“By this means government may secretly and unobserved, confiscate the wealth of the people, and not one man in a million will detect the theft.”
—British Lord John Maynard Keynes on the Central Bank It is tradition that once a year after Americans partake in excessive amounts of turkey consumption, they converge to the mall to partake in excessive amounts of bargain consumption. This American tradition is termed Black Friday. Every year, we are reminded how savage American consumerism can be, as we ogle in horror at the Black Friday sales escapades. Black Friday is an idiom that retailers fashioned to indicate the arrival of the holiday season that hopefully carries them into profitability.
The bargain hunting of Black Friday is just as much an American institution as Thanksgiving and apple pie.
So salient is the Fed’s fear of deflation that it is curious why they don’t push for Congress to outlaw Black Friday. Our central bank is petrified of falling prices. They would assume that the low prices disseminated from sharply discounted items would induce a consumption stoppage, a consumer strike of sorts. Instead of Americans trampling over each other to obtain merchandise at a lower cost, we would wait in hope and anticipation that prices would fall even more.
I can imagine we would peruse that 60-inch flat screen TV on Black Friday—
wanting it, but mired in the possibility that the price of the TV could decline further.
After all, prices for electronics tend to fall over time due to productivity enhancements, so why not wait? This quest for lower prices would leave us frozen, incapable of making the purchase. Day in and day out we lay pining for that TV, scouring newspaper circulars—confirming the price decline but again questioning if further discounts lie ahead. So there we sit in front of our 10-inch tube and trying to get the antenna in just the right place—paralyzed by our inability to make the purchase, consumed by our quest for lower prices. Time passes; major sporting events go by, and while we dream of how that big screen will enhance our viewing pleasure, we are transfixed by the possibility of further discounts and rendered unable to make the purchase. And so we wait, in frugal anticipation for the price to fall just a little more. While we are waiting, the entire economy falls to a standstill—our lack of consumerism is contagious. The entire economy would be held hostage in the awful throes of hyperdeflation—deferring our purchase in the hopes of shaving a few more dollars off the ticket price and living in absolute fear that prices will fall further.
According to Fed-lore, once the deflationary monster comes, it is almost impossible to stave off.
So it must be assumed that after eating turkey, the men and women at the Federal Reserve fall into a tryptophan-induced coma and completely miss the coverage of
Americans trampling over themselves in pursuit of deflated prices.
Of course, once the Black Friday sale ends, prices usually rise and shoppers are merely seeking to take advantage of those temporary bargains. And if there were an entrenched fear of protracted deflation among consumers, there could be an increased desire to defer some discretionary purchases. However, I will show in this chapter that inflation is not a better economic condition than deflation. In fact, it is the U.S.
government’s massive proclivity toward inflation that has caused the formation of the biggest bubble in global financial history.
In the following pages, I will put Keynesian Fed-lore like this to the test. In the previous chapter, Paul Krugman and I starred in the reality game show “End This Depression Now!” Watching Paul spend trillions of dollars an episode in a futile attempt to “end this depression now!” paired with my winning at the last minute by allowing the market to prevail was, as you can imagine, a huge ratings success. We were rumored to have nearly secured the front spot in the must-see Thursday night lineup, a spot held before by such heralded shows as Cosby and Friends.
Unfortunately, network executives found the show’s costs too prohibitive—unlike government, capitalism works on a for-profit model. Apparently, Paul cycling through a trillion dollars or more an episode creating nothing of value, followed by his whining incessantly that he would have been successful had the network allowed him to spend more money, failed to garner the support of the network hierarchy. I also heard through the rumor mill that the network was furious after being named in a lawsuit revolving around Paul’s faux alien attack. That, I was told, was the last straw
—the network cut their losses and canceled. It was getting a little redundant for me anyway—sitting there just spinning my thumbs—I am still trying to get the “Girl from Ipanema” out of my mind. For this chapter, I am running solo on my new series—a spin-off of the popular show on the Discovery channel called Myth Busters. My new show is called Fed Busters, and I am going to put popular Keynesian Fed-lore to the test. And by doing so, explain some of the misconceptions that have helped create the Greatest Bubble on Earth.
