Let's Have Inflation

Required reading: a word from my favorite deflationists — bond investors that have beaten all others handily, at Hoisington Investment Management (.pdf). They agree with my view that most of the actions taken by our government are useless or even counterproductive. They cite Kindleberger, Schumpeter, Minsky and Kondratieff. I would add in the Austrians. High levels of debt and debt complexity lead to large recessions/depressions eventually.

High levels of debt and debt complexity rob an economic system of flexibility. So long as the debt is increasing, there can be one tremendous boom. But when the asset cash flows can no longer carry the debt, the system goes into reverse, with falling asset values. During that time, monetary policy is useless, and fiscal policy is useless, until the debt levels are reconciled.

We are in the midst of a great experiment. Are the Neoclassical heirs of Keynes right? Can you prevent a depression via loose monetary and fiscal policy? Since loose monetary policy led to this crisis, why should looser policy solve it?

Also, fiscal policy has been loose for seven years — should extremely loose fiscal policy solve the problems? And what of those who lend us money? Should they be happy with dilution of their claims on the US economy? What if they stop lending, which is in their long-term interests to do, but not in their short-term interests?

As for the Federal Reserve, with all of their cleverness regarding credit easing versus quantitative easing, the problem still remains. The central bank attempting to fix a lending market becomes a new offerer of credit, at rates the private market won’t touch. As the central bank brings the rates down, grateful borrowers borrow, but private lenders would hang back, unless they became convinced that there was nothing to fear in the absence of central bank lending. That’s pretty tough to achieve.

I don’t like quantitative or credit easing. If we are going to be Keynesians here, let’s let the money supply expand, creating real inflation, and raise the nominal prices of homes that are currently underwater. Rather than trying to be too clever, and trying to solve all problems without inflation, let’s have inflation. I don’t think the problems can be solved without a rise in the price level, which will also make foreign countries adjust their policies to match US actions.

I don’t find the Federal Reserve exit strategies credible. As we have learned before, introducing subsidies is easy, removing them is hard, and it doesn’t matter if the subsidies are monetary or fiscal.

My view is that we will go through continued deflation until the pain is too hard, and then we will experience inflation in a big way. Thus I continue to advocate TIPS, and short corporate debt. Away from that, I encourage caution — focus on companies that can survive the worst.

Comments

[CLH:]

There is no chance of inflation. Interest rates will be low for many years. In order for interest rates to rise people must borrow. This will not happen for a long time.

Jan 19 03:49 PM

[carey_jim:]

To my mind, all this talk about letting the fee market work is admirable but sounds about as realistic as saying we need honest politicians in Washington D.C.to clean the place up.

We all know that honest politicians will clean up Washington D.C on the Twelfth of Never and Free Markets will start operating the next day.

Admirable ideals but not realistic.

Jan 19 04:04 PM

[six:]

I don't think we will see inflation any time in the near future. The US consumer has to come back to the table in a big way to start us on the path to inflation. That is not happening because the consumers that want/need credit can't get it as the banks have turned off the faucet for anyone but prime borrowers. I know- I work at a bank and we are not loaning money to consumers with lower than a 720 FICA score. The consumers that can get credit don't want any... they want to pay off existing debt. Americans have layers of debt they can pay down. Every day Americans pay down debt and spend less than they earn deepens the deflationary conditions as residential real estate LOSES value. Residential real estate is the key driver of deflationary conditions. The American home owner is the real driver of the economy. For years the home owner has borrowed on the equity of their home and inflated the economy with funny money. Funny money is money not created from actual value but rather from the idea that an asset is worth something and will be worth more in the future. That funny money is gone as is much of the value of the assets from which it was created. Most experts are not predicitng the residdental real estate market to recover until 2010 and that is not written in stone. What if it is 2011 until recovery and what if 2011 is just the start of the bottom? How can you have inflation without appreciation in residential real estate? Don't apply what has happened in previous situations. We are now going down a different road.

Jan 19 05:40 PM

[E.D. Hart:]

Bush, Greenspan, Bernanke, and Paulson say: let the free markets work when asset prices increase--then its "let the markets do what markets do best"--set prices. Policy has been to not interfere on the upside.

