round of money printing...and another...and another, with each successive increase larger than the previous one, as is the nature of foolishly trying to restore money's purchasing power with even more money.  The law of diminishing marginal utility applies to money as it does to all goods and service.  The political and social pressure to print more money to prevent a loss of purchasing power by the politically connected and government workers  will be seen as absolutely necessary, proper, patriotic, and ethical.

Many will not survive.  Just as in Weimar Germany, the elderly who are retired on the fruits of a lifetime of savings will find themselves impoverished to the point of despair.  Suicides among the elderly will be common.  Prostitution will increase, as one's body becomes the only saleable resource for many.  Guns will disappear from gun shops, if not through panic buying then by outright theft by armed gangs, many of whom may be your previously law-abiding neighbors.

Businesses will be vilified for raising prices.  Goods will disappear from the market as producer revenue lags behind the increase in the cost of replacement resources.  Government's knee jerk solution is to impose wage and price controls, which simply drive the remaining goods and services from the white market to the gangster controlled black market.  Some will sit out the insanity.  Better to build inventory than sell it at a loss.  Better still to close up shop and wait out the insanity.  So government does the necessary, proper, patriotic, and ethical thing: it prints even more money and prices increase still more.

Now hyperinflation has become an irresistible force

The money you have become accustomed to using and saving eventually becomes worthless; it  no longer serves as a medium of exchange.  No one will accept it.  Yet the government continues to print it in ever greater quantities and attempts to force the citizens to accept it.  Our military forces overseas cannot purchase food or electrical power with their now worthless dollars.  They become a real danger to the local inhabitants, most of whom are unarmed.  The US takes emergency steps to evacuate dependents back to the States.  It even considers abandoning our bases and equipment and evacuating our uniformed troops when previously friendly allies turn hostile.

And yet the government continues to print money.  Its politically connected constituents demand that it do so.  It is seen as the absolutely necessary, proper, patriotic, and ethical thing to do.

The president of the United States declares martial law.  The citizens wholeheartedly approve.  Speculators and price gougers are arrested.  Major industries are nationalized.

Yet prices continue to rise

Stores are looted and farms are invaded by a starving urban populace.  Mexico begins construction of a giant wall to keep out Americans.

And yet the government continues to print money, because it is the necessary, proper, patriotic, and ethical thing to do.

Currency War = Currency Suicide

What the media calls a "currency war", whereby nations engage in competitive currency devaluations in order to increase exports, is really "currency suicide".  They engage in the fallacious belief that weakening one's own currency will improve their products' competitiveness in world markets and lead to an export driven recovery.  As it intervenes to give more of its own currency in exchange for the currency of foreign buyers, a country expects that its export industries will benefit with increased sales, which will stimulate the rest of the economy.  So we often read that a country is trying to "export its way to prosperity".

Main stream economists everywhere believe that this tactic also exports unemployment to its trading partners by showering them with cheap goods and destroying domestic production and jobs.  Therefore, they call for their own countries to engage in reciprocal measures.  Recently Martin Wolfe in the Financial Times of London and Paul Krugman of the New York Times both accuse their countries' trading partners of engaging in this "beggar-thy-neighbor" policy and recommend that England and the US respectively enter this so-called "currency war" with full monetary ammunition to further weaken the pound and the dollar.

I am struck by the similarity of this currency war argument in favor of monetary inflation to that of the need for reciprocal trade agreements.  This argument supposes that trade barriers against foreign goods are a boon to a country's domestic manufacturers at the expense of foreign manufacturers.  Therefore, reciprocal trade barrier reductions need to be negotiated, otherwise the country that refuses to lower them will benefit.  It will increase exports to countries that do lower their trade barriers without accepting an increase in imports that could threaten domestic industries and jobs.  This fallacious mercantilist theory never dies because there are always industries and workers who seek special favors from government at the expense of the rest of society.  Economists call this "rent seeking".

A transfer of wealth and a subsidy to foreigners

As I explained in Value in Devaluation?, inflating one's currency simply transfers wealth within the country from non-export related sectors to export related sectors and gives subsidies to foreign purchasers.

Please note:  It is impossible to make foreigners pay against their will for the economic recovery of another nation.  On the contrary, devaluing one's currency gives a windfall to foreigners, who buy goods cheaper.  Foreigners will get more of their trading partner's money in exchange for their own currency, making previously expensive goods a real bargain, at least until prices rise.