Fed Busters
There are widely disseminated legends, folklore, and wives’ tales that influence judgment and are born out of beliefs held firm at the Federal Reserve; here, I take on these myths and decide if they are confirmed or busted.
Common Fed-lore Myth 1—The Myth of the Deflationary Death Spiral Monster
The monetary system employed in the United States is based on currency that can be created at a central bank’s whim—by a mere touch of an electronic button. In charge of that button are the men and women at our Federal Reserve, who have a firmly entrenched belief that deflation is the worst of all possible monetary outcomes. Due to this belief, they have taken their mandate of stable prices to actually mean “slightly
increasing prices.” So to you and me, the word stable means not easily moved.
However, to the men and women who control our money supply, it means increasing about 2 percent a year. So determined are they that the economy not be met by the evil deflationary monster that they create inflation of 2 percent (as measured by the phoniest of inflation measurements known as the Personal Consumption Expenditure Price Index). This is done as a buffer or wall to block evil deflation from coming in—
because once that evil deflation monster enters the economy, they fear he will never leave.
The word deflation is a little nebulous in that it is used by economists in a technical way to describe a decline in the money supply. Most laypeople view deflation as a generalized decline in prices. Inflation, in turn, would refer to an increase in prices or, more technically speaking, an increase in the money supply or the fear of such a future increase in its supply that causes a decline in the purchasing power of the currency.
As a follow-up to my introduction on decreasing prices, I have decided to start my critique of Fed myths with the Keynesian Fed-lore of the “deflationary death spiral”;
this Fed-lore is very widely held and promulgated. The men and women at the Federal Reserve believe that a slight increase in prices is a sign of a growing economy and falling prices are devastating.
Let’s put this Keynesian Fed-lore to the test and see how it holds up.
In an economic environment of increasing productivity accompanied by a static money supply, one would assume that prices would slightly decrease. As an industry becomes more productive and makes better use of technology, those technological advances aid in the reduction of costs associated with producing the product. Profit margins improve, and in a competitive environment, businesses will pass most of these savings on to consumers. So with truly stable prices, the costs of many items would go down, and that would be a positive result; it would indicate that businesses were leveraging productivity to increase profit margins and decreasing the price of goods to consumers. However, outside of technology, we rarely see this materialize.
Those at the Fed view any deflation as harmful, regardless of the cause. Ben Bernanke has said that “deflation is in almost all cases a side effect of a collapse in aggregate demand—a drop in spending so severe that producers must cut prices on an ongoing basis in order to find buyers.”1
And so, common Keynesian Fed-lore wisdom affirms—if consumers expect prices to fall, they postpone their purchases, causing prices to fall even further.
Let’s put this theory to the test. If I’m hungry, I am not likely to starve myself in the belief that the salami sandwich I crave will reduce in price—eventually everybody has to eat. Gas prices go up and down, but I am not likely to troll around the neighborhood on empty waiting for the price of gas to decrease. But these are staple goods that some popular inflation models conveniently omit.
In technology, an industry whose efficiencies complement price declines, we fail to observe that the knowledge of the inevitability of lower prices thwarts consumption.
Every computer and big-screen TV shopper understands that if they postpone their purchase for a year, they will more than likely get something bigger and better for the
same amount or even less. If the Fed’s deflation theory were accurate, we would have to assume that nobody would ever buy a computer, an iPhone, or a flat-screen TV;
according to this wisdom, they would be waiting for the newer and cheaper model.
According to common Keynesian Fed-lore, if people were aware that the price would go down, they would delay their purchase.
Now you may be thinking, “Pento, what about housing? Isn’t everybody holding off on buying a house, anticipating that prices will go down?” Well, not really so much.