As asset prices decrease on the downside its a different story. Free market ideologues suddenly become pragmatic and flexible, and bank bailouts are now the right and proper thing to do by the most conservative politicians.

It seems that in the foxhole their are no atheists, and in the market collapse their are no free market politicians as the pain is simply too great to bear.

Jan 19 06:38 PM

[Mark in SF:]

Yes!! Let's reward imprudent home buyers and by making their debt burden go away. Brilliant!!

Let's punish savers and and the prudent that that did not get involved in the bubble!!

Let force the world to bail on the dollar as a reserve currency!!

Oh, and while were at it, let's wipe out pension funds, insurance reserves, and all the corporate savings accumulated over the last decade!!

I love it!!

Jan 19 08:10 PM

[Lightway:]

What happens when wages don't rise at the same rate as inflation? They have already been depressed for most of this decade.

Jan 19 08:22 PM

[Marc Michel:]

I couldn't agree more. There is no painless fix. The Feds want to artifically prop up housing prices rather than letting the market work. We need to get the Feds out of the mortgage market altogether. As we speak FHA is writing mortgages with as little as 3% down. This isn't homeownership. This is option financing. As long as the Feds are in the business of making loans to those who don't deserve it, we are going to crowd out prudent lenders from participating in the market.

The fact is that we are going to be subject to a massive increase in our Federal defecit no matter what I or anyone else says. Unfortunately when you are a debtor, some inflation actually serves your purpose to ultimately pay back that debt with inflated dollars. The alternative is to raise tax rates to such a degree that we choke off growth. We are effectively stuck in a proverbial Hobsian choice.




On Jan 19 12:25 PM icandoitdon wrote:

>
>
> i normally like your stuff, dave, but thinking that induced inflation
> will solve our problems is pretty short sighted. do you think that
> a strategy of inducing inflation would be easier to exit when the
> crisis is past? it took paul volker years to solve the inflation
> problem of the 80s and he did it by pushing long treasuries to 14%.
>
>
> here is the paradox today: lenders are doing the logical and prudent
> thing by tightening credit standards because default risk is high.
> borrowers are doing the logical thing in eschewing debt as they try
> to rebuild personal balance sheets savaged by the decline in personal
> wealth. this is a necessary natural healing and the federal reserve
> is fighting it. it hasn't worked and it won't work. this mantra "don't
> fight the fed" is being turned on it's head. it is the fed who is
> fighting the survival impulse in us all and they're wasting their
> time trying.
>
> here is another paradox: the fed and treasury are destroying any
> incentive of the capital markets to help banks boost capital. in
> becoming the "lender of last resort" they are crowding out the private
> capital markets. they're creating the walking dead that will never
> be able to attract private capital becaue there is no incentive to
> do so. only risk...no reward. this is a problem for not only the
> weak banks but the healthy ones too. what does it solve? better to
> let weak institutions fail. lett investors take their losses and
> healthy institutions take over the healthy part of their operations.
> that's how the last credit crisis was solved. which saw over 800
> banks fail. we don't need fewer bank failures here...we need more.
>
>
> there is no painless fix and that's what these lame attempts by the
> congress, the treasury and the federal reserve to hold up this house
> of cards is trying to achieve. the best long term fix is to get the
> government out of the mortgage lending business; let housing recede
> to sustainable price levels; let poorly run companies fail; and let
> risk be priced appropriately by the private capital markets instead
> of being mandated by the federal reserve. and, oh yes...reexamine
> the charter of the federal reserve. it has far to much power for
> an organization that is capable of doing so much damage. we are in
> this mess because of years of bad public, fiscal and monetary policy.
> it will not be fixed by more of the same.
>
>

Jan 19 08:44 PM

[Dirk McCoy:]

It is possible that as soon as President Obama realizes he is President now and there is nothing to be gained from setting the bar lower, he will stop talking down the economy. Continued weakness will hopefully be met with Fed fiscal policy while Republicans stall truly Keynesian efforts, and the seeds of a turnaround will embolden Republicans to stay the course.

At some point, inflation will pick up- oil will recover and gold will appreciate. The moment of truth will then happen- will the Fed allow the economy to strengthen, allow subsitutionary labor and technology to have an effect based on significantly increased costs of some assets? Or will they pull the rug out from banks, borrowers, new businesses, and homeowners by increasing interest rates- like they did between 2004 and 2006 with their 18 straight rate hikes?

