Burning Bridges and Halfway
Houses
by Antal E. Fekete
Professor Emeritus, Memorial University of Newfoundland
March 22, 2005
The corner-stone of my deflation theory is the observation that
there is a double-bias in speculation caused by the central bank's
open market operations as it removes risks from bond (but not from
commodity) speculation, and rewards bond bulls (while punishing the
bears) [4]. This double-bias distorts the economy in favor of deflation.
It is palpable only when deflation is present in the economy in the
first place, in which case it is made worse than it need be by prompting
speculators to compete with the central bank in buying the bonds.
Interest rates fall and through the mechanism of linkage prices fall,
too, as the flow of money from commodities to bonds accelerates.
In the worst-case scenario a vicious circle is activated and the
economy plunges into depression.
The question arises why mainstream economists didn't discover the
deflationary bias and alert central bankers to mend their ways. The
answer is that they did. However, they had to proceed gingerly. The
bridge of the gold standard leading back to monetary sanity and rectitude
had already been burnt. They were looking at the incurable congenital
disease of the regime of irredeemable currency. Mainstream economists
could not talk openly about the dangers of snowballing bond speculation
without exposing the fatal inner contradictions of their monetary
regime. The diagnosis therefore had to be couched in the language
of the liquidity trap.
The term originated with Keynes himself, who in the second half
of the 1930's noted that his contra-cyclical prescription to inject
new money in the economy through central-bank purchases of bonds
in order to combat falling prices wasn't working. In fact, it produced
just the opposite effect of what he had hoped. Deflation got worse,
not better. As always, Keynes was ready with the explanation. The
disease was so advanced that the patient didn't readily react to
medication as it was supposed to. The first dose of money-injection
administered by doctors from the central bank could not spread through
the diseased organism but, instead, accumulated in a "liquidity-trap".
Nevertheless, Keynes was for continuing the money-injection therapy.
He was confident that, ultimately, prices would move higher, as they
had to according to the Quantity Theory of Money. Of course, Keynes
would not admit that the main cause of the malady was the earlier
surgical intervention at his behest to remove the gold standard.
Pallas Athena Born in Full Armor
As the ownership of monetary gold was made illegal in 1933, the
only competitor to government bonds was removed from the arena. The
rising demand for bonds drove bond prices to unprecedented highs
and the rate of interest to unprecedented lows. The federal funds
rate even went negative. Member banks were actually paid a premium
for taking money overnight from the Federal Reserve banks.
At that point in time bond speculation was still unknown in the
United States. But just as Pallas Athena was born in full armor when
she sprang from the skull of Zeus after her father's bizarre pregnancy
ended in a splitting headache, so did bond speculators, a whole army
of them, spring from the skull of Keynes in a remarkable replay of
the mythological story. The speculators did not need any training.
They were ready. They did not need any capital, either. It was made
superfluous by the forcible removal of gold as a competitor of government
bonds. Speculators (read: the banks) were literally paid by the Fed
to take the money to buy the bonds. Thereafter their only worry was
to write up their assets month-after-month, quarter-after-quarter.
Why should the banks risk their money by lending it to ailing business
to help the recovery, when they could invest it in steadily appreciating
bonds, risk-free? The world had never seen anything like that before:
banks betraying their mission to finance business and concentrating
their resources in bond speculation. And why not? Not only did the
continuous injection of irredeemable currency into the economy by
the Fed make bond speculation risk-free, it actually guaranteed profits
on the bond portfolio. The stock-market craze of the Roaring Twenties
was nothing in comparison. The largest speculative orgy in history
was on. It was in the 1930's, and it was in the bond market.
Of course, the theory of liquidity traps does not mention bond speculation.
The s-word is taboo. It talks about liquidity being mysteriously
siphoned off and channeled into a trap where it could not exert its
beneficial effect on the economy. As the central bank fighting a
recession drove interest rates close to zero, the fruits of any further
monetary expansion would be stuck away in mattresses and cooky jars
where they could do nothing for the economy. The process is described
in detail in the first edition of Samuelson's textbook published
in 1948 used in training Keynesian economists.
Truth be told, the "fruit" is not put in mattresses and cooky-jars.
It is taken by the speculators to the bond market where the miraculous
multiplication of money is taking place. But you are not supposed
to utter the s-word as it would conjure up the fatal flaw of the
regime of irredeemable currency.
The chapter on the liquidity trap did not stay in Samuelson's textbook
for long. It was deleted from subsequent editions. Interest rates
were edging up, and the author didn't think that there was a danger
for them ever to come down again to the vicinity of zero. Surely
inflation would see to that. The Fed convincingly demonstrated its
power in ending recession after recession. There seemed no reason
to doubt that it could always do so whenever needed [1].
The regime of irredeemable currency was firmly implanted in the
economy, and the central bank could control practically everything
with the possible exception of the weather.
