Screw it, let’s panic.

We’ve been waiting for a move in the green line substantially up or down from the trend. That would be a nice indicator (two months delayed) of an inflationary explosion or deflationary collapse. From a strictly monetary perspective, neither option seems to be winning right now.

If we examine prices, it is possible that money has moved out of certain asset classes and into other asset classes that we, as a society, are more price sensitive to. Wheat prices have spiked recently, though they are still down significantly from their peak in 2008. This could be due to export restrictions in Russia, and not money movements. Coffee prices are way up, though this too might be due to supply issues. In general, food and beverages seem to be increasing in price. These are the prices we care about on a day-to-day basis. Despite this, CPI growth is rather muted. Part of that is due to the fact that the CPI is weighted in interesting ways and then built up out of statistical voodoo. Part of it is due to the stickiness of consumer end prices.

The Fed seems to be embarking on a journey of new and unproven policy decisions. However, those calling for hyperinflation may still be too early on the call. Prices thus far have been more sensitive to politics, trade, and normal supply and demand issues than they have been to actions by the Fed. And the Fed’s journey may not be into territory all that unexplored. QE2 seems to be more of a continuation of current policies than something new. The Fed’s POMO activity is a weekly occurrence. They are now the number 2 holder of US treasuries after China. They surpassed Japan today.

It isn’t that I don’t believe this will end badly. I certainly think that’s the case. However, when it ends is a huge guess. We can panic now, if we like, but it might take some serious determination to maintain a level of panic into the end. It could be days, months, or even years in the future.

(source: St. Louis Fed: FRED Graph)

Still no reason to panic?

I starting looking at this graph to help convince myself (and a few others) that hyperinflation wasn’t going to be the immediate impact of the exploding monetary base. In the passing year, bread still isn’t a thousand dollars a loaf, so it is possible that we haven’t yet had hyperinflation.

At this point, I’m a little surprised these two have managed to track each other so perfectly. As before, the explosion (and wiggly increase and contraction) in the base money supply is entirely explained by the excess reserves plugging the gaping holes on banks’ balance sheets. Neither inflation nor deflation has emerged as a true victor here. All of this is merely a chart of the Federal Reserve’s (successful, so far) attempt to prop up the banks.

Do you know what would be really impressive? If that green line manages to keep on its current trend through the next crisis. Whether that crisis is crunching state budgets, bank failures in Europe, stock market collapse in the US, or any of the other big potential problems, if those red and blue lines manage to track one another, that would be impressive. There’s only a single small bump in the green line during all of that chaos. And do you know what would be scary? If that green line deviates too far from the trend. That means the Fed has lost control of monetary policy. Unfortunately, sometimes authority and effort aren’t enough to determine outcome.

(source: St. Louis Fed: FRED Graph)

Nothing noteworthy happened today on the economics front. But unlike yesterday, I have a few “must reads” for you. They are all on the same topic.

1. US money supply plunges at 1930s pace as Obama eyes fresh stimulus - This is actually from yesterday, and I didn’t particularly think it was worth linking to. AEP is always worth reading, but I felt there were some severe problems with this article (for factual, not ideological, reasons). The articles that this provoked are amazing.

2. M3 Hysteria and a Look M2, MZM, GDP and PPI - I’m presenting these next two links in the opposite order that I read them. I think this is actually the proper order, though I’ve got my own bit after this that is probably relevant. Open them up and complete reading this post first. I promise the ideas presented are worth reading and debating.

3. Is The Collapse In FX Reserves Even More Dangerous Than The Plunge In Money Supply? - This is a borderline hit piece on the first article, but there is some really good stuff here.

The one thing I wanted to say is actually somewhat against the libertarian philosophy, or at least the 1970s version that seems to persist to the present day. AEP quotes an argument about fiscal policy failure as a justification for rapid monetary expansion. It is true, fiscal policy has failed. The libertarian position is that this is likely to happen. This is not quite the same as saying that it was theoretically guaranteed to happen, though the two are often confused.

Back in February (of ‘09), I wrote about Balance Sheet Stimulus. At the time, I mentioned that deficit spending could be economically justified if it improved the asset/liability ratio. What I didn’t mention at the time (and I danced around the issue quite a bit), was what American assets actually are. As I said, we aren’t about to sell the Statue of Liberty or the White House. Instead, our assets are future tax revenues. Future taxpayers are the only relevant asset of the United States. When we question the success or failure of fiscal policy, we should look to see what has impacted our future tax revenue. Have we built new internets? New Hoover Dams? Unfortunately, no. We’ve allowed people to buy food and pay rent. This may have humanitarian benefit, but from an economic viewpoint, it is a failure.

When Keynesians talk about increasing aggregate demand, they are working off of a broken model. Aggregates don’t drill down, and you are lead to believe that spending will spur production. But not all spending is equal. Food and rent don’t increase capacity utilization (one of the metrics monitored by Keynesians). Food and rent represent products made in the US (good for GDP), but demand forecasts are extremely easy in those industries. Other spending looks even worse. Buying flatscreen TVs doesn’t help (those are made in China). Buying clothes doesn’t help (those are made in Mexico). Buying Thinkpads, LG phones, BMWs, or Suave shampoo doesn’t help. In fact, all of those things increase imports, which actually makes our balance sheet worse than before. New homes and new, American cars help. Most paper products help. That’s actually about it until you hit the service industry.

