Today's lead Wall Street Journal staff editorial, The "Limited Inflationists," was a real eye-opener.
In it, the author identified Sumner Slichter, a Harvard University economist in the 1950s, as the intellectual father of the notion that a little managed inflation is good for an economy.
Early on, the piece states,
"In a hearing on Capitol Hill, his views drew a famous rebuke from Fed Chairman William McChesney Martin, but Slichter's ideas gained currency in the 1950s and 1960s and eventually laid the groundwork for the not-so-gradual inflation of the 1970s.
Slichter died in 1959, but he is staging a rebirth at none other than Martin's former home, the Federal Reserve. A galaxy of Fed officials has fanned out to argue for another round of "quantitative easing," or a further expansion of the Fed balance sheet to boost the economy. The "limited inflationists" are once again at America's monetary helm, promising happier days from rising prices while downplaying the costs and risks."
The editorial then goes on to detail the various players on the Fed Open-Market Committee who are now targeting inflation levels, claiming there is wiggle room, because the actual rate of inflation is below their target, so a little more of it won't hurt.
The author offers some evidence that the QE2 planned to effect this inflation won't achieve very much for the $500B spent.
But the real message comes near the end of the editorial,
"The case for QE2 assumes that the problem with the economy is merely a lack of money. But trillions of dollars are already sitting unused on bank and corporate balance sheets. The real problem isn't lack of capital but a capital strike, as businesses refuse to take risks or hire new workers thanks to uncertainty over government policy, including higher taxes and regulatory burdens. More Fed easing in this environment risks "pushing on a string," adding money to little economic effect.
By keeping interest rates artificially low, the Fed is also contributing to a misallocation of capital and perhaps new asset bubbles. Messrs. Bernanke and Evans say they see no signs of inflation, as measured by the lagging indicator of the consumer price index."
These are both very important points. Most informed observers of the current business situation understand that the author is correct. It's uncertainty with respect to governmental actions on many fronts that has immobilized capital and investment, not rate levels. And more bubbles and capital misallocation are likely, in a repeat of Greenspan's mistakes of the early years of the past decade.
"But investors are having no trouble bidding up the price of commodities, including oil and gold. A rising price of oil will have its own negative impact on growth, as we know from the experience of $147 oil in mid-2008. A commodity price spike might well erase any benefit from the expected decline of 15 basis points in long-term bond yields."
This is a particularly astute observation. Bernanke & Co. are running around announcing that, since the CPI and other baskets of goods aren't rising too fast in price, there's little inflation. They conveniently ignore the commodity bubbles now building. CNBC's Rick Santelli has noted this often in the past months.
Why is, in years past, Fed officials admitted, in hindsight, to asset pricing bubbles, but now, while observing them again, they choose to blithely ignore them and focus on more benevolent measures which are currently behaving to their liking?
Finally, the editorial delivers the coup de grace,
"As the protector of the world's reserve currency, the Fed also risks more global monetary disruption. The mere anticipation of QE2 has already caused Japan to pursue its own purchases of exotic assets, while Britain may do the same, as they and other countries try to avoid sharp rises in their currencies against the dollar. The European Central Bank may well have to follow, as the entire world adopts the "limited inflation" philosophy. In such a world, it's hardly surprising that gold has climbed in price against all major fiat currencies as a remaining store of value."
Forget all the foregoing technical points, if you wish. The argument which should trump all others is that of the Fed standing for price stability for the world's reserve currency. If it doesn't choose to do this, it is abdicating an important responsibility, and inviting further efforts to dethrone the dollar from this role.
That would be a mistake from which America, like Great Britain in the early 1900s, will probably never recover. Thus, the final paragraph of the piece,
"Which brings us back to Sumner Slichter and the limited inflationists. Amid the political and media interest in their ideas, Fed Chairman Martin appeared before the Senate Finance Committee. "There is no validity whatever in the idea that any inflation, once accepted, can be confined to moderate proportions," the father of the modern Fed thundered, in a warning that would be vindicated after his retirement in 1970. That's a warning as well for the QE Street Band."
