Sisyphean Fed Struggle
Earlier today in The Trouble with Porosity and Prosperity Bill Gross mentioned the possibility of deflation in the US and spoke of the Fed’s Sisyphean struggle to create inflation.
Before the advent of central banks in the early 20th century, prices were just as likely to go up as down. The world of the 1930s and the more recent lost decades of Japan give testament. Prices change – and while they usually go up these days, sometimes they do not. We are at such a moment of uncertainty.
That one or the other should be favored, is a fascinating debate. Currently, almost all central bankers have a targeted level of inflation that approaches 2%. Some even argue for higher levels now that deflationary demons approach in peripheral Euroland. They argue that the 2% level is sort of like a firebreak. Once inflation approaches zero, goes their theory, the deflationary firestorm is difficult to stop. With interest rates at zero and quantitative easing approaching potential political maximums, there is little water left to pour on the flames. Best then to keep inflation at a reasonable 2% so that the zero hour never comes. They have a point, but then how to explain to the average 30-year-old citizen that if so, his/her retirement dollar will only be worth half as much come 65, and if inflation averages 3%, it will only be worth a third. Actually, a 30-year-old citizen of the 1970s (yours truly), has experienced a 75% depreciation of his purchasing power.
Jim Grant, one of the most gifted financial historians of our day, has long argued that economies did just fine during bouts of deflation in the 18th and 19th centuries – in fact, in many cases, they did better. America in the 1880s was a period of good deflation with output rising by 2% to 3% from 1873 to 1893.
But Grant must know, I suspect, that our modern finance based economy is not your 19th century Oldsmobile, if there had been one. Stopping the printing press sounds like a great solution to the depreciation of our purchasing power but today’s printing is simply something that the global finance based economy cannot live without.
Why not? Simple math, I suppose. Our 2014 U.S. Oldsmobile requires 4% nominal growth just to keep it running, and Euroland economies need at least 3%. Having created outstanding official and shadow banking credit of nearly $100 trillion with an average imbedded interest rate of 4% to 5%, the Fed presses must crank out new credit (nominal growth) of approximately the same 4% to 5% just to pay the interest rate tab. That of course wasn’t the case in Grant’s 19th century version – there was very little debt to service. But now at 500% to 600% of GDP (shadow debt included), it’s a Sisyphean struggle just to stay above water. Inflation, in other words – or in simple math – is required to pay for prior inflation. Deflation is no longer acceptable.
Such is the dilemma facing central bankers (and supposedly fiscal authorities) in 2014 and beyond: How to create inflation. They’ve made a damn fine attempt at it – have they not? Four trillion dollars in the U.S., two trillion U.S. dollar equivalents in Japan, and a trillion U.S. dollars coming from the ECB’s Draghi in the eurozone. Not working like it used to, the trillions seem to seep through the sandy loam of investment and innovation straight into the cement mixer of the marketplace. Prices go up, but not the right prices. Alibaba’s stock goes from $68 on opening day to $92 in the first minute, but wages simply sit there for years on end. One economy (the financial one) thrives while the other economy (the real one) withers.
The real economy needs money printing, yes, but money spending more so, and that must come from the fiscal side – from the dreaded government side – where deficits are anathema and balanced budgets are increasingly in vogue. Until then, Grant’s deflation remains a growing possibility – not the kind that creates prosperity but the kind that’s the trouble for prosperity.
Faber on Gross’ Deflation Theory and Japan’s Bond Ponzi Scheme
In a Bloomberg TV interview, Trish Regan asked Marc Faber about Gross’ deflation theory. Faber also discussed Japan’s latest QE endeavor.
Faber stated: Japan is Engaged in a Ponzi Scheme. Click on link to watch video.
TRISH REGAN: Hello, Marc. Always good to see you. What do you think here about what Bill Gross is saying? Do you think in fact deflation is a real possibility.
MARC FABER: Well, I think the concept of inflation and deflation is frequently misunderstood because in some sectors of the economy you can have inflation and in some sectors deflation. But if the investment implication of Bill Gross is that – and he’s a friend of mine. I have high regard for him. If the implication is that one should be long US treasuries, to some extent I agree. The return on 10-year notes will be miserable, 2.35 percent for the next 10 years if you hold them to maturity in each of the next 10 years.
However, if you compare that to French government bonds yielding today 1.21 percent, I think that’s quite a good deal, or Japanese bonds, a country that is engaged in a Ponzi scheme, bankrupt, they have government bond yields yielding 0.43 percent.
Well I think they’re engaged in a Ponzi scheme in the sense that all the government bonds that the Treasury issues are being bought by the Bank of Japan.
REGAN: So Japan’s engaged in a Ponzi scheme. What about the US? We’ve done our share of money printing. We’ve had record low interest rates for six years.
