Stealth Inflation and the last ten years, what your professor didn't teach you

In our last post we spent a considerable time discussing inflation and monetary policy and their interrelation with the fundamental health of our economy. Today I would like to talk about stealth inflation. First I will give a brief overview of what inflation is, how it is monitored and what it means to you.

Inflation is measured as a change in the price of products over a period of time. It is measured not based on a single product but on the overall prices of all products. While given products and commodities may fluctuate based on market conditions, the sum of all products should remain stable unless certain economic inflationary or deflationary conditions exist. These are:

An increase in the supply of products, deflationary prices will drop

A decrease in the supply of products, inflationary prices will rise

An increase in the supply of money, inflationary

A decrease in the supply of money, deflationary

An increase in the demand for money, deflationary

A decrease in the demand for money, inflationary

An increase in the demand for products, inflationary

A decrease in the demand for products, deflationary

Ceterus Paribus (and it never is), make sense?

Lets redo the list of factors , shall we, notice any patterns

An increase or decrease in the supply or demand for products OR

An increase or decrease in the supply or demand for money

Last week we talked allot about changes in the supply of money. We discussed quantitative easing/debt monetization and its effect on wealth and we considered briefly how it can effect your financial well being through inflation.

Lets take a closer look.

In the last 18-24 months the United States and the World have experienced a decrease in the demand for products and a increase in the demand for money. This is the credit crunch, as people suffer economically they try to hoard cash, people lose their jobs and stop consuming, banks become less stable and stop lending and demand for products decreases while demand for money increases.

To compensate for these problems we have laid off workers and injected capital into the markets through massive government expansion and direct loans to banks. We have gone so far as to directly purchase companies.

Laying off workers has decreased the supply of products.

Injecting capital has increased the supply of money.

Thus we have experienced very little real deflation despite the magnitude of the economic downturn because we have effectively increased the price of products by making them scarcer while simultaneously increasing the supply and availability of capital.

So what is stealth inflation?

First we need to consider what has happened with prices.

Lets take a look at what has happened over the last, say, ten years.

Gold is currently 1090.60 per ounce. In 1998 it was 294.24.

As has been observed before, do to recent turmoil in the markets, the stock market is effectively flat over a ten year period.

....

I took a little break here, and I have to apologize to reader, I got busy with school and did not finish the post. Gold is now currently... 1219.80 an ounce.

...

Lets get down to business, since neither I nor you have time. What is all this stealth inflation stuff about anyway?

Stealth Inflation is devaluation of a currency in the face of price stability. Wait, wait, wait... go back?

Lets look again, the dollar is way down, and gold is way up. Put in other terms, unless you want widgets your money is eroding like sand underneath your feet.

This is possible because what we have always aimed for is price stability. Congratulations, prices are stable.

But the US currency is collapsing, it wont be long before a lot more people see it.

Note: I am not saying the problem is unsolvable, simply that it is big, present and ugly. I have an idea.

About this blog

Just a reminder that this is an anonymous and non-academic blog.

This is intended as a forum for discussion of current economic issues and the ideas posted here have not been researched to the standard that should be expected of final conclusions.

I invite comments and discussion on the matters posted.

Also, since most of what is written is single draft, grammatical and typographical errors can be expected.

Theo

Redistribution of wealth on a grand scale, the present solution (and there was much rejoicing)

For those of you in doubt of the veracity of my last post, take the approach the government is currently using.

I found this to be enjoyable, but I am afraid slightly more technical than the audience I aim my little, oh what shall we call them... stories, at.

http://seekingalpha.com/article/166269-debt-monetization-he-s-heading-for-that-small-moon?source=feed

Debt monetization means literally printing dollars to buy back the national debt (which has been issued in various bonds, bills and notes) so, for example, if your grandparents bought you a federal savings bond for college, that was a part of the national debt. The government is going to print some dollar bills and hand them to you in return for that bond. (this is again an oversimplification but still on the point, in actuality they create bank reserves which has the same effect).