No kidding. Just ask Paul Volcker.
Showing posts with label Reserve Currency. Show all posts
Showing posts with label Reserve Currency. Show all posts
Friday, October 08, 2010
Tuesday, October 27, 2009
Allan Meltzer On Excessive US Deficits & The Weakening Dollar
I've written quite a few posts recently regarding what I believe is the arrival of the US at a new tipping point involving the weakening dollar, excessive deficits and externally-held US debt, taxation, additional social spending programs, and coming inflation. As I explained in an email to a friend recently, for the first time in thirty years, I'm genuinely concerned that the predictions of the dollar's and US's economic and, eventually, military superiority's decline, are now within view of coming true.
In fact, with all the government intervention of the past year, posts focused on cases of firms chalking up consistently superior total return performance have declined. Instead, the most interesting topics seem to be the economics of the dollar and deficit spending, and massive government intervention in the private sector of the US economy.
In last Friday's Wall Street Journal, respected Carnegie Mellon political economy professor Allan Meltzer weighed in with a reinforcing editorial entitled "Preventing the Next Financial Crisis."
The crisis to which he refers is not a private sector banking crisis like last year. Instead, he begins his editorial,
"The United States is headed toward a new financial crisis. History gives many examples of countries with high actual and expected money growth, unsustainable budget deficits, and a currency expected to depreciate. Unless these countries made massive policy changes, they ended in crisis. We will escape only if we act forcefully and soon."
Echoing others, and my own concerns, Meltzer then observes,
"Massive purchases of dollar debt by foreigners can of course delay the crisis, but today most countries have their own deficits to finance. It is unwise to expect them, mainly China, to continue financing up to half of ours for the next 10 or more years. Our current and projected deficits are too large relative to current and prospective world saving to rely on that outcome.
Worse, banks' idle reserves that are available for lending reached $1 trillion last week. Federal Reserve Chairman Ben Bernanke said repeatedly in the past that excess reserves would run down when banks and other financial companies repaid their heavy short-term borrowing to the Fed. The borrowing has been repaid but idle reserves have increased. Once banks begin to expand loans or finance even more of the massive deficits, money growth will rise rapidly and the dollar will sink to new lows.
Many market participants reassure themselves that inflation won't come by noting the decline in yields on longer-term Treasury bonds and the spread between nominal Treasury yields and index-linked TIPS that protect against inflation. They measure expectations of higher inflation by the difference between these two rates, and imply long-term investors aren't demanding higher interest rates to protect themselves against it. But those traditional inflation-warning indicators are distorted because the Fed lends money at about a zero rate and the banks buy Treasury securities, reducing their yield and thus the size of the inflation premium.
Further, the Fed is buying massive amounts of mortgages to depress and distort the mortgage rate. This way of subsidizing bank profits and increasing their capital bails out these institutions but avoids going to Congress for more money to do so. It follows the Fed's usual practice of protecting big banks instead of the public.
The administration admits to about $1 trillion budget deficits per year, on average, for the next 10 years. That's clearly an underestimate, because it counts on the projected $200 billion to $300 billion of projected reductions in Medicare spending that will not be realized. And who can believe that the projected increase in state spending for Medicaid can be paid by the states, or that payments to doctors will be reduced by about 25%?"
There you have it. Meltzer does a great job of ticking off the sources of unease many, including me, feel about the current monetary and fiscal situation. It truly feels like a nearby bomb, the timer on which is finally, after some 60+ post-WWII years, nearing zero.
On the matter of who owns this mess, Meltzer, in a genuinely bi-partisan vein, writes,
"The Obama administration chooses to blame outsize deficits on its predecessor. That's a mistake, because it hides a structural flaw: We no longer have any way of imposing fiscal restraint and financial prudence. Federal, state and local governments understate future spending and run budget deficits in good times and bad. Budgets do not report these future obligations.
