In 1913, President Woodrow Wilson was successful in publishing the Federal Reserve Act through Congress. The act allowed the government to establish the third central bank in the nation’s history.

Think of the Fed as the bank of banks, and the government’s bank — the gatekeeper of the U.S. economy. The board, which is run by seven governors and presided over by a chairman and vice chairman, is charged with managing the supply of money and credit to the economy. By manipulating interest rates and creating money, the Fed can either stimulate or stifle the economy. The Federal Reserve is the primary force in determining our nation’s money supply. The Fed’s two main goals are (1) to help stimulate economic growth and (2) to try to keep inflation low. These goals often conflict.

The central bank Federal Reserve System has a tremendous amount of power and a monopoly control over money and credit. The chairman of the Federal Reserves is more powerful than even the president because he has so much control over the economy. The Fed is the key to how much money and credit is in the U.S. economy in any given time. This is due to the fact that the United States currency is a fiat money — in other words, it is not backed by anything tangible, and therefore it can be created out of thin air.

The U.S. dollar was not always a faith-based currency. There was a time when for every dollar in circulation, there was a coinciding amount of gold to back it up — a gold standard.

“In the nineteenth century, starting with the Napoleonic Era, all the major money systems of Europe were anchored by gold,” Bill Bonner explains. “All of these countries had gold lining their systems, so when they traded with one another they could either trade their gold, or if you traded paper money, it was certain that there was gold backing their currency.

“And that system was very, very successful. The prosperity of the nineteenth century was amazing,” Bonner continues. “But that system broke down in World War I; the governments, as they always do, spent too much money. Britain borrowed too much, the French borrowed too much, and then they couldn’t pay it back because they didn’t have enough gold to pay that kind of expense.”

Even so, that gold-backed system lingered on throughout the twentieth century — but not perfectly — and the last stage of this system was Bretton Woods, which lasted until 1971.

Bonner tells us: “Prior to 1971, we had the Johnson administration, we had the Great Society and the Vietnam War, and those things were very, very expensive. And somebody told Johnson, ‘Wait a minute, you can’t have both guns and butter. You can’t have a huge domestic spending program and the Great Society, at the same time that you have a huge war going on in Asia. That won’t work, we can’t afford that.’ At the time the Democrats, led by Johnson, said, ‘Oh yes we can; we’re a big rich country, we can afford both guns and butter.’ Well, sure enough it wasn’t true, and they couldn’t afford that much without raising taxes, and they didn’t want to raise taxes because then they wouldn’t be reelected. So they had this big problem. And what resulted from that was a run on America’s money.”

Other countries, especially the French, led by Charles de Gaulle, noticed that the dollar was weakening. So de Gaulle told then-President Nixon that he wanted to exchange the dollars France had for gold. Nixon examined the situation and realized that if France took all of that gold, the United States would not have much gold left, and in turn decided to close the gold window. That was August 15, 1971, and since then, no foreign government could trade dollars for gold.

Money Supply and Inflation

Now, with the Bretton Woods System a thing of the past, when the Fed determines that the economy needs a stimulus, interest rates are lowered, borrowing becomes easier, and more money flows into the economy. This is known as opening the Fed window, and the result is an increase in the money supply. If the money supply is increasing, consumers are feeling wealthier and more money is changing hands as they buy goods and services.

This puts a chain of events into motion. Businesses see increased sales and therefore order more materials and increase production. This, in turn, increases the demand for labor and goods. What happens after that, in a buoyant economy, is that prices of stocks rise and firms issue equity and debt. If the money supply continues to expand, the prices for these goods and services begin to rise, especially if output growth reaches capacity limits — in other words, a bubble is formed. As the public begins to expect inflation, lenders insist on higher interest rates to offset an expected decline in purchasing power over the life of their loans. When inflation is rising, the dollar is quickly losing value, and the Fed raises interest rates, which means borrowing becomes more expensive and money eventually flows out of the economy.

When the supply of money fails, or when its rate of growth declines, economic activity declines and either disinflation (reduced inflation) or deflation (falling prices) results. Closing the Fed window decreases the money supply.

In a worst-case scenario, the economy can become stagnant and inflation can rise simultaneously, a situation called stagflation. The Fed is then faced with an extremely difficult choice, because it can’t raise interest rates and lower them at the same time. It must choose either to stimulate the economy or to fight inflation. This last happened in the United States in the late 1970s, and it proved to be very difficult time for the country.