The Interest-targeting Cabal
While out of textbooks, the liquidity trap was not out of ivory
towers. It was still being discussed in the rarified atmosphere of
academia. The world center for liquidity-trap studies and for the
inflation-targeting cabal is the Woodrow Wilson School at Princeton
University in New Jersey. Under the leadership of department head
Ben Bernanke a team consisting of Paul Krugman, Lars Svensson, and
Mike Woodford has been busy investigating the liquidity trap and
finding ways to unplug it through inflation-targeting should it get
plugged again. The Princeton plumbers worked out esoteric mathematical
models to show that, indeed, the danger of liquidity traps was real.
Here is the verbalization of their mathematical hocus-pocus. (A less
polite expression, the title of [1], could also be used. I stay with
the more polite one. As Krugman points out, according to Goodwin's
Law, the party that blinks first and mentions bodily wastes loses
the argument.)
The cabal turns on the concept of "potential output". It is defined
as maximum output consistent with a stable inflation-rate. (Please
don't heckle the plumbers with interjections that a stable inflation
rate is an oxymoron.) If actual output exceeds potential, then the
rate of inflation will rise; if below potential, then it will fall.
In the latter the Princeton plumbers sniff great danger. Suppose
that, for whatever reasons, the economy is operating below potential
output (there is an "output-gap"). Then the situation is no longer
stable. We are staring right into the liquidity trap. Disinflation
makes inflationary expectations fade, leading to more disinflation,
whereupon inflationary expectations fade more. The vicious circle
is on and pushes the economy right into the liquidity trap. Once
that happens, the central bank can pump money into the economy as
much as it wants, it will all end up in the liquidity trap. The output-gap
will worsen, leading to even lower inflation, and so on. The thing
to worry about is the spiral of declining output relative to potential,
and fading inflationary expectations [1].
Krugman adds the punchline: "zero is not a big number, whether for
growth, or whether for inflation" [2]. In plain language, if you
want growth, you had better target inflation, and target you must
well above zero. The trouble with fading inflationary expectation
is that it jerks the rug from underneath the interest-rate structure.
Please note how the Princeton plumbers studiously avoid any reference
to bond speculation, a hard fact of the economy, and substitute
for it "fading inflationary expectations", a soft economic
euphemism.
The Japanese Bubble Bursts
So when the Japanese bubble burst, the Princeton plumbers were ready.
The Fed quickly tapped Ben Bernanke, bringing him to Washington and
making him the heir-apparent to Greenspan. Recent rumors have it
that the threat of the Japanese sickness is so serious that Bernanke
will have to be moved from Constitution Avenue to Pennsylvania Avenue,
right into the White House, to head the council of the President's
economic advisors. Well, we won't have to wait too long to learn
where upstairs the head-plumber will be kicked.
By 1996 Japan looked an awful lot like a country in a classic liquidity
trap. And that was scary. It meant that "our grandfathers were not
as stupid as we thought" in the words of Princeton plumber Paul Krugman,
who is moonlighting as staff writer for The New York Times.
A 1930-style slump may not be that easy to fix, after all. A disease
we had thought was under control reappeared in a form resistant to
all the known antibiotics. Japan's trap was real.
But if Japan remains stuck in that trap, who cares? Well, you should.
Not only is Japan the world's second largest economy; until recently
it seemed to be the economy of the future. Worse still, if it could
happen to Japan, why not to us? [1]
As the Princeton plumbers must not utter the s-word in public, talking
about the mechanism whereby depression can metastasize across the
Pacific is taboo, too. This mechanism is the yen-carry trade whereby
bond speculators are doing arbitrage between the Japanese and the
American bond market. They sell the ultra-high-priced Japanese bonds
and buy the relatively cheap American. The net effect is to push
interest rates in the United States down to the unprecedented low
levels prevailing in Japan.
Can Deflation Be Prevented?
This is the title of an article [3] written by Paul Krugman six
years ago when he was still at MIT, from which the following quotations
are taken. What gives it timeliness is that those six years have
not solved any of the underlying problems but, in many ways, the
economy has deteriorated in the wake of the continuing exponential
growth of debt and its symbiotic parasite, bond speculation.
"The cover story from The Economist makes it more or less
official. Deflation, not inflation, is now the greatest concern for
the world economy. Over the past year, producer prices have fallen
throughout the advanced world; consumer prices have been falling
for the last 6 months in France and Germany; in Japan wages have
actually fallen 4 percent over the the past year...
"So far none of these price declines looks anything like the massive
deflation that accompanied the Great Depression. But the appearance
of deflation as a widespread problem is disturbing, not only because
of its immediate economic implications, but because until recently
most economists - myself included - regarded sustained deflation
as a fundamentally implausible prospect, something that should not
be a concern.
"The point is that deflation should - or so we thought - be easy
to prevent: just print more money. And printing money is normally
a pleasant experience for governments. In fact, the idea that governments
have a hard time keeping their hands off the printing press has long
been a staple of political economy; dozens of theoretical papers
have argued that the temptation to engage in excessive money-creation
causes an inherent inflationary bias in fiat-money economies. It
is largely to combat that presumed bias that most of the world has
accepted the notion that monetary policy should be conducted by an
independent central bank, insulated from political influence - and
has been written into the charters of those central banks that they
should seek price stability as their main, often only, goal.
"Yet here we are, with deflation turning out to be a serious problem
after all - and with policymakers finding that it is not as easy
either to prevent or to reverse as we all thought.