Except for a few years in the 1990s, both parties have been at fault for decades, and the Obama administration is one of the worst offenders. Its $780 billion stimulus bill, enacted earlier this year, has been wasteful and ineffective. The Council of Economic Advisers was so pressed to justify the spending spree that it shamefully invented a number called "jobs saved" that has never been seen before, has no agreed meaning, and no academic standing."
And there's the rub. Anyone with a brain who has been watching federal government behavior since Reagan's exit from office knows that both parties have allowed our society to rack up huge debts to finance promises which are simply unable to be kept.
Having come of age in business during the Reagan years, with Volcker at the Fed, I never really thought that the lessons of the Carter, and post-Carter years could be forgotten, or simply denied. But, as Meltzer concludes,
"One reason for the great inflation of the 1970s was that the Federal Reserve gave primacy to reducing unemployment. But attempts to tame inflation later didn't last, and the result was a decade of high and rising unemployment and prices. It did not end until the public accepted temporarily higher unemployment—more than 10.5% in the fall of 1982—to reduce inflation.
Another error of the 1970s was the assumption there was a necessary trade-off along a stable Phillips Curve between unemployment and inflation—in other words, that more inflation was supposed to lower unemployment. Instead, both rose. The Fed under Paul Volcker stopped making those errors, and inflation fell permanently for the first time since the 1950s.
Both errors are back. The Fed and most others do not see inflation in the near term. Neither do I. High inflation is unlikely in 2010. That's why a program beginning now should start to lower excess reserves gradually so that the Fed will not have to make its usual big shift from excessive ease to severe contraction that causes a major downturn in the economy.
A steady, committed policy to reduce future inflation and lower future budget deficits will avoid the crisis that current policies will surely bring. Low inflation and fiscal prudence is the right way to strengthen the dollar and increase economic well being."
I feel like I'm economically much older than my years, because I recall arguments concerning Arthur Burns' ineffective reign at the Fed. His inability to pre-empt inflation during the LBJ "guns and butter" years of the Vietnam war and the Great Society program spending.
Even this morning, as I write this, I have listened to CNBC's senior economic moron, Steve Liesman, argue that commodity price inflation has no information value for the coming storm of CPI inflation.
Milton Friedman reminded us that
"Inflation is always and everywhere a monetary phenomenon."
With the recent explosion of US dollar liabilities and the Fed funding our debt, Meltzer is clearly correct on the need for the Fed to begin tightening now. Burns' ineptitude was a classic example of waiting too long, then watching the inflation genie escape and run rampant for more than a decade.
Let's hope we are not going to experience that again, along with losing the dollar's reserve currency status.
In fact, with all the government intervention of the past year, posts focused on cases of firms chalking up consistently superior total return performance have declined. Instead, the most interesting topics seem to be the economics of the dollar and deficit spending, and massive government intervention in the private sector of the US economy.
In last Friday's Wall Street Journal, respected Carnegie Mellon political economy professor Allan Meltzer weighed in with a reinforcing editorial entitled "Preventing the Next Financial Crisis."
The crisis to which he refers is not a private sector banking crisis like last year. Instead, he begins his editorial,
"The United States is headed toward a new financial crisis. History gives many examples of countries with high actual and expected money growth, unsustainable budget deficits, and a currency expected to depreciate. Unless these countries made massive policy changes, they ended in crisis. We will escape only if we act forcefully and soon."
Echoing others, and my own concerns, Meltzer then observes,
"Massive purchases of dollar debt by foreigners can of course delay the crisis, but today most countries have their own deficits to finance. It is unwise to expect them, mainly China, to continue financing up to half of ours for the next 10 or more years. Our current and projected deficits are too large relative to current and prospective world saving to rely on that outcome.