FABER: I think the good news is – for Japan is that most countries are engaged in a Ponzi scheme and it will not end well. But as Carlo Ponzi proved, it can take a long time until the whole system collapses.
Faber on Gold
Here are a few excerpts courtesy of Bloomberg that did not appear in the above video.
REGAN: I know you have been bullish in gold for – well, pretty much forever, Marc. But now we’re in a situation where gold is at a four-year low. Goldman now predicting 10, 15 down [percent]. Soc Gen saying $1,000. Where do you see gold finishing the year?
FABER: I would say Goldman Sachs is very good at predicting lower prices when they want to buy something. I would say, yes, we are down from $1,900 to $1,160 or something like this, and it’s been a miserable performance since 2011. However, from the 1990 lows we’re still up more than four times. So I just looked at performance tables over 10 years and 15 years. Gold hasn’t done that badly, has done actually better than stocks.
Now I personally, I think that we may still go lower. It’s possible. I’m not a prophet, but I’m telling you I want to own some gold because I don’t trust the financial system anymore. I think the whole thing is going to collapse one day and then I’ll be happy to have some assets. But of course the custody is important. I wouldn’t hold my gold at the Federal Reserve because they will lend it out. I wouldn’t hold my gold in the US at all.
REGAN: Okay. So you want gold even at these levels. Where do you see – you still see it going lower however as we close out the year?
FABER: I don’t know whether it will go lower, but I think by the time I die, it will be meaningfully higher. I’m now 68 and I don’t think it will be 100 [I will die at 100]. I’m not that optimistic.
Mish Comments on Gross’ Deflation Theory
Gross and Faber are primarily talking about prices (price inflation and deflation), not monetary inflation and deflation. However, Gross mixes the two when he discusses printing presses and credit math.
Nonetheless, Gross’ context is clear. I run into this myself and dislike having to write “price”, “monetary”, or “credit” in front of every inflation or deflation reference when context should make it clear.
Good Deflation vs. Bad Deflation
Bill Gross says “Deflation is no longer acceptable.”
I suggest, ordinary consumer price deflation will not hurt banks one bit. The problem for the Fed is not price deflation, but asset-price deflation.
Gross should be able to figure this out. Interestingly, Gross even spoke of “good deflation with output rising by 2% to 3% from 1873 to 1893.“
The truth of the matter is falling consumer prices never have and never will hurt banks.
The alleged “bad deflation” which Gross did not mention is in regards to falling asset prices. If banks extend loans on houses or other investment property, and the loans go sour, banks become capital impaired, unable or unwilling to lend.
The irony is the Fed (central banks in general), cause asset price inflation (followed by deflationary asset price busts), when they attempt to create 2% inflation willy-nilly as if consumer price deflation is bad.
“Bad Deflation” Doesn’t Really Exist
Actually, there is no such thing as “bad deflation”. All deflation is inherently good. Deflation is the natural state of affairs as a result of rising productivity and technological advancements.
Falling prices means more affordability for more people.
Deflation only seems bad when banks make poor lending decisions on risky assets, then become capital impaired when the loans go bad. Why does that happen? Easy … The Fed has created a moral hazard. Banks believe the central bank will always bail them out if they get in trouble.
And so far they have. So banks keep making risky loans, and investors keep plowing into riskier and riskier assets.
Bubbles of Increasing Amplitude
Via the moral hazard of bailouts, the Fed sponsors bubbles and crashes of increasing amplitude over time.
But the biggest bubble of all is belief central banks will always be able to handle these busts.
Gross needs to replace “simple math” with “exponential math” coupled with the fact central banks can (for a while) target prices in general, but they cannot target wages or the prices they want.
Back to the Drawing Board
The Fed expanded money supply by $4 trillion dollars and the CPI is up less than 2%!
What’s the Fed going to do for an encore when the global economy slumps, US jobs with it, and prices of goods services, and assets sink?
Expand money supply by $8 trillion? $16 trillion? $32 trillion? Buy equities? Buy more than 100% of debt issuance like Japan?
How nuts does it get?
Gross concludes with “The real economy needs money printing“. I suggest Gross go back to the drawing board and come up with a different answer.
Suggested Reading for Bill Gross
- Deflationary Spiral Nonsense; Keynesian Theory vs. Practice; Eurozone Policymakers Concerned About Falling Prices
- Challenge to Keynesians “Prove Rising Prices Provide an Overall Economic Benefit”
- “Will These Central Bank Morons Ever Learn?” asks Albert Edwards at Societe General
- James Grant Conference Video: Inflation Expectations, Growth, Policy Problems; Europe Has Become Japan.
Mike “Mish” Shedlock