Over time the nation which weakens its own currency will find that it has "imported inflation" rather than exported unemployment, the beggar-thy-neighbor claim of Wolfe and Krugman.  At the inception of monetary debasement the export sector will be able to purchase factors of production at existing prices, so expect its members to favor cheapening the currency.  Eventually the increase in currency will work its way through the economy and cause prices to rise.  At that point the export sector will be forced to raise its prices.  Expect it to call for another round of monetary intervention in foreign currency markets to drive money to another new low against that of its trading partners.

Of course, if one country can intervene to lower its currency's value, other countries can do the same.  So the European Central Bank wants to drive the euro's value lower against the dollar, since the US Fed has engaged in multiple programs of quantitative easing.  The self-reliant Swiss succumbed to the monetary debasement Kool-Aid last summer when its sound currency was in great demand, driving its value higher and making exports more expensive.  Lately the head of the Australian central bank hinted that the country's mining sector needs a cheaper Aussie dollar to boost exports.  Welcome to the modern version of currency wars, AKA currency suicide.

Germany can stop money suicide

There is one country that is speaking out against this madness--Germany.  But Germany does not have control of its own currency.  It gave up its beloved deutschemark for the euro, supposedly a condition demanded by the French to gain their approval for German reunification after the fall of the Berlin Wall.  German concerns over the consequences of inflation are well justified.  Germany's great hyperinflation in the early 1920's destroyed the middle class and is seen as a major contributor to the rise of fascism.

As a sovereign country Germany has every right to leave the European Monetary Union and reinstate the deutschemark.  I would prefer that it go one step further and tie the new DM to its very substantial gold reserves.  Should it do so, the monetary world would change very rapidly for the better.  Other EMU countries would likely adopt the deutschemark as legal tender, rather than reinstating their own currencies, thus increasing the DM's appeal as a reserve currency.

As demand for the deutschemark increased, demand for the dollar and the euro as reserve currencies would decrease.  The US Fed and the ECB would be forced to abandon their inflationist policies in order to prevent massive repatriation of the dollar and the euro, which would cause unacceptable price increases.

In other words, a sound deutschemark would start a cascade of virtuous actions by all currency producers.  This Golden Opportunity should not be squandered.  It may be the only non-coercive means to prevent the total collapse of the world's major currencies through competitive debasements called a currency war, but which is better and more accurately named currency suicide.

The Cost of a Day in London--1971 vs. 2013

My wife and I lived in England from 1971 to 1975, when I was in the Air Force.  I was stationed at RAF Upper Heyford, just north of Oxford.  We lived in an apartment in Oxford.  About three or four times a year we would treat ourselves to a day in London.  This would be a special day for us, not something that we would do on a whim, because 42 years ago this would be an "expensive" day for us. 

There were four major costs to our day: round trip train fare from Oxford to London's Paddington Station, lunch usually at the Hard Rock Cafe (that chain's first restaurant and the only place in London where an American could get a real hamburger, fries, and a milk shake), a matinee performance at any London theater, and dinner at the Columbia Club on Bayswater Road, the US military's officers' club in London.

The cost of each of these four parts was approximately one pound per person, at a time when the British pound cost $2.50.  Therefore, our total cost was $20.00 (8 parts times $2.50).  The meal at the officers' club probably was subsidized to some extent, so we will assume that its cost to us was one half of the market price, boosting the real cost of an evening meal to $5.00 per person rather than $2.50.  Our new total cost of a day in London circa 1971 would be about $25.00.

Let's compare that cost of a day in London 1971 to the cost today.  I looked up specific prices on the internet for Saturday, November 9th, 2013.  Below is what it would cost the two of us today.

·         Round trip train ticket from Oxford to London for November 9th was $25.00. 

·         The ticket price to see the matinee of Billy Elliot for November 9th was 86 pounds per ticket or $137.60 at today's exchange rate of $1.60 per pound.

·         Meal prices are more difficult.  The Hard Rock Café website shows the menu but not prices.  My wife and I go to London almost every year, most recently this past May.  We are confident that the cost of a burger, fries, milk shake, tax, and tip at the Hard Rock Cafe would be not less than 15 pounds or $24.00.

 

·         A dinner of the quality of the old Officers' Club on Bayswater Road would cost double that, I'm sure.  (I remember that our cost include a drink, too.)  So we estimate that a nice evening meal of that quality would cost at least $48 per person.

So, grand total:  $25 for the train; $137.60 for the play; $24 for lunch; $48 for evening meal. The total cost of a day in London for one person on November 9, 2013 would be $235 or $470 per couple.  Therefore, the cost of a day in London is around 19 times as expensive in 2013 as it was 42 years ago in 1971.