Hopefully Mr. Geithner will get past his tax issues, because I think he gets it. And the "global warming", "suburban sprawl", "sustainability" crowd may not be as vocal in bringing down an Obama economy.

Jan 19 09:45 PM

[Yohei:]

I don't think wages will increase meaningfully. Prices will go up, though, and perhaps surprisingly rapidly. Interest on loans will become high. Existing Treasuries will collapse. I expect unemployment to remain high. We could see 6% bank CDs this year. The dollar will drop and oil will cost more per barrel. Obama will become less esteemed.


On Jan 19 08:22 PM Lightway wrote:

> What happens when wages don't rise at the same rate as inflation?
> They have already been depressed for most of this decade.

Jan 19 09:55 PM

[John Lounsbury:]

I read the Hoisington paper tonight (courtesy of John Mauldin) and then found it as a reference at the beginning of your article. Readers with enough interest in this subject to have gotten this far down the comment stream should go back and click on the link you provide.

The Hoisington paper gives a complete a description of the case for long-term deflation as I have read. Whether their positionis correct or not remains to be seen. However, I am influenced enough to increase my wariness of shorting treasuries and investing in banks (the wariness of banks was already high).

Again, I urge you to go back and read the Hoisington paper.

Jan 20 12:55 AM

[adam d.:]

actually it's a great reason to buy the very much out of favor REITs.

www.ezraschartbooks.co...

or just buy land.

Jan 20 01:06 AM

[Tom Perkins:]

Six wrote:

"That is not happening because the consumers that want/need credit can't get it as the banks have turned off the faucet for anyone but prime borrowers. I know- I work at a bank and we are not loaning money to consumers with lower than a 720 FICA score."

and

"For years the home owner has borrowed on the equity of their home and inflated the economy with funny money."

You know, I seem to recall that banks primarily created this crisis by lending money imprudently*. Before you mindlessly underpriced risk, now in an equally mindless panic you are overpricing risk.

How do you suppose you 720 score is a rationally justified benchmark at this time?

Jan 20 07:23 AM

[PierreLegrand:]

So then a bankrupt country is bailing out bankrupt banks with fiat money promising to pay later for the hamburger eaten last week. And that same country refuses to drill for oil, dig for coal, build factories, build refineries, produce goods because none of the used to be rich when their houses were worth something want a factory, rig, pit behind their used to be expensive houses...mmmmkay. Yea that will work.

Jan 20 08:37 AM

[PierreLegrand:]

And all of those used to be rich folks want to fix all of this and they don't want any pain. Sure that is possible.

Reading Peter Schiff's book and given that he was able to predict this nonsense in advance it might behoove Obama to take a look see.

Jan 20 08:39 AM

[Chris B:]

I don't think Merkel means to say that returning to an inflationary environment is the right, fair, or just thing to do as some posters have taken it. He is saying that inflation is the inevitable consequence of the Keynsian expansionary policies that are the only known way to get out of a depression. As they say in Macroeconomics class, inflation is the tradeoff for stimulating aggregate demand, and a Keynsian can get you out of a depression, but not out of inflation. Yes, government decisions will create winners and losers in the investment markets, but that is an inevitable consequence of any choice they make.

The closest historical parallel that we have to predict the future is the few years right after the great depression. It is surprising that we see so little discussion about what happened during this period, when government shifted from stimulating aggregate demand to creating balance in the monetary supply. The result was a few inflationary/deflation... jolts, followed by the world's most stable currency.

Jan 20 09:37 AM

[akapital:]

what do people think about letting people borrow against their Social Security?

What it effectively does is used future soc sec entitlement as default insurance and would get a serious injections of money into the economy. So when people are paying off their house they are also putting money back into their retirement?

Jan 20 01:24 PM

[HARM:]

<i>I'm not saying you're wrong, but let's remember that all of the "prudent people who have been doing the right thing all along" also suffer as real estate values decline. The only true winners in such a scenario are those who rent their homes.</i>

Wrong. If you did not "lever up", HELOC or cash-out refi to the sky or recklessly speculate, you will not be hurt at all. In fact, those 30% or so of American families that own their homes outright will actually BENEFIT from falling prices in the form of lower property tax bills. Existing prudent owners will also benefit from the fact that, when they need to move, their NEXT home will cost much less, and they will not have to compete with NINJA Option-ARM armed speculators.