The truth is that the mortgage-lending market has, thankfully, returned to some form of sanity and the job market remains anemic. If consumers had their erstwhile access to credit and a viable form of employment, people would be buying houses. Think about it. Let’s say a newly married man tells his bride that he is postponing the purchase of their first home until prices bottom, and he thinks it could find a floor in just a few years. But in the meantime, since their rental doesn’t come with a washer and dryer, his beloved needs to walk several miles to the laundromat—he told her car prices had a bit more to drop, too. The bride would be more inclined to walk to the nearest divorce attorney’s office. And remember, housing is an area that the Federal Reserve and the federal government has yet to allow to form a bottom that can be supported by the free market. We saw the opposite in the stock market: without a tremendous amount of government manipulation, the stock market was allowed to bottom—that was a painful process. However, once the market found its bottom, it soared. People stopped waiting for stocks to go down and started worrying about missing the rally. The same thing would happen to housing if it were allowed to reach a true bottom.
The Truth about Price Deflation
Historically, we have seen long stretches in U.S. history when prices gently fell and wages remained stable. This price deflation didn’t lead to disaster; on the contrary, it was consistent with real economic growth. After all, what’s so bad about falling prices? We increase our standard of living when goods and services become more affordable through technological improvements. Declining prices increases our aggregate ability to spend and offers consumers that were shut out by those formerly high prices the opportunity to now raise their standard of living.
During the 30-year period 1870 to 1900, the United States experienced a period of true price stability coupled with a period of great prosperity. This period of the classical gold standard was marked by gently falling prices and increased productivity that raised living standards and gave us the first glimpses of globalization.
In fact, the 1880s were described by some to be our most ebullient and prosperous decade. While prices fell, the U.S. economy prospered. Industry expanded; the railroads expanded; physical output, net national product, and real per capita income all roared ahead. For the decade from 1869 to 1879, the real national product grew 6.8 percent per year and real-product-per-capita growth was described by Murray Rothbard, in his book, History of Money and Banking in the United States: The Colonial Era to World War II as “phenomenal” at 4.5 percent per year.2
This is a piece of history that Keynesian Fed-lore doesn’t talk about. The Fed was
created in 1913; this was a time before the Fed. There was no pseudo–government entity creating inflation under the guise of maintaining stable prices. There was just the gold standard and 30 years of stable prices coinciding with 30 years of prosperity and advancement.
As costs fall through innovation, profit margins remain. In contrast, far from achieving long-run price stability, the Fed has allowed the purchasing power of the U.S. dollar, which was hardly different on the eve of the Fed’s creation from what it had been at the time of the dollar’s establishment as the official U.S. monetary unit, to fall dramatically. A consumer basket selling for $100 in 1790 cost only slightly more, at $108, than its rough equivalent in 1913. But thereafter the price soared, reaching
$2,422 in 2008).3
People associate deflation with the awful Great Depression, but most don’t know that the consumer price index (CPI) steadily fell (albeit much more gently) from late 1925 through 1929, in the midst of the Roaring Twenties — hardly a time associated with economic stagnation.4
Furthermore, the 1970s dispelled the myth that inflation and high unemployment rate/recession can’t coexist, as the pre-Volcker Fed of the 1970s thought they, too, could inflate their way to prosperity. They ended up creating a condition known as stagflation—rising prices and zero economic growth. This was largely responsible for the malaise of the 1970s (in case you thought it was caused by bell-bottom pants).
I’ll have more to say about the relationship between inflation and the unemployment rate when I debunk myth 3.
Unlike the Volcker Fed—which crushed inflation with unprecedented hikes in the Fed Funds rate—Mr. Bernanke may find it nearly impossible to raise rates without causing massive economic carnage. The reason is clear: the level of debt outstanding in both public and private sectors has increased to the point where servicing it becomes impossible without artificially induced low interest rates that remain low forever.