Debt monetization or as it can be called on a smaller scale, quantitative easing (adjusting interest rates). Is one way to create inflation/stimulate the economy as I discussed in my last post. Is it bad? It is redistribution of wealth on a grand scale. To understand this you need to understand how the government works.

The government can pay for its operations and expenses wars, healthcare etc, in three ways.

First, they can tax people and businesses and goods to get dollars and then expend those dollars right back for people (employees), businesses (the army, navy, department of human services) and goods (artillery shells, fighter jets, concrete for roads, iron for buildings). This is non-inflationary it cannot create inflation because the money supply does not change. HERE IS A SUPER SECRET: It can create deflation if we tax people but don't spend the money, for example if we try to repay the national debt to china. This could be deflationary in our market. Irrelevant for our current discussion, but something to keep an eye on.

Second, they can borrow money. The government can issue government debt, in the form of treasury bills, bonds, and notes (they are different, it depends on when they mature). This is actually semi-deflationary, (if you view the world from a perspective of a private and public economy, which most people don't) since it tends to pull money out of the private sector and give it to the government to spend, which does not always make its way back into private sector enterprise. But lets not go there today.

Third and finally, they can simply print money. This is called debt monetization because, in practice, the way it works is that rather than taxing money for revenues to repay their issued debt instruments they simply print and repay. They "monetize" the debt. This is a dangerous game. The trouble with debt monetization is that it is fundamentally unfair. Or so some would argue. You can decide for yourself later. The government is weakening the dollar by printing more. So If I saved money my whole life in a cookie jar and now have a million dollars. and the government doubles the money supply (the term for the total amount of "dollars" real or imaginary extant, my million dollars is worth half as much when I try to exchange it for goods) This is the same thing as inflation but on a grand scale. It is called hyper-inflation and tends to spiral out of control. This is what won a certain african nation the ignoble prize for "in one year printing denominations of currency between .01 and 100,000,000,000,000; for those who don't like counting zeros thats one hundred trillion dollars. It is also what led to a Germany where a loaf of bread costs a wheel barrow full of Deutsch Marks.

What are we arguing about then? Well, you cant have deflation (bad) and hyper inflation (really really bad). What we are aiming for is inflation, somewhere in between. So the trick is, as always to print THE RIGHT AMOUNT OF MONEY. This will solve our current economic problems, or so say the people in Washington who are in charge and charged with solving it. Now its time to learn something.

What are we trying to do again? Create inflation. Why? Well, what did we learn last week? Oh yeah, I remember, people have things, they think they are worth allot, it turns out that no one can afford to buy them (tune in next time for a discussion of purchasing power and intergenerational equity). But they don't want to drop the price cause they are convinced it is worth allot. (I got this thing and it is f#$%ing golden). But the only way to get out of this recession is to redistribute wealth by affecting a lower price across the market. This would be deflation right so that is bad? So what is the government right now actually trying to do?

Rather than letting you sell your house for less we are going to print more money so that everyone has more of it, of course it is worth less, but you will get for your house what you think it is worth. And coincidentally, what your bank thinks its worth because that is how many dollars they loaned you for it. So you can repay your mortgage. Everybody's happy. (and there was much rejoicing).

It all works out in the end...

So whose the patsy?

"If you don't know who the patsy is, odds are, you're the patsy!"

"Its all about the Benjamin's." If I have $50,000 and you do what you want to do. I will still have $50,000 but it will only get me half as much. Guess what, YOU'RE THE PATSY. You, yes you out there, anyone who has money. Note... not anyone who has things. People who have money. Becuase things maintain their relation to each other just about no matter what inflation or deflation does. (simplification) Its money we are trying to control.