Worse, banks' idle reserves that are available for lending reached $1 trillion last week. Federal Reserve Chairman Ben Bernanke said repeatedly in the past that excess reserves would run down when banks and other financial companies repaid their heavy short-term borrowing to the Fed. The borrowing has been repaid but idle reserves have increased. Once banks begin to expand loans or finance even more of the massive deficits, money growth will rise rapidly and the dollar will sink to new lows.
Many market participants reassure themselves that inflation won't come by noting the decline in yields on longer-term Treasury bonds and the spread between nominal Treasury yields and index-linked TIPS that protect against inflation. They measure expectations of higher inflation by the difference between these two rates, and imply long-term investors aren't demanding higher interest rates to protect themselves against it. But those traditional inflation-warning indicators are distorted because the Fed lends money at about a zero rate and the banks buy Treasury securities, reducing their yield and thus the size of the inflation premium.
Further, the Fed is buying massive amounts of mortgages to depress and distort the mortgage rate. This way of subsidizing bank profits and increasing their capital bails out these institutions but avoids going to Congress for more money to do so. It follows the Fed's usual practice of protecting big banks instead of the public.
The administration admits to about $1 trillion budget deficits per year, on average, for the next 10 years. That's clearly an underestimate, because it counts on the projected $200 billion to $300 billion of projected reductions in Medicare spending that will not be realized. And who can believe that the projected increase in state spending for Medicaid can be paid by the states, or that payments to doctors will be reduced by about 25%?"
There you have it. Meltzer does a great job of ticking off the sources of unease many, including me, feel about the current monetary and fiscal situation. It truly feels like a nearby bomb, the timer on which is finally, after some 60+ post-WWII years, nearing zero.
On the matter of who owns this mess, Meltzer, in a genuinely bi-partisan vein, writes,
"The Obama administration chooses to blame outsize deficits on its predecessor. That's a mistake, because it hides a structural flaw: We no longer have any way of imposing fiscal restraint and financial prudence. Federal, state and local governments understate future spending and run budget deficits in good times and bad. Budgets do not report these future obligations.
Except for a few years in the 1990s, both parties have been at fault for decades, and the Obama administration is one of the worst offenders. Its $780 billion stimulus bill, enacted earlier this year, has been wasteful and ineffective. The Council of Economic Advisers was so pressed to justify the spending spree that it shamefully invented a number called "jobs saved" that has never been seen before, has no agreed meaning, and no academic standing."
And there's the rub. Anyone with a brain who has been watching federal government behavior since Reagan's exit from office knows that both parties have allowed our society to rack up huge debts to finance promises which are simply unable to be kept.
Having come of age in business during the Reagan years, with Volcker at the Fed, I never really thought that the lessons of the Carter, and post-Carter years could be forgotten, or simply denied. But, as Meltzer concludes,
"One reason for the great inflation of the 1970s was that the Federal Reserve gave primacy to reducing unemployment. But attempts to tame inflation later didn't last, and the result was a decade of high and rising unemployment and prices. It did not end until the public accepted temporarily higher unemployment—more than 10.5% in the fall of 1982—to reduce inflation.
Another error of the 1970s was the assumption there was a necessary trade-off along a stable Phillips Curve between unemployment and inflation—in other words, that more inflation was supposed to lower unemployment. Instead, both rose. The Fed under Paul Volcker stopped making those errors, and inflation fell permanently for the first time since the 1950s.
Both errors are back. The Fed and most others do not see inflation in the near term. Neither do I. High inflation is unlikely in 2010. That's why a program beginning now should start to lower excess reserves gradually so that the Fed will not have to make its usual big shift from excessive ease to severe contraction that causes a major downturn in the economy.
A steady, committed policy to reduce future inflation and lower future budget deficits will avoid the crisis that current policies will surely bring. Low inflation and fiscal prudence is the right way to strengthen the dollar and increase economic well being."