This is why fiscal policy has failed. The money wasn’t spent on anything that will lead to new capital investments or efficiency gains, and therefore the future tax revenues are unlikely to offset the costs. Now, ideologically, I’m predisposed to say that this was guaranteed from the get-go. If you do favor future fiscal policy as an economic cure, you’ve not only got to figure out why it will spur new production, but you’ve got to figure out why the particular spending target isn’t a malinvestment. This is particularly relevant given the new attempts to increase housing production. Sure, houses are built in America, and GDP will go up, but we’ve got too many houses already. Building more will just exacerbate the problem. Anyway, perhaps such failures are guaranteed by some sociological or political rule, but there’s nothing mathematically that suggests such idiocy is necessary (c.f. the consequences of our monetary system). There’s room for ideological debate here.

I don’t dispute that our attempts at fiscal policy have failed. The evidence is quite strong. This doesn’t automatically mean that monetary expansion is the correct response. This idea is a throwback to the 1970s. Unfortunately, the idea got its origin from the libertarian thinker Milton Friedman. And, to Friedman’s credit, monetarism was a big advancement on the prevailing flavor of Keynesianism at the time. The money supply matters. This statement was a breakthrough, believe it or not. Collapsing the money supply is just as damaging as exploding the money supply. However, this doesn’t give moral authority to monetary expansion as a cure-all. When the money supply expands, there is a transfer of wealth from savers to borrowers. Worse, the transfer isn’t uniform or controllable. Those with first access to the new money benefit the most. Who are those people? Historically, those people were government employees. Their paychecks were the distribution point for new money. This is the root cause of libertarian mistrust of government employees’ desire for inflation. But now, government employees don’t benefit first. Wall Street banks are the first to benefit. They are the ones who can borrow at zero interest rates. They are the ones who can buy US treasuries on the open market and sell them to the Fed for a profit. They get leveraged returns on inflation attempts that government employees of the ’70s could only dream of.

Anyway, when the money supply expands, those with first access benefit first. They get the money and contribute toward demand. Then prices rise. Then CPI measures the increase in prices. Then wages for the middle class increase to track “inflation.” Between the time that the new money is created and prices rise, those with first access to the new money benefit. Between the time that prices rise and wages compensate for the increase, the poor suffer. This is the transfer of wealth. This is why monetary expansion must be tracked separately from price increases for those interested in inflation.

When you read these articles, I hope that you read them with a very critical mind. Understand the consequences of fiscal policy. Understand the consequences of monetary policy. Understand that aggregate demand is even more worthless than GDP as a measure of economic health.

Oh, and the Dow closed above 10,000 today (yesterday, it’s late) after closing below 10,000. We get to celebrate that every time, right? Party!

Jeff Miller asks (and I paraphrase to avoid an awkward poop joke): The Fed created a lot of dollars that are sitting on the banks’ balance sheets. Sure, that money may not be circulating through the economy, but we can all see it. It looks like a giant, coiled spring. Doesn’t that impact inflation expectations? Aren’t inflation expectations enough to drive prices (Friedman, 1968 and Carlson, 1975)?

Well, Jeff, I’m glad you asked. That’s a difficult question (Mankiw, 2003). Let’s suppose, hypothetically, that you (or less hypothetically, Mankiw) compared four different surveys that measured inflation expectations and compared them to each other and to either the GDP deflator or to CPI. You would probably find that the surveys were fairly well correlated and also were decent predictors of price movements. Unfortunately, you would find that there were deviations in all of the correlations and that it was hard to determine which survey was going to be the best predictor at any given time. Nuts. You’d probably then propose a “sticky-information” model and defend it as the best explanation.

So what does this tell us? Largely, it tells us that a complete picture of what feeds inflation expectations and how actors react to their expectations eludes us. Certainly, if you see the coiled spring, you are tempted to buy hard assets to hedge yourself. It is a factor, of potentially many factors. But let me ask you:

1. Do you have the money to buy said assets?

2. What do you buy?

If you are one of the millions of unemployed, or the one in ten mortgage holders missing payments, or one of the millions of recently bankrupt, or one of the millions living paycheck to paycheck, you might not have the money to buy said assets. If that’s the case, your inflation expectations don’t move prices.

But let us assume that you do have a pile of cash. What do you buy? Milk? Beef? Rental properties? Gold? What if you don’t have the cash? Do you sell one asset to buy another? Do you borrow money to lever up (since you expect your debt to be easier to repay in the future, post inflation)? Do enough people in your situation arrive at the same conclusion? Is it enough that your group moves from being a price taker to a price setter? All of these can be individually measured, with varying levels of accuracy. There’s significantly more lag on the data for purchases of rental properties than for Gold. We can even track whether people are borrowing more or less. Of course, those are coincident indicators, not leading indicators.

Unfortunately, I’m not much help. I can say that it has not yet been a huge problem. Could it become a problem? Theoretically, there’s not an obvious yes or no. Certainly it is plausible, but you should try to find a trigger. If it were to happen, why hasn’t it already happened? Perhaps you don’t need to answer that question. Perhaps your response is that it already has happened. After all, why the heck did oil prices shoot back up that high when the inventory data was screaming surplus? Why did silver have a quick move higher? My counter-response is that most hard assets are now financial assets. Big players are moving money around quickly, looking for whatever returns they can get. There was a lot of correlation between historically non-correlated assets. Treasury yields stayed low during this time. That tells a different story than just “inflation hedge.” That story reads, “Time bomb.”

Still No Panic

While I’m in the mood to update some graphs, here’s the other one I like. The explosion in the monetary base is still entirely explained by the black hole on the banks’ balance sheets. That blue line (the difference between the monetary base and bank reserves) still appears to be following the trend. In other words, any money created by the Fed exists only for the purpose of pretending our banks are solvent.

On the plus side, this graph means that we’re still not on the verge of hyperinflation due to an exploding money supply. On the negative side, until the game of pretend ends, this is going to act as a huge drag on the economy at large.

(source: St. Louis Fed: FRED Graph)