So why does that matter to most of us? Start dancing all you college educated debt laden money wasting fools. You see If I borrowed say, for a nice round number. $250,000. For an education, car, house, anything. And I get the thing. Then I have to pay back what I paid for it. I have the thing which (remember the house) is now worth $500,000 but I only have to pay back what I borrowed. "Only now, in the end, do you understand." YAY!

So those who have money are punished because their money loses half its value and those who have debt are rewarded because their debt loses half its value. Twisted right. This is our solution to the current economic problem. Inflation baby... redistribution of wealth. We will take those who have money and we will give it to those who have debt, without moving a bill. Oh this is where you going to get mad. THIS IS WHERE YOU MIGHT SCREAM OR CRY. Because guess where allot of peoples "money" is.

Have you ever heard of a defined benefit plan? Work at GM... PERS? What about social security? So let me get this straight. I gave you dollars my entire life, and now you are going to give me back my dollars for the next 30 years. Only wait a minute, you've got my dollars? And whats happening to them?

I don't want to wax poetically any more than necessary. So I think I will stop there. Do you get me. This is the kind of massive redistribution of wealth I was talking about. Anyone who has been wise and prudent and saved money in any liquid assets, bank account etc. Is going to have that money taken away and anyone with debt is going to have that debt taken away. Robin of the Hood, you prince of thieves you.

Tune in next time and remember only you can prevent forest fires.

DISCUSSION OF MATERIAL CONCEPT IN THE ARTICLE

So what is the difference between debt monetization and quantitative easing. It is in fact a semantic one, the idea behind quantitative easing is that it is an adjusting game, some times we print money and buy government debt but other times we are selling government debt and "destroying" money. So overall its a wash, but when we start talking real monetization of the national debt (or just giving trillions of dollars of new money to banks) well...... see above.

The Great Recession and other fun games you can play with family and friends

There is allot of confusion out there about the present state of the economy. I thought I would clarify for those who are late in joining our little game.

The avowed purpose of the federal reserve bank is to create stability and predictability in the relationship between unemployment and inflation in the national economy. Thus for some time prior to our present downturn we experienced about 2-3% inflation and about 4-6% unemployment. A seemingly ideal balance. The means of controlling inflation is to set target interest rates such as the federal funds rate and the discount rate. If interest rates are high inflation is reduced as money stops flowing into the economy (a very crude explanation, I know). If on the other hand interest rates are low inflation grows high as capital rushes into new investments and buys up fundamentally scare assets, land, labor etc. By setting these targets they don't "control" national rates but instead influence them.

Unemployment is then controlled by the interest rates in a very keynesian model. If money is abundant investors will be more likely to make aggressive or risky decisions because even if my new business only makes a return on investment of 5%, if I can get the money at 3% I just made 2% on however many billions of dollars I invested (borrowed). If on the other hand interest rates are set to 7% I would have lost 2%, thus with higher interest rates businesses and individuals are less likely to take risks that "might" result in a return of lower levels. Thus the interest rates determine the rate of unemployment since risk taking is exactly what creates new businesses and new jobs, as well as maintaining old ones.

A simple system at is essence, yes? (and I must say a simple minded explanation, my apologies) The trouble lies in the fact that the ability of the federal reserve to balance unemployment and inflation is controlled by gatekeepers. Only certain organizations have the power and ability to borrow money from the federal government at these targeted interest rates. And the only way in which that borrowing is reflected in the national economy is if those organizations in turn invest that money in some meaningful way inside the national economy that can influence inflation and unemployment. In our present case these organizations are borrowing that money and not investing it. Even though the federal reserve has lowered interest rates to 0%, a theoretically infinite incentive to invest in any opportunity that can return any benefit, WHY?!

Two reasons, and this is where we get to the gist of the matter.

One, the banks are still in such risky financial position that they are borrowing money at incredibly low rates in order to stabilize their current liquidity positions, they are in essence hoarding cash to the effect of hundreds of billions and in fact trillions of dollars.

Two, there is nothing in the national economy worth investing in.......