The forces of inflation had been picking up steam throughout the 1970s, and the prices of just about everything were hitting record highs. Pete Peterson, then secretary of Commerce under the Nixon Administration, remembers this period in U.S. history clearly. “I was in the Nixon White House,” Peterson recalls, “first as an economic adviser to President Nixon and then as secretary of Commerce. History will record the Federal Reserve was part of the problem. They let money supply get out of control. When Paul Volcker took over he realized he had to take truly courageous action. And he did.”

Dr. Volcker’s office in New York City is adorned with poster-size caricatures depicting the former Fed chairman as a warrior, battling runaway inflation. And these cartoons are hardly exaggerating. Over the din of the ice skaters enjoying themselves at Rockefeller Center, 20-odd stories below. Dr. Volcker told us the tough medicine he had to spoon-feed the United States when he took the helm of the Federal Reserve in 1979. Inflation had reached a “crisis point,” he said, and in less than a year, the Fed’s key rate rose from 10 to 19 percent.

“Inflation,” explained Dr. Volcker, “gets built into expectations, and when people think it’s going to happen it affects their wage demands, it affects pricing policies, and it has a certain built-in momentum, which clearly happened during the 1970s.”

While his raising rates to an all-time high certainly caused some controversy, Dr. Volcker did what was necessary to achieve and sustain stability in the U.S. economy — and found that, overall, the country was ready for him to step in.

“I think the mood of the country was willing to accept action, which ten years earlier they wouldn’t have been willing to accept,” he told us. “And once the country got caught up in an anti-inflationary effort, while they were difficult years, I think there was a certain acceptance of a willingness to take, among other things, very high interest rates and eventually a rather severe recession, [because] there was this underlying core that the country had not been on the right path economically and that it needed to be shaken up, in a sense, to restore stability. And that faith not only sustained me, it sustained the country.

“One of the lessons of the early 1980s is don’t let inflation get started because once it gets momentum it’s very difficult to deal with, but it’s also destructive for economic growth and prosperity. If that happens — and right now it seems like there is a little flavor of it — we will all find ourselves in the days of stagflation and unacceptable economic performance.”

As Dr. Volcker suggested, current economic indicators show we’re entering a similar cycle in the economy. In the second half of 2008, Americans’ inflation expectations have jumped to their highest level since 1981, according to the Reuters/University of Michigan Surveys of Consumers. Not only that, but growing concerns over the country’s two largest buyers of U.S. home loans, Fannie Mae and Freddie Mac, drag down the already hurting U.S. stocks; the price of crude oil hits a new high every day; and consumers are seeing their grocery and energy bills grow by leaps and bounds.

“With respect to the fiscal crisis looming out there in the future,” says Paul Volcker, “We’ll see whether a democracy can deal with an obvious problem that’s going to be present in not too many years. The earlier we take action to deal with it, the better.”

Addison Wiggin
Executive Publisher, Agora Financial
Executive Producer, I.O.U.S.A.
October 6, 2008

Greg’s Endnote: Addison and co-author Kate Incontrera have a lot more to tell us along with some fantastic interviews with Bill Bonner, Pete Peterson, Ron Paul, Paul Volcker, Alan Greenspan, Warren Buffett, and more. You can get your copy of I.O.U.S.A. at Amazon.com by clicking here.

“I.O.U.S.A.” Excerpts was originally featured on Whiskey and Gunpowder

There has not been a chairman of the Federal Reserve Board with sound monetary instincts since Paul Volcker resigned in 1987. It was Volcker who brought the dollar back from the brink of hyperinflation in 1987.

On May 14, Volcker testified before Congress. Scattered around the monetary world, and particularly influential in Europe, there is a group of central bankers who admire Volcker, as I do myself, and share his analysis of the present situation. The Volcker analysis is very similar to that of the European Central Bank, and to that of Mervyn King, the governor of the Bank of England.

Volcker testified that the Fed ought now tackle the threat of inflation more forcefully. He is particularly concerned about the danger of a return to the conditions of “stagflation” of the 1970s. The Bank of England also expects that the next two years will see the pressure of rising inflation combined with low rates of growth. In the 1970s, this unpleasant combination of economic trends resulted from the loose monetary conditions of the early 1970s and the oil shocks of the mid-1970s.

Those who experienced the 1970s were taught a painful lesson about the negative effects of inflation. In standard monetary theory, some emphasis is given to the initial phases of inflation, in which an increasing money supply funds economic expansion and tends to cause booms, bubbles, and speculation.

