Inflation?

by Jim Davies

Exclusive to STR

January 8, 2009

You'll be wondering about that question mark.  

As Dave Barry so accurately put it, “. . . the troubled 'big three' auto makers . . . ask Congress for $25 billion, explaining that if they don't get the money, they will be unable to continue making cars that Americans are not buying.” Others suggest that once bailed-out, the Big Three will no longer make cars, but will just keep paying the pensions to their former workers, which they so foolishly promised way back when. So it does seem that fewer goods are being produced and that a reduced level of production will continue for quite a while.  

Since a vast amount of new money has been deliberately injected fresh from the government print-room into the economy, surely there can be but one result, when that larger sum of money chases the smaller quantity of goods: a serious price hike, starting later this year. Steep price inflation looks like a sure thing.  

However, my first reason for adding the question mark is that prices are actually set by vendors, and if--as now--vendors are scrambling to keep solvent and make sales, they will not rush to raise them. If survival is at stake--and for many, it is--they will more likely reduce prices, so as to make at least some sales and stay in business, albeit with poor or zero profits. We can see this happening right now; retailers marked goods down before Christmas, and even further afterwards. Gasoline prices have dropped 60% in six months. House prices are down 20% from their 2005 peak, sometimes more, and stocks are down by a third or so. All car makers are pleading for customers with strong incentives. Possibly these trends may reverse later this year, but for now they are very clear: despite all the huge "injections of liquidity," prices are tumbling off cliffs.  

My second reason comes more as a question than an assertion: I am wondering where the money went, when trillions were wiped off housing values and the stock market. Yes, the Fed is injecting new money, a trillion or two of it, but was that not more of a partial replacement for lost money, than the creation of new currency where none previously existed? If it was, then the above premise--that more money is chasing fewer goods--is incorrect; yes, there are fewer goods, but no, there may not be much more money, if any. We say rightly that the former price rises in housing and stocks resulted from the irresponsible creation of money by Greenspan and Bernanke, so now that those bubbles have burst, must it not mean that their excess money has vanished in a puff of smoke? Perhaps we don't actually know how much money is there at all. Perhaps its total supply is actually down, not up. Perhaps government statistics about money supply (inadequate anyway, since M3 is omitted) are simply incorrect; perhaps they record how much currency was created, but not how much was destroyed.  

Was any destroyed? It's not easy to tell. If one asks Google "Where did all the money go?", a variety of answers pop up from all manner of experts, not one of whom shows signs of understanding that the Fed creates money out of thin air, let alone that prices rise as a consequence. Since they don't appear to understand the question, their answers are unpersuasive.  

One view is that no, none was vaporized. Take a house, the Fed-inflated 2005 price of which was $500K but which is now down to a less unrealistic $400K. Where is the missing $100K? Owner-occupier John has a $450K loan and enjoys living in the house, so he lost nothing, except expectations. His mortgage banker is still getting paid to the terms agreed (because John still has a job) and so he, too, lost nothing--yet. They say money may be distributed differently, but it's still there, in the system.  

What was lost was merely a book entry in John's net-worth account. He thought he had a $500K asset of which $50K (say) was net equity which might be used, thanks to a further home-equity loan, to put young Patrick through a year of Harvard; but now, he doesn't. He's in the hole for $50K, so Patrick will have to flip burgers and go to night school. But still, does that mean the money supply shrank?  

A quick reference to Murray Rothbard's trusty What Has Government Done to Our Money reminds us that fiat money is fabricated by an engine with two parts: first the Feds write a large IOU to the Fed, which the latter buys with a kited check. Then the Feds use that large influx to make payments to their suppliers, employees, supporters, clients, pimps and hangers-on, which the latter deposit in their local, friendly Federal Reserve member bank. As the second part of the engine, each such deposit can then be loaned out again to the extent of 90%. Those loans get re-deposited, and so the cycle goes; an original billion-dollar IOU turns after some weeks or months into a ten billion dollar supply of new "money."  

So in John's case, the money supply may not have shrunk, but it did fail to grow as expected. The reason is that if he'd had that net home equity of $50K, he would have taken out a new loan to pay Patrick's college bill, and that money would have been plucked from thin air as above by the bankers' "fractional reserve" system, the magic wand that creates money; but he didn't.  

If John never takes out the $50K loan, because the book value of his house went down instead of up, a wrench gets tossed in to that engine; nothing is created beyond the original IOU injected by the Feds. The fall in John's house value has therefore stopped the fiat engine in mid-crank; back in D.C., the magic wands are being waved, but the rabbit remains in the hat.  

This may be why there is so little hesitation in that city about rushing through bills that flood the economy with very large sums; $750 billion a couple of months back, another trillion coming up shortly . . . if that $1.75T were being created in normal times, some months later it would get magnified to $17.5 trillion by the fractional-reserve multiplier, and that would take the money supply from about $12T to nearly $30T in less than a year; an unprecedented explosion of "money" that might well be fatal to an economy upon which, ultimately, even politicians depend. So why their reckless abandon?  The explanation may be that they have done this calculation already and know that this time, the multiplier will not work. They are therefore "safe" in throwing out such large sums--and if their arithmetic should happen to be a bit off, they can always force a change to the fraction; that is, forbid banks to lend more than, say, 40% of their deposits instead of 90%.  

Still, this explanation suffices only to suggest that the money supply will not grow as fast as one might have expected--not that it will actually shrink. For it to shrink, John or his neighbors must not only fail to take out new loans, they must also pay down loans that they already have. Is that happening, or will it soon happen?  

Yes, I think it is. Every month that forty four million mortgage holders make a payment reducing the principal owed, that's exactly what they do; so if new mortgages are not being written to replace them, deposits in banks will fall and the fractional-reserve engine will work in reverse--destroying money, instead of creating it.

And are new mortgages being written to replace them? No! Because houses are selling very slowly, and when they are sold, the price is lower than it used to be so the new mortgage for the new owner is for a smaller amount than its predecessor. Further, an unprecedented number are in foreclosure, meaning that the lending bank is having to write off a large part of its former loans.

All those factors mean that the fractional-reserve part of the government's inflation engine has flipped. It may be this is the first time that has ever happened, but it seems to me likely that it's happening now. What an exciting time! No wonder that none of the King's Men seem to have any idea how to put Humpty together again.

I could be wrong about this and have not seen any more scholarly writer put it this way, but I think that in the past few months, a vast amount of money has, for just these reasons, disappeared; and so that the frantic attempts to use the first component of that engine--the issuance of IOUs to the Fed, in multiples of $100B--have not had and will not have their normal consequence of high inflation. I have no idea how to calculate what supply of money really is out there now, nor how much may be destroyed or created in the coming months; but I suggest that despite the shrinkage of goods being produced and despite that largess of the Feds, there isn't much of a supply increase, if any at all, and so there's no reason to expect significant price inflation in the coming year.

Only events will prove me right or wrong, but a possible early indicator that I may be right comes in an estimate of M3 published by nowandfutures.com and reproduced here. It shows that in spite of all we may have supposed, while its absolute total has continued to rise a bit, the rate of increase in the total supply of US money has fallen like a rock, from 17% to 7%, since the middle of 2008. Go figure.