Does the thought make you shudder? Banks and investors who have billions of dollars of cash hoarded up are not interested in any investment whatsoever. Why? This brings us to our lesson in fundamental economics and finance for the day. Whether or not they should invest is determined by whether the present cost of an asset/investment is outweighed by the future returns they can expect (discounted for the risk that those returns will not occur).

Those returns take two forms.

Earnings: If I own a share of IBM and the company earns money and pays me a dividend that is earnings, an investment can expect some kind of earnings over time and theoretically into perpetuity.

Appreciation: If on the other hand I own a share of IBM and rather than paying me a dividend they reinvest the money into new factories, land, patents, employees my asset has gained in fundamental value. My share is de facto worth more, it has appreciated.

So the fact that interest rates are at effectively 0% and inflation is not occuring (in fact we have had deflation) indicates that those with the power to invest believe that the combination of appreciation and earnings from ANY POSSIBLE INVESTMENTS will not exceed 0%.

What does this mean? Two things, one unlikely and another quite likely.

One, that there is no way to earn money, this is quite unlikely, people still need to produce products and by definition then there will be a financial incentive for those who can efficiently and proficiently outperform competitors in the manufacture and provision of goods and services.

Two, that every single investment is overpriced. What this means is complicated. At 0% cost of capital, at first glance, it would appear that something could not be overpriced, but this ignores the element of risk. A business that returns for me every year 1% on my million dollar investment is a great purchase if I can get my million dollars at 0%. Unless of course the business goes bankrupt and I lose the million in the next say.... (for simplicity) 100 years. The element of risk determines that I have to make far more money than just a slight margin over my cost of capital to account for the chance that the business/investment may fail. Why then would the investments/assets not automatically reprice themselves to match the market cost of risk by lowering the purchasing price of the investment. Get ready for the punchline.

BECAUSE THIS MEANS A MASSIVE REDISTRIBUTION OF WEALTH. Are you scared yet? Do you understand what I mean? What this means is that your dad and my dad bought IBM for $20, they thought it had appreciated to $50 and that that was what it was worth. To sell it now for $20 or $10 or $25 seems unreasonable, they would rather just not sell. They will hold it believing that things will change. This the simplest and least illustrative example I could use. Also the least efficacious, lets try something that will hit closer to "home". There are houses for sale all over the country, on every street. Why do you say for sale? why not sold? Think of all those banks with their billions of dollars. People thought that what they were buying was worth more than what it is. They are unwilling to sell at the price that an investor is willing to buy at.

This is true across the market for every asset and investment. They thought they were rich, but they were mistaken. The only ones rich are those in possession of what is in demand. Thus in this case, the rich ones are the young workers who can provide the resources and products that those who have the "assets" right now want to exchange them for. But the "wealthy" do not want to trade what they worked their whole life for in exchange for less than they thought it worth. So the houses sit on the markets. The stock prices remain high. And the banks sit back running equation after equation, disagreeing within themselves when the risk of future investments is outweighed by the return they can expect. For that matter what is the quantification of either?

What does all of this mean to you? THE ECONOMY WILL NOT AND CANNOT RECOVER UNTIL THE WEALTH IS REDISTRIBUTED. Because the way to reduce unemployment (CHAIN -> increase buying power, reduce the burden on government, lower the tax rates, further incentivise investment, raise the price of goods, create inflation) is to inject capital into the markets. And the only way that that is going to happen is if we can reduce the price of the investments such that the returns of those investments discounted for their riskiness outweighs their cost.

CAVEAT: This ignores the discussion of whether we could instead reduce the riskiness of those investments and thus affect the worthiness of purchasing them. This is done because I do not believe that it would have the required effect. There are enough investments of sufficiently stable nature available in the economy that the problem is not excessive risk aversion but rather far more excessive price/ supply in-elasticity. Although right now we are feeling the affects of both.

Tune in later for more fun with economic collapses, courtesy of theoretical nonsense.