Less attention is usually given to the second stage of inflation, in which prices rise; interest rates are increased; and economic growth rates, after an acceleration, begin to slow down. There is an illusion that inflation is good for growth; that is true of the first stage, but only of the first stage. Staglation, in which rising prices are accompanied by reduced growth, comes as a second stage.

Volcker warned Congress that he saw a “resemblance” between present monetary conditions today and those of the early 1970s, when the economy had an overall tendency toward rising prices, including big increases in energy and agricultural prices. He observed, “If we lose confidence in the ability and the willingness of the Federal Reserve to deal with inflationary presses and to sustain confidence in the dollar, we’ll be in real trouble.”

On the same day, the Bank of England published its latest quarterly forecasts and came to much the same conclusions. The bank’s inflation projections will not return to the 2% target figure until early 2010, which suggest that it will have no room for rate cuts until then.

Britain and the United States have different political cycles. The next presidential election in the United States will come nearly two years earlier than the next British general election; the latest date for a British general election will be June 2010. The Bank of England’s economic forecast suggests that there is little chance of interest rate cuts much before that time. The government’s reluctant tax cut on the lowest income tax band will strengthen the bank’s hand in keeping interest rates at their present level.

Mervyn King observed that “The consequences of price increases would be a squeeze on real take-home pay that will slow consumer spending and output growth, perhaps sharply.”

There exists what might be termed the Volcker consensus that inflation has returned as the real threat to world economic conditions. This consensus includes Paul Volcker himself, the Bank of England, and the European Central Bank. It does not include Ben Bernanke, the Fed, or the current president of the United States. After November, we may find out whether it includes the next president of the U.S.

Regards,
Lord William Rees-Mogg
May 15, 2008

The Danger of Stagflation was originally featured on Whiskey and Gunpowder

Let’s take a look at two definitions and a comment:

1. “Sluggish economic growth coupled with a high rate of inflation and unemployment” (American Heritage Dictionary)

2. “A condition of slow economic growth and relatively high unemployment — a time of stagnation — accompanied by a rise in prices, or inflation” (Investopedia.com)

3. “Investopedia commentary: “Stagflation occurs when the economy isn’t growing, but prices are, which is not a good situation for a country to be in. This happened to a great extent during the 1970s, when world oil prices rose dramatically, fueling sharp inflation in developed countries…For these countries, stagnation increased the inflationary effects.”

From above context, stagflation seems to be based on rising prices (instead of an expansion of credit), and furthermore, the term seems to imply that rising prices are bad only in context of the “stag.”

An Austrian View of “Flation”

Inflation — Expansion of money and credit

Deflation — Contraction of money and credit

Disinflation — Expansion of money and credit, but at a declining pace

Hyperinflation — Rapid rise in inflation accompanied by a complete loss of confidence in currency

In Austrian terms, I find little use for such a term. Where exactly does it fit in?

Several days ago, I sent an article that called for “stagflation” to a good friend of mine who posts under the name “Trotsky” on Kitco. We had not discussed that term before, but knowing his Austrian leanings, his answer did not surprise me at all. It is as follows (Note: He does not capitalize his sentences):

“what immediately comes to mind is that the term was coined with a Keynesian mind-set — as if it were a new phenomenon that sort of ‘just happens’ without a sensible explanation at hand. at the time of the 1970s K summer, economists had been conditioned to associate economic downturns with deflation — the inflationary recession of the early 1920s was long forgotten. when suddenly recession coincided with the effects of the concurrent inflationary monetary policy becoming highly visible, something happened that wasn’t supposed to happen. so they thought it required a new term — ’stagflation,’ equaling recession cum inflation, the supposedly ‘unnatural’ state of affairs. Obviously, once you define inflation correctly (expansion of the fiat money supply), such a term makes no sense. especially considering that the Keynesian (as well as monetarist, i might add) recipe for ‘combating economic downturns’ consists of deficit spending cum monetization, i.e., printing lots of money, as a matter of course! perversely, application of this recipe leads only to bigger failures (proven by EVERY major application of it, including, IMO, the most recent one, which only created yet another surge in malinvestment, namely the housing bubble).

“the only reason why at times the inflation seemingly ‘works’ and at other times doesn’t is that the initial conditions, as defined by the K seasons vary. IMO, there are two aspects that play a role — the state of the pool of real funding (if it is shrinking, no amount of monetary pumping can even create the illusion of a new boom — that’s Japan from ‘89 onward) and the size of the private sector debt extant at the conclusion of the last boom.

