Sunday, September 12, 2010

Class interests and the future of inflation

It is a frequent conceit among hard money advocates that central banks and especially the U. S. Federal Reserve Bank are out to debase their currencies in order to save debtors. Below I will show why this statement--although seemingly borne out by observation--can result in misleading conclusions about the motives of central banks. But first, let me lay out more thoroughly the hard money advocates' explanation of how the world works.

Central banks debase currency by printing excess currency or by enabling the rapid expansion of credit, both of which put more money in circulation. When the amount of money in circulation rises with no corresponding rise in the production of actual goods and services, then more money is chasing after the same amount of goods and services. That creates an inflation, that is, a general rise in prices, which usually leads to a rise in wages and in asset values in such areas as housing and the stock market. If you are in debt and your wages are rising, this naturally makes it easier to pay back your loans which are, of course, for a fixed number of dollars or euros or other currency. In other words, the loan amounts are not adjusted for inflation even as wages and the price of assets rise.

Naturally, those who've been prudent and saved and therefore have money to lend are penalized since when their loans are repaid, the money they receive back, even with interest, often buys less than it did when they lent it. This is the standard explanation of how savers get gypped and profligates get rewarded under what is called a fiat money system, that is, a system of currency which is merely decreed by a national government. In the United States the U. S. dollar is legal tender because the government says it is. There is no formal backing with precious metals or anything else.

Why do central banks supposedly cater to debtors? It's because they make up the majority of the electorate who have any combination of home mortgages, car loans, credit card debt, and installment credit. The political pressure on the banks is thought to be so great to bailout the masses who are in debt that these banks cannot carry out their primary mandate to maintain the purchasing power of the currency.

Maintaining the value of currency would, however, favor savers, and the majority of savings are held by the very wealthy. In the United States the wealthiest 10 percent of the population hold a whopping 70 percent of all wealth. In Switzerland the numbers are almost the same. In Denmark the wealthiest 10 percent hold 65 percent of the total wealth. In Germany the amount is 44 percent.

But is it true that inflation is never good for the wealthy who are the world's chief lenders? It depends on what the wealthy own and what type of inflation one is talking about. If they own real estate, and the wealthy own a substantial amount of it, inflation can make these prices rise. If they own stocks, and the wealthiest 10 percent in the United States own more than 80 percent of all equities, inflation can make them rise either by stimulating economic activity or by encouraging people to enter the stock market to preserve their wealth thus bidding up stock prices.

Naturally, the wealthy have bank deposits which are lent out. And, they own bonds, government, municipal and corporate. In fact, they buy lots of them. Now, inflation hurts the value of these investments, but bank deposits and bonds are by no means the principal investments of the wealthy.

Now, let's return to the role and purpose of central banks. The purpose of any central bank is to ensure the stability of a country's banking system. And, the banking system in most democratic countries is in private hands, and that means in the hands of the wealthiest, either through stock and bond ownership or through direct investment in banks. So, indirectly, at least, the purpose of central banks is to insure a major repository of wealth for the world's very richest people. So far, in this task, the central banks have performed miracles. Many of the world's largest banks are, in fact, insolvent, and yet they have continued to function after the 2008 financial meltdown through a combination of regulatory forbearance, massive liquidity injections from central banks, and government guarantees and direct investment.

The hard money advocates warned that this bailout of the banking system would make so much money available for loans that the world would experience a bout of high inflation if not hyperinflation. Credit would once again flow so freely that money would flood the economy without a corresponding increase in goods and service. As people realized the inflationary effects of this new credit bubble, they would rapidly flee paper claims on wealth such as bonds and bank accounts and move their money into real goods such as commodities, particularly precious metals, and claims on real productive assets such as stocks.

But this has not happened. Instead, the banks, at least in the United States, have chosen to park their massive liquidity injections at the Federal Reserve or in government bonds where they earn essentially risk-free returns. This has turned out to be a backdoor method for transferring public funds to ailing banks through government expenditures on bond interest. And so, by any reasonable measure, private credit continues to shrink worldwide as public credit (i.e. government borrowing) expands. So far this has enabled a more orderly deleveraging on the part of companies and households than would otherwise have been the case. This is because you can deleverage in two ways; either you can pay back your loans or you can simply default on them. So far defaults have been kept in check. But government support of the economy has resulted in neither a substantial economic recovery nor an inflationary spiral. In fact, the biggest fear among central bankers is that the world could once again fall into the maw of deflation as it did in 2008.

The new and as yet untested prediction made by those who say we are heading for a bout of intense inflation is that as the economy once again weakens, the Federal Reserve will take the extraordinary step of creating fresh money to buy stocks and to buy real estate directly from homeowners. This would supposedly put money into the hands of "the public." But is this actually what would happen?

By "public" we can assume that the commentator cited above is talking about people who make considerably less money than he does. And yet, we already know that more than 80 percent of all equities in the United States are owned by people in the top 10 percent measured by assets. These people are unlikely to spend on consumer goods a substantial portion of the proceeds from any stock sale since their basic needs have already been met. They are much more likely to reinvest the money they receive in something else. As for the other 20 percent of equities which are held by "the public," many of those are held in pension funds, 401K plans, and IRAs, hardly sources of ready spending money. There's not much fodder for an unstoppable inflationary spiral here.

