June 2010


A Richmond Va. Federal Reserve Economist, Kartik Athreya wrote a paper recently that trashes economic bloggers. Mr. Artheya has a PhD from the University of Iowa.

Writers who have not taken a year of PhD coursework in a decent economics department (and passed their PhD qualifying exams), cannot meaningfully advance the discussion on economic policy.

The response of the untrained to the crisis has been even more startling. I listen to Elizabeth Warren on the radio fearlessly speculating about the nature of credit market dysfunction, and so on.

The real issue is that there is extremely low likelihood that the speculations of the untrained, on a topic almost pathologically riddled by dynamic considerations and feedback effects, will offer anything new. Moreover, there is a substantial likelihood that it will instead offer something incoherent or misleading.

The sophomoric musings of auto-didact or non-didact bloggers or writers is instructive. For those who want to really know what the best that economics has to offer is, you must look here.

The general public are simply being had by the bulk of the economic blogging crowd.

The views expressed are my own, and do not necessarily represent those of the Federal Reserve Bank of Richmond, or Federal Reserve System.

Go on my son!

I purchase a house in America. I am granted a mortgage from a bank, that creates the funds from fractional reserve lending, viz credit creation.

This credit creation, is not real, it is backed by nothing, not even existing fiat currency. Therefore, legally, the bank have provided no consideration in contractual terms.

Without consideration, I owe them nothing, thus, I need pay nothing on that mortgage.

Food for thought.

Wise words. Unheeded. History rhymes.

There is a good piece on ZeroHedge that summarises the deflationista’s position well, using the arguments of their two intellectual heavyweights, Mish and Steve Keen [Australian economist] Let’s have a look:

The deflationists have a different take on the data. They point to theories by economist Steve Keen which states that first banks make loans, and then the Fed increases money supply to meet demand. According to Keen and Mish, money supply is created first by banks making loans, then by the Fed supplying the money, because you can’t increase money supply without getting it into the economy. If there is no lending the money supply remains unchanged. Thus it is a rise in credit that leads to money supply growth.

This chain of causality is correct. The making of a loan precedes the expansion of total money. The bank creates a new deposit [loan] from a fractional reserve of an existing deposit, which might be a fractional reserve loan from yet a previous deposit.

The take home point is however that, loans precede, and create the expansion of credit and money in the system.

Mish also argues that excess reserves don’t really exist; they are a fiction created by the Fed, a mere computer entry. If you consider all the loans made by lenders, and the actual or potential defaults of their loans, those losses would absorb all the “excess” reserves. Therefore, those “reserves” are more or less spoken for and don’t represent money for making new loans.

This is also true. However, the ability to create new credit by the government, is in theory, unlimited. Thus the losses suffered by lender X can be made whole by the government creating the fiat money to pay his credit. In reality, this of course leads to unmitigated disaster via an inflation that destroys the function of money.

Thus, new deposits or reserves, in excess of current losses, can be created at will by the Federal Reserve. Thus Mish’s argument is incorrect in it’s conclusions.

Mish also believes that reserves aren’t the problem with banks; rather it is their shaky capital base. Lending is constrained by their lack of capital and financial instability rather than by reserves.

This is essentially a nonsense argument. Reserves, simply because they are fractional reserves, and not a 100% backing, and because they are loans based on DEMAND DEPOSITS and not TIME DEPOSITS, have created the dichotomy which directly correlates to the instability and lack of capitalisation within the banking system

The deflationists say that because the size and breadth of the crash in the real estate markets and related debt, the problem is too big for the Fed to handle. Until debt is deleveraged and banks and businesses repair their balance sheets, the Fed’s effort to increase the money supply is like pushing on the proverbial string.

I would agree that the problem is too large for the Fed. I also agree the way forward is to de-leverage and liquidate.

The problem is that the Fed and government refuse to allow this to happen. They are fully committed to inflating their way out. This has since the 1930 debacle been their only policy response. Time-after-time, inflation is the methodology chosen. No different this time.