In the first quarter of 1980, the financial obligation ratio (FOR)—a measure of household debt service as a percentage of disposable income, which includes rent and automobile leases—was 15.9 percent. It is now over 16 percent. So why worry? The number is the same simply because interest rates plunged from 20 percent to near zero percent. If interest rates were to normalize, that number would soar. To illustrate that point, the FOR pales in comparison to the level of household debt as a percentage of gross domestic product (GDP), which is now 85 percent of total output. Back in the early 1980s, by contrast, it was just 46 percent. On the public-sector level, the numbers are just as grim. National debt as a percentage of GDP has now reached 104 percent of output, while in 1980 it was a mere 40 percent.
Just imagine the stress on the consumer and the government that would be experienced if the Fed were to raise rates aggressively, as Volcker did. How could the consumer continue to service his or her mortgage and how could the U.S. Treasury finance the titanic national debt if rates were to increase much above today’s levels?
The problem with inflation is real. That’s the monster that the Fed is creating that should be feared. That’s the monster that should be the cornerstone of Fed-lore
because when the inflation monster comes, Bernanke’s counterfeiting isn’t going to slay it—it will feed it.
After Volcker slew the evil inflation monster—that monster that Fed-lore conveniently overlooks—throughout most of the 1980s and 1990s the U.S. exercised a strong dollar policy where we enjoyed a stable dollar, strong growth, and low unemployment, proving once again that a strong dollar, stable currency, and economic growth can all happily coexist.
However, today the Fed is exhaustively fighting a decline in prices, opting instead to keep prices at what their popular models would show as a modest inflation rate. The key point they totally miss is that deflation must occur to reconcile the imbalances created by decades of inflation. Asset prices must fall, money supply levels must shrink, and debt loads must decrease. But they are doing even more damage than just creating a huge bubble in the Treasury and bond market. As soon as they engage in another round of counterfeiting, the first thing to rise is food and energy. This is how it works: It first involves the purchase of an asset by the central bank. The Fed issues electronic credits to banks in exchange for their assets, which include Treasuries and mortgage-backed securities (MBSs). Their purchases drive up the demand for those assets, bringing about rising prices. In fact, Bernanke has clearly stated that the purpose of his “quantitative easing” (QE) program is to raise the rate of inflation, which in his mind is too low.
What the Fed is accomplishing is a reduction in the purchasing power of the U.S.
dollar. It creates inflation by vastly increasing the money supply, and thus lowers the confidence of those holding the greenback. If international confidence in the dollar is shaken, most dollar-based asset prices will increase—with the exception of U.S. debt.
When people perceive that the value of their dollar is decreasing, they cling to hard assets like gold, oil, and commodities.
Individuals with low to moderate income levels spend a disproportionate amount of their disposable income on food and energy; thus, a rise in commodities affects low to moderate incomes in a more substantive way. In contrast, those who are the owners of hard assets like gold and real estate see the value of their items increasing—they are the primary beneficiaries of the Fed’s counterfeiting. Bernanke may think that by inflating away debt and reducing borrowing costs he is allowing consumers to deleverage. But he conveniently overlooks the negative side of that equation: the destroyed purchasing power of the low and middle classes. Lower wage earners typically don’t own precious metals, stocks, and multiple homes. And they see the central bank’s phony money last—if they do at all. Therefore, many are struggling today with falling real incomes and are unable to reap any benefit from the Fed’s inflation. By not allowing low wage earners to benefit from what would naturally be the outcome of deflation—falling food and energy prices—the Federal Reserve has become the most pernicious redistributor of wealth—stealing the purchasing power from the poor in order to inflate the balance sheets of the wealthy.
The truth is that the Fed always has the means to inflate. Even if all the banks were unwilling to make one new loan to the private sector, the Federal Reserve could fund the federal government, which in turn could issue $100,000 checks to everyone. Not