I feel like I'm economically much older than my years, because I recall arguments concerning Arthur Burns' ineffective reign at the Fed. His inability to pre-empt inflation during the LBJ "guns and butter" years of the Vietnam war and the Great Society program spending.
Even this morning, as I write this, I have listened to CNBC's senior economic moron, Steve Liesman, argue that commodity price inflation has no information value for the coming storm of CPI inflation.
Milton Friedman reminded us that
"Inflation is always and everywhere a monetary phenomenon."
With the recent explosion of US dollar liabilities and the Fed funding our debt, Meltzer is clearly correct on the need for the Fed to begin tightening now. Burns' ineptitude was a classic example of waiting too long, then watching the inflation genie escape and run rampant for more than a decade.
Let's hope we are not going to experience that again, along with losing the dollar's reserve currency status.
Wednesday, October 07, 2009
On The Dollar Losing Reserve Currency Status
My business partner and I were both horrified that yesterday, on a day when there was so much news about secretive, joint talks between Arab oil producers, Russia and China on establishing a non-US dollar reserve currency basket, the S&P500 Index didn't plummet, but rose 1.4%!
What about this potential calamity don't investors understand?
Like many other business people, I've read warnings about the loss of reserve currency status for the US dollar for decades. It's usually the same song- large deficits, inflation debauching the value of dollar assets held by foreign governments, etc.
In the past, though, no other nation held out such hope for economic growth with fairly stable regimes and legal frameworks. Next to the US, other potential reserve currencies paled in comparison.
Now, however, the threat takes a slightly different, and more credible form.
First, Arabian oil producers are viewing US military hesitancy over Iran, and potential withdrawals from Iraq and Afghanistan, with alarm.
Add to this an unprecedented flooding of the world with dollars and dollar liabilities. Despite what many talking heads my believe about current modest price deflation due to lower demand, there has never not been a relationship between excessive printing of money and subsequent hyper-inflation of said currency.
Finally, three other global powers or power blocs- Arab oil producers, Russia and China- each have a desire to see the US weakened. It's no secret that post-WWII US power has always implicitly rested on the dollar's reserve currency status.
When our own Treasury Secretary begins to talk up the use of SDRs to replace the dollar, and the US, as part of the G20, lends credibility to this move, the jig is nearly up.
This is, of course, idiocy on the part of the current US administration and its misguided new sense of multi-lateralism and global harmony.
With these forces as context, it becomes chillingly plausible that some major oil producers and a major consumer- Arabia, Russia and China- could indeed jointly agree on a basket of commodities and currencies with which oil may be purchased, none of which is the US dollar.
I'm quite familiar with what would be the counter-arguments to this development. In brief, it will be the repetition of what I, too, used to believe. That current holders of so many billions of US dollars and dollar-denominated liabilities won't dare precipitate the loss of value of their own substantial assets.
The question, now, is at what point these countries essentially choose to finally go cold turkey on the US dollar, reasoning that loss of wealth by a sudden switch to other stores of value is preferable to a few more decades of gradual erosion of value of the dollar.
Google the topic or relative currency values over time and choose any of the results you see. By many measures, be it purchasing power, other currencies, or gold, you'll see that the US dollar has fallen by at least a quarter in value in the past 8-9 years.
Now consider the massive issuance of dollar-denominated government debt in the past year, and the monetizing of that debt by our own Fed. And the coming huge inflationary spending on stimulus, health care and 'cap and trade' bills.
Any thinking person in the rest of the world is watching this and seeing a monetary train wreck ahead for the US dollar and its debt instruments.
On our current trajectory of government spending and legislation, it's not far-fetched to see a weakening of our economy, as we impose self-inflicted, crippling increases in energy prices and pollution costs, while spending money we don't have on living standards we will no longer be affording through economic growth.
Add to this the probably loss of global trade through over-priced products, again, thanks to increased energy prices and self-imposed faux pollution costs, and you come to a choice between two very bad options.