The result is that real estate asset prices are declining and that results in deflation. They say it is similar to what the Japanese experienced in the late ‘80s and ‘90s, when they experienced almost zero growth, no inflation, and declining asset values. Banks, they say, are not going to lend until this deleveraging occurs and businesses become solvent and creditworthy.

True asset prices are declining. That asset prices are declining however is not sufficient to create a deflation. What is necessary is a repudiation of debt, or default.

The problem with declining prices rests on the fact of the securitization of mortgages. That these MBS have a transparent market price, that fluctuates, that impacts the Balance Sheets of the financial institutions holding them on a mark-to market basis, created the deflationary or liquidity issues for the banks, based on their fractional lending model.

Why?

Because their lending was based on demand deposits which are deposits that have to be paid [liquidity] on demand, not at maturity, which a time deposit allows. Thus, a run to liquidity, forces the banks to run to the central bank, to provide the liquidity, to close demand deposits upon demand.

The deflationists say that the current measures of prices are inaccurate because they don’t reflect the declining values of real estate. If real estate was factored in, then prices would be shown as declining.

This is true, and the exact reason that the government has taken the toxic securities onto the governments balance sheet – to prevent transparency of falling prices, further driving a run to cash.

The only measure of real estate in the CPI computation is what is called the real estate rental equivalent which measures the rental value of homes rather than their asset value.

This is correct. It is the rental value that should be included. Mish’s argument for deflation centres around the following assertion:

I believe housing belongs in the CPI. Regardless, the Fed could have and should have taken housing prices into consideration instead of following a fatally flawed OER as its measure of housing prices.

Let’s first define exactly what the CPI actually is.

CPI’s measure the cost of a basket goods and services purchased by the average household each month. The baskets composition and weighting are usually based on surveys of household or family expenditure habits.

Now whether you argue that CPI’s are useful or worthless, that at this juncture is simply irrelevant. What is relevant however is that it is monthly expenditures.

Here then the argument shifts to rent, or, mortgage payment. Any difference quantitatively or qualitatively? No, not really. On that basis I have no issues with either being included. There will of course be quantitative differences in the CPI for those who take variable rate mortgages as opposed to fixed rate mortgages, they will likely be more volatile – that however is not Mish’s point.

Mish wants house prices included in the CPI. This under the definition of the CPI is simply nonsense.

As in the case of any other good, the capital value of land is equal to the sum of its discounted future rents. The value of the land increases as the capitalization rate falls with interest rates. Thus when the Fed lowered rates, the present value of the implied future rents on land became more valuable.

Ground land, then, is ‘capitalized’ just as are capital goods, shares in capital-owning firms, and durable consumers’ goods. Why is land classified as a capital good? Essentially the answer is durability. Land, is for all intents and purposes, eternal and unchanging, as such, it is capitalised, because otherwise it’s value becomes infinite, and it could never be bought or sold for money.

The raw land cost is generally 10 to 25 percent of a home. In 2001, the Bureau of Land Management (BLM) sold government-owned land to developers for $26,672 per acre in Las Vegas, Nevada. Four years later, BLM acreage was going for $270,000 per acre. So while land prices were increasing tenfold, the medium new-home price shot from $130,000 in December 2000 to $350,615 in early 2006.

They suggest that prices are indeed falling anyway if you look at Core CPI (CPI less energy and food) on a year-over-year percentage change basis:

Pure nonsense argument. Sure if you look only at data that supports your argument, then you’ll find corroboration. Everyone needs to eat and use energy. To exclude these components is simply untenable.

We understand that inflation or deflation is a monetary phenomenon, not just an increase or decrease in prices. And, in order to cause inflation new money must find its way into the economy.

So how is the new money finding it’s way into the economy?

