Inflation Folly

“The ultimate result of shielding men from the effects of folly is to fill the world with fools” - Herbert Spencer, an English Philosopher (1820 – 1903)

Questions to ponder

Why do people who can readily explain why it makes no sense for anyone to dictate the price of tomatoes believe that it is reasonable for a central bank to dictate the price of short-term money?

Why do people who know that socialism has never worked and understand why it never can work, still believe that central planning is effective or feasible when it comes to money and interest rates?

Why is it widely accepted without question that the Federal Reserve is needed to control inflation, maintain financial stability and promote employment growth when the historical record clearly shows that there was generally less inflation, greater financial stability and lower unemployment BEFORE the establishment of the Federal Reserve?

We confess that we don’t have the answers, but we do understand that people like easy answers and solutions particularly when there is uncertainty. As Friedrich Nietzsche suggested, “any explanation is better then none”.

Investors hear so much nonsense it is no wonder they are left somewhat confused. Part of this confusion stems from the central bank itself. The great folly is that the central bank is providing cover for the distortions it introduces to the natural development of the market. So investors who prefer to believe in the omnipotent wisdom of the central bank could end up being dangerously blindsided in their understanding both of the markets and their own financial position.

Indeed it is overwhelmingly clear that most people do not understand what inflation is, or even its correct definition. This allows central banks to take advantage of this confusion, while presiding over what is a deliberate policy of real and highly destabilizing actual inflation.

Money Supply and Inflation confusion

“What people today call inflation is not inflation” – Ludwig von Mises.

Simply put the correct definition of inflation is the increase in the quantity of money and money substitutes.

Changes in the cost of living index, whether it’s called a consumer price index or retail price index, is one of the consequences of money inflation, but not really what inflation is. This is not semantics. This completely changes the way in which markets and the economy work, and the correct definition provides a far sounder basis for understanding what is happening in the financial world.

Consumer prices are a measure of the cost of living, but this has limited value as a guide. For several reasons:

1.     It is very difficult to calculate. How do we decide what goods and services should be in the index, and what data is readily available in a timely manner. Does the end product really reflect our total cost of living?

2.     The basket of goods used in the calculation is forever changing as spending habits change, and it is doubtful that proper allowance can really be made for this.

3.     Even supposing it is calculated well, it is lagging indicator, and so has limited use as a policy guide.

4.     The index calculations and methodology are forever being changed by governments, who have a strong vested interest in low increases in the value of the index.

For all these reasons cost of living indexes are very far from ideal. Nevertheless there is always endless discussion about them. Why? Once again our old friend Ludwig von Mises explains:

“Inflation can be pursued only so long as the public still does not believe it will continue. Once the people generally realize that the inflation will be continued on and on and that the value of the monetary unit will decline more and more, then the fate of the money is sealed. Only the belief, that the inflation will come to a stop, maintains the value of the notes.”

In other words the very fate of fiat currency hinges on the ability of the central banks to convince its users that the cost of living is under control, hence the focus and constant rhetoric. However, at the same time it is really the money supply growth that provides the main driving tool for economic policy changes.

So now that we’ve cleared that up where does this leave us with the markets?

Money Supply and the Markets

Our problem today in analysing the economy and markets is that we have just experienced a 10 year avalanche of excessive money supply growth. If you have any doubt about this, take a look at the chart in Market Notes 63, titled “Who’s the Patsy?” The idea that we or even the central banks have any clear idea of where we currently stand given the magnitudes is simply unrealistic. For now central banks have finally started an attempt to reduce liquidity by gradually raising interest rates. But quite how far they will have to go to offset the previous credit binge is really anyone’s guess. If anything it now looks as though they are being far too cautious, interest rates are still very low in Japan and Europe. Even in the US, interest rates still look like they are below the nominal growth rate in the economy, which may still not be sufficiently restrictive. So far around the world, growth still seems very strong and liquidity abundant.

Until the indicators clearly weaken, or policy becomes far more aggressive, it may be wise to assume that current strength in worldwide growth may still have some time. Current trends may, therefore, continue for much longer than many expect and interest rates may need to continue to rise.

Longer term we still have to be somewhat careful. With such a high proportion of the growth being artificially stimulated and debt levels being so high. The slowdown, when it does arrive, could be quite sudden and severe. A good money management system may well be the key to not just profiting from the current benign environment but also to hanging on to those profits, when the turn eventually comes.

Greenspan  and Bernanke

“Heroing is one of the shortest-lived professions”

Will Rogers (1879 – 1935)

Greenspan managed to leave a complicated legacy to the new Fed chair Ben Bernanke. While the enormous boost in the money supply, presided over by Alan Greenspan has so far seemed benign, unwinding such a vast excess will be a great challenge to Bernanke. Withdrawing all the excess liquidity would produce a recession, and everything that Bernanke stands for suggests that this path is not his preferred outcome.  Nevertheless, Bernanke will need to tighten enough to regain sufficient control of inflation to keep the economy, at least to some extent, stable.

No doubt, Bernanke is all too aware of the risk of tightening policy too quickly. The main engine of the economy in recent years has clearly been the housing market, and with inventories of unsold homes already at record high levels, further aggressive tightening could well be disastrous. However, this may well be the risk he has to take to regain control of the economy.

This is where excessive use of money supply inevitably leads - to highly unstable economic conditions. It also leads in the end to a less efficient economy as planning and investment becomes so much more difficult with a volatile economic background. It also means that in the long term the risk of runaway inflation increases. While Bernanke is currently trying to restrain demand, he is clearly and candidly on record as a strong believer in using excessive money supply to counter any risk of a major economic downturn. This means that over the economic cycle, the excessive use of money supply as a policy tool, that was introduced by Greenspan will continue with Bernanke at the helm.

This impression is strongly reinforced by the background of substantial budget deficits as far as the eye can see. Unless financial discipline can be restored, which involves a degree of unavoidable restraint and hardship, then there will be a great temptation to once again use excessive money supply to inflate away much of the debt. One way or another, we have clearly entered an era in which excessive money supply manipulation will remain very much at the forefront of policy management at the Federal Reserve.

Summary

Investors need to be fully aware of the correct definition of inflation. Rather than focus too much of any cost of living index, they need to carefully monitor measures of money supply growth. Taken together with a clear understanding of the consequences of money supply distortions, investors will be much better equipped to gauge their own financial position and choose appropriate investments.

Investors also need to be fully aware of the interventionist nature of central banks. There are always significant risks in a fiat money system that money supply growth will become excessive, as it usually provides policy makers with the easiest short term palliative for any real or feared economic weakness. As excessive money supply manipulation becomes entrenched, however, it results in an increasingly volatile and inflationary economy, and the harder it becomes to return to a stable well managed economy.

 

 

 

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