Financial Sense Newhour Focuses On Energy

The theme of this week's somewhat-truncated Financial Sense Newshour podcast was energy, a topic that's outside the scope of this blog. However, the hosts did pay attention to the resolution of the current debt crisis, and concluded that the most realistic way of tackling it (or of kicking the can down the road) is inflating.

They came up with a good catch: an IMF Staff Position Note entitled "Rethinking Macroeconomic Policy." [.pdf file] The authors of it have joined the small but growing "inflation lobby" within monetary-authority ranks. The gist of it is that monetary officials have been good at responding to crises whose implications they can see easily, but get poleaxed when a system shock comes along that has implications which are hard to assimilate. The "Great Moderation" since the 1980s is credited to better macroeconomic policy, specifically inflation targeting by central banks. The crisis with its deflationary impact, though, shows the limit of current policy. The zero-interest-rate bound makes it impossible to use interest-rate targeting in a deflationary environment. And, the targeting of inflation at too low a level leaves too little of a 'margin of safety' to avoid a deflationary crisis. Fiscal policy has had to fill the gap in the current crisis, even though it's less reliable as a tool than monetary policy.

The authors' take-out is five recommendations for thought. The first, although expressed tentatively, is to raise the targeted rate of inflation to, say, 4%. Although it would raise nominal rates in normal times, it would also provide a larger cushion for deeper rate cuts in times of crisis or trouble.

Granted that they don't explicitly come out of the side of higher inflation, but the questioning nature of their recommendation suggests that they're chipping away at standard procedure. The costs of a higher-inflation approach are mentioned, but are largely rebutted. Not mentioned was the cost of higher nominal rates on debt-encrusted government budgets.


Like many official publications, that one dances around the elephant in the room: an addition to the money supply - creating new currency - means that the new purchasing power has to go somewhere. The confluence of high money supply growth, low inflation and recurrent asset bubbles is no coincidence. To repeat, the new money has to go somewhere. It has to show up in added demand for something.

There are four ways in which newly-created money can shape (or distort) the economy. The first is rising prices: X% money growth translates into X% inflation. This is the standard monetarist model. The second, and most terrifying, is increased demand for cash: the newly-created money gets socked away into cash balances, which indicates a deleveraging process if the cash is earmarked to pay off debt. (In today's debt-ridden economies, that's the most likely use.) The risk for policymakers is deleveraging becoming a kind of anti-bubble, which acquires a momentum of its own as debtors are encouraged by success in getting out of a debt hole into paying off more debt. It's not debatable that this would harm the economy during the deleveraging process, but the long-term effects are debatable. The end game is a lower debt level, and/or a higher savings level, with some swearing off borrowing outright. To the extent that high debt is erosive of ordinary prudence, which does regulate bubbles on the spot, deleveraging could be a long-term blessing.

The third way newly-created money stirs things up is asset bubbles. Instead of going into ordinary goods and services or cash balances, the money increases demand for a specific type of asset. A combination of high money growth and low inflation, and low nominal interest rates, works wonders on the stock market. When nominal rates are high, stocks have to meet a higher bar to compete as investment alternatives. The converse applies when nominal rates are low. Disinflation combined with the same level of money growth or higher, and combined with the "whew" effect of receding price inflation, makes stocks go for a pretty good run if they're not overvalued to begin with. As the market of this last decade demonstrates, though, an overvalued stock market - one coming off a previous bubble - doesn't benefit all that much on the whole. The stock market is the typical venue for an asset bubble, but assets such as housing can form bubbes too if the bulk of the demand for them comes from loans. Lower nominal rates make for a lower mortage payment ceteris paribus, which increases a consumers' "housing carrying capacity" as long as rates stay low. It's no secret that the housing bubble was kindled by very low rates, and kept going by more dubious loan arrangements that kept initial payments low. That's a classic response by lenders benefitting from the fat years which come to an end naturally: lowering lending standards to keep the gravy flowing. To be blunt, turning from lenders into indirect speculators. LCTM did precisely that when their arbitrage opportunites began to vanish.

The fourth way is the most seductive, and the most lethal because of its one-hoss-shay character. It's new money growth translating into a capital-equipment bubble, making for an entire bubble economy. The trouble with this kind of bubble is that it seems far more real than a mere asset bubble. More goods are being produced; companies are hiring; wages are rising. Had it not been for the money-supply figures, it would be difficult to tell this kind of bubble from a great run of economic growth. It's this kind of bubble that's referred to, common-sensically if not quite accurately, as "overproduction." The downside of this bubble bursting is a gutting of the economy itself.

The trouble with policy-makers is that they seem inclined to the fourth kind of bubble. Inflation eventually hurts, although not immediately like deleveraging does. Asset bubbles are easy to take credit for, but they create imbalances and lead to an interst group getting stung when it bursts. They also don't spread very well over the entire economy, leaving a group of relatively dissatisfied citizens (or subjects.) Only the fourth kind of bubble can be spun as the entire country finally coming into its own.

Until the collapse comes. Then, whoever's in charge is at risk of being demonized.


It's a hard lesson of history, but the way to best eliminate economic imbalances - including time-imbalances, which aren't often mentioned - is either a real gold standard, with corresponding credit limitations like 100% reserve banking, or a fiat-money surrogate like Friedman's monetary rule: fixed, 3-5% money supply growth. The trouble with the gold standard is that it's not reassuring to people who want price stability. The trouble with the Friedman rule is that it's too easy to get rid of as "obstructive" when ordinary times of trouble arise. The former depends upon supply and demand, which isn't easy for some to trust in. The latter depends upon a fixed rule being imposed upon an essentally discretionary system.

There's also the value-judgement angle to consider. Evidently, there are more than a few people who regard inflation and asset bubbles as just an intermittent cost of goosing economic growth. Trouble is, we don't know when deleveraging or - worse - economic gutting will set in. Those who like, on balance, the effect of monetary inflation will be partial to quick fixes or capped deleveragings (for high inflation) when trouble sets in. That's the kind of policy-making which is now normal.


P.S.: There's a fifth way in which higher money supply growth can express itself, but it tends to be limited to reserve currencies like the U.S. dollar. Demand for the currency expands in foreign countries. The greenback, far more now than in the 1970s, is used as a parallel currency throughout the world - and not just by shady characters. This "cash-balance revolution" did lessen the inflationary impact of high U.S. money growth in the '80s and '90s.