*Increased Welfare payments
*Deficit Spending [public works etc]
*Bailouts [removing toxic assets to Fed Balance Sheet]
*Open Market Operations
*Bank lending
*Expansion of government payrolls

Let’s start to provide the data to support the above assertions:

First off, consumer loans. The argument has been that the banks are not lending. The data does not support this argument. The data actually shows a tremendous expansion of consumer lending by some $400 billion dollars. This is not chickenfeed.

The second chart shows the overall impact on total lending here the story is different, showing that total lending is off from it’s peak in 2008. This is the impact of business lending.

Where has the ability to lend and create credit come from? Directly from the swap of toxic assets for government backed assets.

Here we view the power of fractional reserve lending in leveraging the creation of credit. $440 billion of demand deposits and $1.2 trillion of government securites support the consumer loans of $1.2 trillion. This is a levearge factor of 1X This same base, also supports total loans [including businesses] of $9 trillion which takes the leverage up to 9X This leverage is highly dangerous and unstable, and the predominant reason why the government will not allow a true deflation, and will inflate till currency destruction, or hyper-inflation intervenes.

Expansion of government Welfare [payments] system:

These payments represent the creation of new money and credit, that is directly placed into the economy, directly into the hands of consumers.

How do we know that it is new money?

The difference represents the deficit that to provide their services [expenditures] government must create the new money [credit] to fill the gap or deficit.

As can be seen, the total currency, which is only part of the money and credit creation has been increasing inexorably. The deficit has exploded, which again illustrates the creation of new money and credit.

Last, but not least, the expansion of government bureaucracy:

In summary, the expansion of money and credit, and most importantly the transferance into the economy directly into the hands of consumers is progressing at a frightening clip.

The economic data reflects this inflation. Economists also realise that the increase in the economy is simply the effects of government spending, it is not real in any shape or form.

The question is then: will government continue to inflate, or, not? The answer to this question will provide the answer in how to position yourself for the economic conditions to come.

I posit that government will continue to inflate for three main reasons: first, historically, that has always been their response. Second, the consequences of allowing a deflation, from the level of debt built into the economy, are simply too terrible for a politician to contemplate. Third, they simply have no ideas other than Keynesian prescriptions of ever increasing inflationary measures.

Take your pick, you simply can’t lose baby! Moslernomics at work.

Obviously the UK are delusional. We have our own fiat currency, beholden to no-one else, unlike those pathetic European slobs, why are we raising taxes, VAT, and making budget cuts?

Doesn’t our new chappie at the helm realise that, f**k this austerity nonsense, we can print up the hundreds of billions of pounds sterling, and have a few extra quid left over, and just pay cash, up front, on the head if you please sir, and be done with it.

Mr Mosler, you obviously need to phone our chappie, and you know, educate the recalcitrant fellow to the benefits of Moslernomics.

Obviously, early. While this is by no means a minor problem, I’m reasonably confident that the major error is being early, and not a really botched call. Of course, the proof will be in the pudding. For the moment, over the W/E, I’m happy to sit in the position. On a side-note, I have been looking at timing issues, and think I have a fix, I’ll see how this pans out into the future.

What does this chart show?

It shows the YoY changes in M2 money supply. The deflation gang will quite correctly direct you to the changes from 2008 to today. At the peak, money, via M2 was inflating at 10% per annum. Currently it is inflating at about 1% per annum.

This claim the deflationists, is deflation. If you measure todays rate against 2008, yes, relative to 2008, we have disinflation, or deflation. However, it is still an inflation rate in M2 of 1%

How, in the wake of a housing sector melt-down nationwide, unemployment at 10%, long term unemployment at levels not seen since the 1930’s do we have any inflation?

The answer of course is that the government, simply will not countenance any deflation at all. Therefore, to offset the deflation engendered via the housing collapse etc, they have been moving all this imploding debt onto their balance sheet, to avoid accounting practice of marking-to-market, and hence the bankruptcy of the major money centre banks – Citi et al.

Hence, in a chart that should be deep in the red zone, to reflect the huge debt destruction taking place, we have a chart that is still in the black, with a government deeply committed to further inflation to offset any further losses.

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