The Big Inflationist Scare

Inquiring minds are reading Pushing on a String by Gary North.

Gary always writes an interesting column. Indeed, there is too much to excerpt that I suggest reading it. Gary has many of his facts correct, yet still manages to come to the wrong conclusion.

CONCLUSION

The Federal Reserve can re-ignite monetary inflation at any time by charging banks a fee to keep excess reserves with the FED.

Anyone who predicts an inevitable price deflation does not understand that the present scenario is the product of legitimately terrified bankers and the Federal Reserve’s Board of Governors. At any time, the FED can get all of the banks’ money lent. But the FED knows that this will double the money supply within weeks. This will create mass price inflation.

This is the central fact in the inflation vs. deflation debate. Until the deflationists answer it with a unified voice, they will remain, as their predecessors remained, people with neither a theoretical nor a practical case for their position.

So, the FED waits. Meanwhile, the Federal government’s share of the economy rises relentlessly because of the deficits. This is not going to change in the next few years.

We are seeing Keynesianism’s last stand. When it fails, the FED will force the banks to lend. Then we will see mass inflation.

Mass deflation? Forget about it.

Yes, the bankers are terrified, not just in the US but globally.

However, Gary’s hypothesis "the Federal Reserve can re-ignite monetary inflation at any time by charging banks a fee to keep excess reserves with the FED", is just that, a hypothesis, and I believe a very poor one at that.

Bernanke’s idea to pay interest on reserves will slowly recapitalize banks over time. This is why he desperately wanted to do so. To suggest he is about to charge interest on deposits is silly.

The key fact now is there are not enough credit worthy customers for banks to want to lend, or for that matter willing borrowers looking to expand debt. Thus, if banks had to pay interest on reserves, rather than causing mass inflation, the Fed would cause mass panic.

Indeed, the likely result would be banks scrambling for dollars to repay the Fed as opposed to a mad dash to lend dollars.

Clearly the Fed understands this. Thus, it’s not the Fed who is screaming about the banks’ unwillingness to lend; it’s Congress. Moreover, banks won’t lend because most of them know the score as well, regardless of what lies they tell the public about being well capitalized. This is why "reserves" are accumulating in the first place.

Of course those "excess reserves" are a mirage; they don’t really exist. Banks need those reserves because of the massive wave of credit card defaults and foreclosures yet to hit the books. Every uptick in unemployment exacerbates credit card losses, foreclosures, losses on home equity loans, etc, something that Gary North ignores.

So charging interest on reserves would not bring about inflation, it would cause a systemic deflationary crash if Bernanke was foolish enough to attempt it.

No Unified Voice

Gary writes "Until the deflationists answer it with a unified voice, they will remain, as their predecessors remained, people with neither a theoretical nor a practical case for their position."

There is no such thing as a "unified deflationist voice". Of course there is no such thing as a "unified inflationist voice" either.

No Inflationist Voice

Most inflationists, Gary North included (but certainly not all), look at the situation through the eyes of money supply in conjunction with the Fed’s so-called ability to cause inflation at will. However, if the Fed could cause inflation at will, it would have done it long ago. Note: Congress can create inflation at will by giving everyone $1 million, but the Fed cannot do such a thing, nor would they even if they could, because it would destroy banks.

The Fed does not really give a damn about consumers; all it cares about is banks. That is why bailout money went to lending institutions not individuals. However, individuals are still loaded up in debt with no way to pay it back given the collapse in jobs. Still others are able to pay back loans but instead are walking away.

Anyone ignoring the complete collapse of credit or assuming as Gary does in the above article, is making a second huge mistake. Indeed, the Flow of Funds Report Offers Hard Evidence of Deflation.

Other inflationists look at consumers prices, some look at commodity prices, still others look at the price of gold as a measure of inflation. Of those watching money supply, some concentrate on Base Money supply as Gary North does, others M2, M3, MZM, or even Austrian Money Supply as a measure of inflation. Interestingly, there are even two different versions of Austrian Money supply with a pretty big difference between the two versions.

Every one of them is wrong.

We have a credit based economy and anyone watching money supply and not watching credit is simply wrong. This is a statement of fact, not idle conjecture. Only those watching and expecting the collapse in credit and understanding the role of gold got things correct. This is a very small group of people.

No Deflationist Voice

Just as there is no unified inflationist voice, there is no unified deflationist voice. Some, like Prechter were 30 years early. Prechter finally got his deflation. However, he did not get the collapase in gold back to $250 as he called for years. Prechter simply does not understand gold is money, and what that means during deflationary times.

Certainly most in mass media treat deflation as if it can be measured by a drop in consumer prices. Gary North plays ping pong with inflationists and deflationists stating what they believe as if they all believed the same thing, yet interestingly he decries the lack of a "unified voice". Here is one interesting section:

Why anyone worries about price deflation is a mystery to me. With the power of money creation through the purchase of assets, there is no theoretical limit to how high prices can rise. Because people associate rising prices of whatever they sell or own as a sign of prosperity, there is always support for fiat money.

The deflationist says, "the banks can create credit, but people may decide not to borrow." This is true. But why wouldn’t they borrow?

Actually, no one should be worried about a drop in prices because deflation is a natural state of affairs on account of rising productivity over time.

More importantly Gary makes a huge leap of faith, overstating the Fed’s ability to cause inflation, and concludes "Why wouldn’t they borrow?" The answer should be obvious.

Why Consumers Won’t Borrow

Cash strapped boomers headed into retirement are finding they do not have enough money on which to retire. They are traveling less, spending less, and have too much of their assets tied up in illiquid real estate investments. Moreover, banks will not lend because there are too few qualified borrowers.

Peak Credit is in. The Effect of Household Deleveraging on Housing, Consumption and the Stock Market is massive.

Moreover, please note that the Fed cannot control sentiment of either borrowers or lenders. The Fed can merely encourage.

Personal Savings Rate Rising

click on chart for sharper image

The savings rate is rising, as expected. And in case inflationists have not noticed, lending standards have tightened dramatically.

Pending regulation is massive and will likely restrict credit in aggregate. Everyone wants to prevent a recurrence of the last bubble. There is no need. The housing bubble will not be reblown for decades.

There is virtually no evidence consumers want to borrow. Likewise, there is virtually no evidence, none, that banks are about to go on a lending spree. Moreover, there is no evidence the Fed is attempting to force banks to lend. And finally, there is no evidence the Fed is considering charging banks a fee to keep excess reserves with the FED, or that if they did, that it would accomplish anything other than a deflationary collapse.

Fears of massive inflation are at this point ridiculous.

Mike "Mish" Shedlock