The disaster of de-linking the dollar from gold

What significant event occurred in 1971 that would explain such price inflation?  Just kidding.  We all know that President Nixon took the US off the gold exchange standard on August 15, 1971.

For decades the US had been inflating the dollar in violation of the 1944 Breton Woods Agreement by which the US vowed to deliver gold specie to its trading partners' central banks at $35 per ounce.  When it became obvious that the US was printing dollars to fund its guns and butter policy of fighting the Viet Nam War while implementing Lyndon Johnson's Great Society welfare programs, our trading partners started asking for gold at the promised price.  When our gold stocks started shrinking dramatically, President Nixon, backed into a corner, took the US completely off the gold standard rather than devalue the dollar to some new dollar-to-gold ratio and accept monetary discipline henceforth.

Two things followed:

1.  We entered into a New Age of Floating Exchange Rates among different fiat monies,

and

2.  We embraced a permanent policy of Planned Inflation, which means continuous debasement of our currency, with no end in sight.

Thus, there was no longer any pretense that the US would maintain monetary discipline.  Every crisis became an excuse to print more money.  Over four decades this increase in money has caused prices to rise magnificently, as our "expensive" day in London in 1971 compares to today.

Gold Coverage Price: 1971 vs. 2013

One way to quantify the tsunami of monetary profligacy is to calculate the gold coverage price for the two periods.  The gold coverage price is what the Fed would have to charge a customer to redeem an ounce of gold without running out of gold before all dollar claims had been extinguished.  The gold coverage price can be determined by dividing M2 (the largest measure of money, which includes cash outside bank vaults and all demand and near demand savings accounts at banks) by the Fed's stock of gold.

Here are the facts:

·         The Fed's gold stock has remained unchanged from 1971 to 2013 at 261.5 million ounces.

·         M2  stood at $700 billion in December 1971.  This means that the gold coverage price--the true price per ounce of gold--was really $2,677 in 1971 instead of the official $35 per ounce.  No wonder the Fed was running out of gold!  Foreign central banks, especially the French, clearly saw and understood this.

 

Now by contrast, today:

·         M2 on September 2013 was $10.8 Trillion.  (Note the "T"!)  This means that the gold coverage price in September 2013 was $41,300.

Let's take a deep breath...

So, the Fed has inflated M2 by a factor of 15 since the last link to gold was broken in 1971.  This goes a long way to explaining why a day in London costs 19 times as much today.  With this planned inflation policy in place, can you guess what an "expensive" day in London will cost 42 years from now?  Answer: Every Day is becoming an "Expensive" Day.

My letter to the NY Times re: Krugman's economics of capital consumption

Re: The Mutilated Economy, by Paul Krugman

Dear Sirs:
Paul Krugman's economics can be summarized as simply a childish desire to consume capital.  Once viewed in this light, one may understand how little Krugman really has to say about economics.  He is like the child who sees money in his daddy's wallet and demands that it be spent on toys and ice cream.  His consistent demands for money printing by the Fed to support government's wasteful spending on make work projects assures us that those employed, even if temporarily, will be better off in the long run, because...well, Krugman never presents a theory that would explain how either money printing or make work spending are beneficial.  He just assures us that they are.  Perhaps he should consult the Japanese with their bullet trains to nowhere and the Spanish with their empty and crumbling superhighways.

Krugman displays monumental cognitive dissonance in failing to reconcile his view of an economy still in doldrums after five years with his demand that governments double down on their very Krugman-like policies of money printing and deficit spending.  He tops off his latest column with the completely fallacious and discredited sophism that we need not worry about debt because "we owe it to ourselves"!  If this is the case, Paul, then please lend me one million dollars, which I will never repay, of course. But don't be alarmed, you and I owe it to ourselves.

Here's my advice to the owners and editors of the New York Times--get new economic columnists.  Your current crop haven't a clue about real economic theory, Austrian economic theory.  Thursday's OpEd by Mr. Jared Bernstein and Mr. Dean Baker, titled "Taking Aim at the Wrong Deficit" is a case in point.  It is nothing more than a hodgepodge of money manipulations that supposedly will move their favorite economic indicator, the trade deficit, into credit rather than debit territory.  Their theory, such as it is, is that prosperity can be achieved through money manipulation.  This is probably the greatest economic fallacy of the modern era.  Austrian economists know, through proper theory, that money is as much a product of the market as any other economic good.  Its manipulation will result in economic dislocations, and the more the manipulations the greater the dislocations.