Either US tax rates will soar to previously inconceivable levels, depressing demand and wealth creation, or the crushing debt load and interest payments on said debt will result in the dollar's rapid decline in value.
All this near-term babbling about deflationary pressure on the CPI due to demand moderation misses the point.
When other major global resource players openly deny the secret talks that are obviously occurring, on the subject of replacing the dollar as oil's payment mechanism, it's finally very late in the reserve currency game for the US.
How this can possibly be seen by investors as a reason to bid up US equity prices is beyond me.
What about this potential calamity don't investors understand?
Like many other business people, I've read warnings about the loss of reserve currency status for the US dollar for decades. It's usually the same song- large deficits, inflation debauching the value of dollar assets held by foreign governments, etc.
In the past, though, no other nation held out such hope for economic growth with fairly stable regimes and legal frameworks. Next to the US, other potential reserve currencies paled in comparison.
Now, however, the threat takes a slightly different, and more credible form.
First, Arabian oil producers are viewing US military hesitancy over Iran, and potential withdrawals from Iraq and Afghanistan, with alarm.
Add to this an unprecedented flooding of the world with dollars and dollar liabilities. Despite what many talking heads my believe about current modest price deflation due to lower demand, there has never not been a relationship between excessive printing of money and subsequent hyper-inflation of said currency.
Finally, three other global powers or power blocs- Arab oil producers, Russia and China- each have a desire to see the US weakened. It's no secret that post-WWII US power has always implicitly rested on the dollar's reserve currency status.
When our own Treasury Secretary begins to talk up the use of SDRs to replace the dollar, and the US, as part of the G20, lends credibility to this move, the jig is nearly up.
This is, of course, idiocy on the part of the current US administration and its misguided new sense of multi-lateralism and global harmony.
With these forces as context, it becomes chillingly plausible that some major oil producers and a major consumer- Arabia, Russia and China- could indeed jointly agree on a basket of commodities and currencies with which oil may be purchased, none of which is the US dollar.
I'm quite familiar with what would be the counter-arguments to this development. In brief, it will be the repetition of what I, too, used to believe. That current holders of so many billions of US dollars and dollar-denominated liabilities won't dare precipitate the loss of value of their own substantial assets.
The question, now, is at what point these countries essentially choose to finally go cold turkey on the US dollar, reasoning that loss of wealth by a sudden switch to other stores of value is preferable to a few more decades of gradual erosion of value of the dollar.
Google the topic or relative currency values over time and choose any of the results you see. By many measures, be it purchasing power, other currencies, or gold, you'll see that the US dollar has fallen by at least a quarter in value in the past 8-9 years.
Now consider the massive issuance of dollar-denominated government debt in the past year, and the monetizing of that debt by our own Fed. And the coming huge inflationary spending on stimulus, health care and 'cap and trade' bills.
Any thinking person in the rest of the world is watching this and seeing a monetary train wreck ahead for the US dollar and its debt instruments.
On our current trajectory of government spending and legislation, it's not far-fetched to see a weakening of our economy, as we impose self-inflicted, crippling increases in energy prices and pollution costs, while spending money we don't have on living standards we will no longer be affording through economic growth.
Add to this the probably loss of global trade through over-priced products, again, thanks to increased energy prices and self-imposed faux pollution costs, and you come to a choice between two very bad options.
Either US tax rates will soar to previously inconceivable levels, depressing demand and wealth creation, or the crushing debt load and interest payments on said debt will result in the dollar's rapid decline in value.
All this near-term babbling about deflationary pressure on the CPI due to demand moderation misses the point.
When other major global resource players openly deny the secret talks that are obviously occurring, on the subject of replacing the dollar as oil's payment mechanism, it's finally very late in the reserve currency game for the US.
How this can possibly be seen by investors as a reason to bid up US equity prices is beyond me.
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