But what about direct real estate investments? Here the Federal Reserve would have to distinguish between rich homeowners trying to dump mansions or second homes and middle or working class homeowners who might spend more freely the money which they'd receive from any sales of their homes. But typically people of average means who must sell their homes are selling them because they can no longer pay the mortgage. This means that much of the money the Federal Reserve might pay for such homes would simply go to the bank holding the mortgage where, if current conditions continue to prevail, the bank will simply invest the money in low-risk government bonds.

So, even in the very unlikely circumstance that the Federal Reserve embarks on such a program, I am doubtful it would do much good. Instead, I regard the most likely course for the world economy as continued deleveraging by businesses and households for some time. And, I expect governments and central banks to continue to attempt to stimulate the economy. But all they will accomplish is to partially offset the contraction of credit which must proceed to its conclusion, that is, down to a point where debt service is manageable and prices for assets such as homes and stocks are compelling based on long-term historical trends, not compared to recent bubble-induced pricing.

Where does this leave us? While central banks seem incapable of preserving the absolute wealth of the rich, they are supremely accomplished at working in concert with central governments to preserve and even enhance the relative position of the wealthy. That is, wealth is now even more concentrated in fewer hands than it was before the 2008 crash despite the large percentage losses that the wealthy suffered along with everyone else. This is, of course, the result of failures of banks and other businesses outside the world's main financial centers, failures which have have reduced competition for the businesses and banks controlled by the superwealthy. These people may not be quite as wealthy as they were before the crash. But relatively speaking they have gained against the rest of the population in their wealth and power.

However, the wealth of the rich depends on other people, usually middle class people and the governments they fund, paying back their loans. Much of the government bailout effort has been focused on shoring up the value of the bonds of government and government-sponsored entities such as Fannie Mae and Freddie Mac, the home mortgage giants. Far from being concerned about the needs of feckless American homeowners or the Greek government, the bailouts of Fannie Mae, Freddie Mac, and Greece, to name three examples, are really about securing the investments of the banks and wealthy individuals who hold the bonds of these entities.

Of course, central bankers are right to worry about systemic financial collapse. But they always seem to think that the response to such a threat should be to guarantee the investments of the rich using the public's money. Central bankers and financial regulators often come from investment houses and banks which are, of course, controlled by the rich, and so are infected with an idea that infects so many of those who are rich or who cavort with the rich, namely, that what is good for the wealthy is more or less identical with the public interest.

The threat of inflation then comes not from any conscious policy on the part of central bankers or even most central governments who have already made their iron-clad allegiance to the wealthy classes abundantly clear. Rather the threat of inflation comes from the eventual exhaustion of government credit in the face of an intractable and unstoppable deflation brought on by continuous deleveraging of companies and households. When the governments of the world can no longer entice lenders to give them money, they will be forced to print their own. (This is usually done through the sale of bonds to central banks which then create deposits out of thin air for governments to spend.) At that point the inflation worriers may turn out to be right, in spades. Private deleveraging will have halted, but, of necessity, government credit will continue to grow at a frightening pace, probably just in order to pay the interest on and roll over the debt previously shouldered to fight deflation through government spending.

If inflation does arrive in this way, it won't be because the central banks and the government meant for it to happen. They have shown themselves to be faithful guardians of the rich. No, such a result will be pure and simple--if anything related to central banks and governments can be said to be pure and simple--a gargantuan policy mistake borne of a misunderstanding of the financial predicament we face.

When households and/or companies as a group take on more debt than they can service, then they are obliged to shed it, either by paying it down or defaulting. When this happens on a grand scale, it takes the entire economy into a deflationary depression which in turn makes it even more difficult for households and companies to pay their debts as incomes and profits tend to fall relentlessly with each new round of deflationary pressures. Every player in the economy is acting rationally by saving and by holding back on investments because they cannot be justified by consumer spending or on purchases because prices are likely to be cheaper in the months ahead. This rational behavior leads to worsening results for everyone until the deflationary spiral comes to its natural end.

No doubt there are many unforeseen events which might halt the world's slide into the deflationary mire--perhaps a large-scale war or central bank policies that essentially print paper money and hand it out to the populace. But barring such extraordinary events, inflation is likely to show up only as a latecomer to the global economy's wake. What course inflation will take and whether governments and central banks will once again be capable of stemming the losses of the wealthy is impossible to know. That they will try to stem the losses of the wealthy is beyond question.


skintnick said...

How can it be that there is such contention between experts who forecast hyperinflation and deflation when, to the man in the street, those two conditions seem to be polar opposites? Can the causes of each really be so similar?

Archer's Arrow said...

Our best course is to maintain the delicate balance between inflation and deflation to enable an orderly deleveraging of existing debt. If the economy begins to post numbers indicative of an inflationary trend, then interest rates will rise which will, in turn, add to the inflationary trend. Falling prices hurt those who must sell or lend while rising prices hurt those who must purchase or borrow without regard to class distinctions.

Henry Warwick said...

My opinion, from a month ago:

mattbg said...

Very good and thought-provoking post, Kurt!