"How can this be happening? What does it imply for policy? The purpose
of this note is to argue that more or less conventional economic
theory actually does suggest some answers to these questions - but
that these answers fly in the face of conventional policy wisdom.
And because the answers are so hard to accept, deflation is indeed
a real risk."
We may skip the hocus-pocus part of the article and go directly
to its conclusions.
"The obvious answer to sustained deflationary pressures, then, is
the now-notorious proposal for 'managed inflation'... But the idea sounds
crazy, and that is a problem. How can we get finance ministers
and central bankers, who have spent their whole careers preaching
the evils of inflation and the virtues of price stability, to accept
the idea that price stability may not be an available option?
"For if deflationary forces are as powerful as they are in Japan
- and may soon be in the rest of the world, if The Economist is
right - there is no middle ground... Attempts to find a halfway house
- to aim merely for stable prices rather than sufficiently high inflation
- will be doomed to failure.
"In short, if you really believe that deflation is now a global
threat, you should also believe that only policies lying outside
of the realm of what is conventionally regarded as responsible will
contain that threat. And because unconventional thinking is not what
one expects (or, in normal times, wants) from finance ministers and
central bankers, there is now a real risk that deflation will indeed
become a global scourge."
Thus concludes the article. It nicely explains what has happened
in the intervening six years. The powers that be were scared by the
deflationary threat much more than they ever admitted. Without any
hesitation they took the advice of Krugman, abandoned policies "conventionally
regarded as responsible", unilaterally betrayed their mandate, burnt
the halfway house of price stability, and hit the warpath of inflation,
euphemistically calling it "inflation-targeting".
One Irresponsible Monetary Policy Deserves Another
What Krugman conveniently ignores is that inflation may not be 'manageable'
like a per dog. More like a hungry tiger sniffing blood, it could
get out of hand following reckless increases in the money supply.
Just as burning bridges, burning halfway houses is not a very good
idea. Mainstream economists burnt the bridge of the gold standard
and made it the whipping boy for the Great Depression. Through that
bridge we could have retreated to monetary rectitude after the insane
experiments with the fiat dollar. Now they burn the halfway house
of price stability, too. Where will the Fed find shelter after the
tornado of runaway inflation has struck?
The seriousness of the problem cannot be overstated. A steep rise
in interest rates at this juncture would be the horror of horrors.
Normally higher interest rates would strengthen the value of the
currency as they attracted foreign investors. Not this time. Apart
from pricking all the bubbles in the economy starting with the housing
bubble, and ballooning the budget deficit, there is the larger problem:
the effect that steeply rising interest rates have on the value of
bonds held widely at home and abroad. The effect is inevitable and
instantaneous. Higher interest rates make bond values collapse.
You have to be very clear in your mind about this, so I spell it
out. The dollar losing value on the foreign exchanges because of
the trade gap is one thing. Dollar-bonds losing value due to higher
interest rates is another thing. Nevertheless it is entirely possible,
and right now appears highly probable, that the two losses will be
inflicted simultaneously. The loss in bond values will compound the
loss in the value of the dollar. The compounded loss shall exceed
the critical mass of bearable losses, and will trigger a chain reaction
of further losses. The confidence in the dollar will be fatally and
irreparably shaken, domestically as well as internationally.
Yet I don't think that the dollar will be wiped out at this time.
The Fed must have a contingency plan to prevent a steep rise in interest
rates. Paraphrasing Krugman, if you really believe that runaway inflation
is now a global threat, you should also believe that only policies
lying outside of the realm what is conventionally regarded as responsible will
contain that threat. One irresponsible monetary policy deserves another.
The contingency plan to prevent a steep rise in interest rates will
have to involve a conspiracy between the Fed and the Bank of Japan,
to punish speculators short-selling the dollar and dollar bonds.
Nothing else is left in the Fed's bag of tricks other than check-kiting
between the Fed and the Bank of Japan that could contain the furious
forces of monetary destruction waiting in the wings. Never mind that
it is conventionally regarded as irresponsible. Never mind that it
is illegal. Never mind that it is criminal.
Nothing else could defer the day of reckoning.
References:
[1] Elephant Shit, by Paul Krugman, May, 2003
[2] Zero Is Not Enough, by Paul Krugman, May, 2003
[3] Can Deflation Be Prevented? by Paul Krugman, February,
1999
[4] Is "Linkage" Broken? No, the Symmetry of Speculation Is,
by Antal E. Fekete, March, 2005
------------------------------
Dr. Antal E. Fekete is an economist and monetary theorist, born
and raised in Hungary, who taught for many years in Canada. He also
worked in the Washington D.C. office of Congressman W.E. Dannemeyer
for five years on monetary and fiscal refom until 1990. Since 2001
he has been consulting professor at Sapientia University, Cluj-Napoca,
Romania. In 1996 Professor Fekete won the first prize in the International
Currency Essay contest sponsored by Bank Lips Ltd. of Switzerland.
He is the author of numerous scholarly articles and the widely read Monetary
Economics 101. His articles are archived at www.goldisfreedom.com.