“note that the term ‘boom’ is actually a negative term, or should be. during the boom, which is itself a result of lax monetary policy, capital is malinvested and the economy’s production structure damaged/distorted. the bust is the economy’s attempt at RECTIFYING the mistakes of the boom by liquidating malinvested capital and redirecting those resources to their optimal use (usually, that entails the realization that assumptions about future demand were simply wrong, as they are based on the illusion created by the credit expansion).

“anyway, the rarer condition of deflation as we understand it in the context of the fiat system is simply a credit contraction so massive that it overwhelms the countervailing attempts of the central bank to inflate. one must not forget the credit was largely created from thin air — in a deflation, it simply goes back there.

“in any event, ultimately, ’stagflation’ does not describe anything really…even though we know what it is meant to describe. simply put, it’s the type of bust where the usual inflationary policy is noticed by everybody because prices and wages start to rise everywhere (because the ‘debtberg’ is still able to expand further).”

An Austrian Debate

Actually, I think the origin is probably far simpler. Someone wanted to talk about “stagnation” and accidentally said “stagflation” or perhaps said “stagflation” purposely trying to be cute. In any case, the word stuck, but as Trotsky pointed out, the word makes no real sense from an Austrian point of view. Yet it is only from the Austrian point of view that I wish to debate anyone on inflation.

That last sentence is key, and it has caused a lot of frustration recently. In addition, I keep responding to the same questions over and over again from e-mail and replies to blogs, many from people that do not know (or refuse to accept) what inflation is. In other cases, people are just now finding my blog and just happen to be asking a question I have addressed elsewhere a dozen times. Here are some of the typical questions:

“Mish, doesn’t the rise in the price of oil prove you are wrong?”

“Mish, you still haven’t explained how we can have a falling U.S. dollar and deflation”

“Mish, the U.S. is not Japan”

“Mish, how is your favorable view of gold consistent with deflation?”

“Mish, isn’t it about time for you to throw in the towel?”

“Mish, inflation is our past, present, and future”

And so on and so forth, with no one adding anything to the debate.

One of the problems I face is that people want to be a part of the debate, even though they refuse to accept the terms of the debate. Austrians in general would accept the “Flation” list above (or something reasonably close); others do not. Unless one can agree on definitions, however, there can be no meaningful debate. People keep telling me I am wrong when they do not agree to the terms of the debate.

Following are three people whom I believe do agree with those “Flation” terms as defined above:

1. Marc Faber
2. Steve Saville
3. Robert Blumen

Note that I said they agree with those definitions. All of them disagree with my position. Taking the other side of a debate with Faber is dangerous, but we agree on far more things than we disagree on. Faber also admits deflation is possible (even if unlikely). Most inflationists will not even grant that.

Anyway, I want to thank Robert Blumen for his piece “Must Bernanke Choose Deflation?” simply because he not only agrees with the terms of debate, but he also made a serious effort to understand what I am saying. Hardly anyone else has bothered to try. If you are new to this discussion, not only do I ask you to read Blumen’s article, but to click on all the embedded links in his post and read those too. Unless you do that, you cannot understand what I am saying or why.

Blumen disagrees with my position, but there is nothing wrong with that. Should unanimous opinion ever form on something economically related, I confidently predict we would all be wrong, and probably sooner, rather than later.

Questions Answered

I will reply later to his rebuttal, but for now, I want to address some of those questions above.

Q: “Mish, doesn’t the dramatic rise in the price of oil prove you are wrong?”

A: No, the price of oil could be rising for many reasons, and perhaps much of that price is related to Peak Oil, dwindling supplies, and geopolitical concerns, rather than directly to monetary expansion. One cannot know for sure what causes any price increase, and that is a key reason why attempting to define inflation by looking at prices is dead wrong. It simply cannot be done. At any rate, prices rise and fall for many reasons, so one simply cannot look at prices to decide if there is inflation. My views on deflation are forward looking, and in response to an expected credit collapse in housing. For now, I freely admit there is inflation, as credit and money supply are still expanding, but note that it is possible for oil prices to keep rising, perhaps dramatically, even during deflation on account of Peak Oil.

Q: “Mish, you still haven’t explained how we can have a falling U.S. dollar and deflation”

A: I have not explained how, because a falling dollar is not part of the equation. Inflation is an expansion of money and credit. Rest assured, there was inflation when the U.S. dollar index hit an all-time high of 120. Rest assured the U.S. dollar can sink even in a contraction of money and credit. I am not saying the dollar will fall — I am saying it could fall. More than likely, the dollar will hold its own. If it falls, I have many reasons why it is unlikely to crash (anytime soon). For starters, it has already collapsed in just a few short years. Everyone thought the euro was trash a few short years ago, and now everyone seems to be a euro bull. That said, I do think the dollar could crash much later on down the road, after debt is wiped clean. A dollar crash will probably occur after everyone gives up on it. In the meantime, I expect savings will rise, and in a worldwide economic debacle, there will be safety in U.S. Treasuries. Note too that many other fiat currencies look just as bad from where we are now. Ideas about hyperinflation with a housing bust and loss of jobs and a worldwide economic bust seem rather silly to me. You are free to disagree, of course. For a more complete discussion of the U.S. dollar, please consider “Is the U.S. Dollar Toast?”

Q: “Mish, the U.S. is not Japan, and besides, Japan really did not have deflation anyway”

A: I never said the U.S. was Japan. And yes, there are big differences. In fact, I have outlined many of those differences between the Japan and the U.S. Some factors, such as demographics, favor the U.S. for avoiding deflation versus Japan. Other factors, most notably consumer debt, are a bigger problem here. Even though we are not Japan, I expect the deflation experience here will be quite similar. Part of that was addressed in “Inflation: What the Heck Is It?” And as for “Japan being a nation of savers” and the U.S. being not: That fact will actually make the snapback to the mean all the more vicious for over-expanded retail stores of all kinds. The U.S. was once a nation of savers, and will likely be again.

Q: “Mish, how is your favorable view of gold consistent with deflation?”

A: This question is really simple. If one views gold as money, it will be hoarded in deflationary times. Housing and equities will both plunge relative to gold, even if gold just manages to stay flat against the U.S. dollar value. That is the key idea. I believe that gold will more than hold its own, but there are no guarantees.

Q: “Mish, isn’t it about time for you to throw in the deflation towel?”

A: On the verge of victory? No chance. One of the conditions required for my deflation scenario to unfold was a housing bust: a loss of jobs and income, and rising bankruptcies. Housing is just starting to bust, and eventually that will affect jobs and income. The scenario is just now finally starting to play out.

Q: “Mish, inflation is our past, present, and future”

A: Spoken like a person that has not studied history. Yes, three-quarters of the time, those believing in inflation will be correct. K Cycles are long cycles, lasting up to 80 years in length. By the time a deflationary winter is upon us, most people have known nothing but inflation all their lives. That is why no one sees deflation as a possibility. Memories of 1930 are long, long gone. Note too that length makes timing it a problem. In a 60-80 year cycle, pinpointing the start is not that easy to do. If housing is the “bubble of last resort,” as I believe it to be, we can be in a world of hurt over the next seven years or more.

Those questions and similar ones keep coming up again and again and again. I thought I would address them all in one place, and of course, everyone is free to disagree with my conclusions. That said, one cannot have a rational discussion unless one agrees to definitions, and I choose to accept Austrian monetary definitions. In that regard, stagflation is simply not the answer to the “Flation” debate. It has little to do with “Flation” at all, from my point of view.

Mish Addendum: I started writing the above last Thursday. No sooner do I finish writing the article, but right before posting it, a good friend of mine going by the name “Chispas” on Silicon Investor sent me a link to a Forbes article on the topic.

What are they doing reading my mind? Or can it be vice versa? Regardless, let’s briefly consider “If It’s Not Stagflation…”:

“It’s not stagflation, but no one can seem to agree on the new term for an economy in which growth is slowing while inflation is rising, such as it is today.

“Could it be ‘fearflation,’ a term that means it’s all just fear, rather than actual inflation that’s driving the current economy? Maybe it’s ‘bubblenomics,’ as the U.S. seems to be stuck in a bubble of higher prices, growing unemployment, high housing prices, and a falling dollar. Then again, it could be ‘transflation,’ the cycle of high gas prices leading to higher inflation. Or how about ‘moderflation,’ a slowing down accompanied by inflation?…

“Of course, if Bernanke is to be believed, it’s not inflation we need to fear, but expectations of inflation…

“So maybe we should describe the current economy as ‘Fedflation.’”

Eleven terms were submitted to Forbes to describe the current economy. Click on the above link to see them. YES, I agree with Forbes that it’s NOT stagflation (at least someone agrees with me), but NO, we do not need another term for it. With that thought in mind, I changed the title of this article from “Stagflation Anyone?” to the current title selected, because, quite frankly, I am “Flationed Out.”

Regards,
Mike Shedlock ~ “Mish”

May 1. 2007

Flationed Out was originally featured on Whiskey and Gunpowder