No "Detector" in BS --just BS.

Jan 20 02:21 PM

[Vox Rationalis:]

"If you did not 'lever up,' HELOC or cash-out refi to the sky or recklessly speculate, you will not be hurt at all."

And those banks reporting huge mark-to-market losses don't have losses - from a certain point of view. But just look at how Wall Street's reacted to STT. Welcome to the real world.

"In fact, those 30% or so of American families that own their homes outright will actually BENEFIT from falling prices in the form of lower property tax bills."

First off, there's no difference in this "benefit" for somebody who owns the home outright and one paying a mortgage. But more importantly, your argument is not well conceived. What drives property tax rates? Do you think that the cost of local government has declined by the same percentage as home values? Do you think the costs of your local government dropped by 20% during 2008, like home prices? Of course not. And so, if property taxes are the primary source of revenue for local government (or the source that's most easily manipulated, as opposed to sales taxes), the government will raise rates as the value of homes decline across the board, just as it lowered rates as home values climbed.

"Existing prudent owners will also benefit from the fact that, when they need to move, their NEXT home will cost much less, and they will not have to compete with NINJA Option-ARM armed speculators."

And they will be hurt for the same reasons when selling their current homes. If home prices fall uniformly, people benefit if they are buying more expensive homes than they are selling. If they are moving into comparable homes, it's a wash. But a retired couple that moves into a smaller home will be hurt by a uniform percentage decline in home values, as they won't come out of the transaction as far ahead in dollar terms.

"No 'Detector' in BS --just BS."

And yet I poked gaping holes in everything you said without even having to do any research. Hmmm.

Jan 21 08:21 AM

[Deep Thinker:]

We are in unchartered waters here. Traditional economic thinking will not solve this one. It is far too complex and we have not seen the major unraveling yet.
Allowing inflation to correct the economy will put us in a worse situation than the one we are in. We have been spending more than we earn.We are in major debt. Inflation would cause a greater fallout and precipitate a groundswell of economic of social problems i.e more homeless, more people below the poverty line.
The improbable solution to this problem is universal bad debt cancellation and debt rescheduling . Yes! Every corporation, every individual has to write off every bad dollar owed to it/him/herself and reschedule others.This has to be then followed by economic reforms. The government has to play a much stronger role in regulating and leading the economy.
It is now glaringly evident that a purely capitalist system (free market regulated) is unsustainable beyond a hundred year period.
There is a story of capturing a type of monkey by putting a bait in a container that allows the monkey's open palm in but prevents the clenched fist from coming out. This is our dilemna. We have to release the debt in order to be freed. Hard choice, but this is the sacrifice we collectively have to make.
The result will be an easing of the weight of the debt on the majority of individuals and significant stimulation to savings and spending.
Mr Merkel allowing Inflation is not the way.

Jan 21 11:07 AM

[Remington:]

Uncharted waters.. I guess "there be monster here" and for you it is capitalism at the 100 year mark. Odd that you offer the culpit in this affair as the solution; more government.

In the roaring 1920's,the Fed (created in 1913) designed an expansion of credit prior to the onset of the Great Depression. The Fed designed the speculative condition that led to the 1929 crash. President Hoover was not a "hands off" guy as Keysians would have us believe, in fact much like Bush II, he threw free market principles to the wind and made the situation worse. FDR came in and lavishly spent on government programs yet the country was still in the economic depression by the breakout of WWII - 1929 -1940.

In the above case, the Federal Reserve created the speculative environment and the Federal government made a corrective recession far worse and prolonged;thus the Great Depression. True Free market principles had little effect in the above scenario, because the Fed and the government injected itself into the economy to "manage it" and it created a trail of speculation and moral hazard . A free market usually punishes speculation harshly and government management of the economy fosters mal-investment. We saw it then and we see the same now.

This time around, we have similar political causes of economic depression but a far different economy to try to revive.The Fed again eased monetary policy to create the bubble. It created the favorable condition for wild speculation and the Federal government aided it with Fannie & Freddie, coercive regulation and liberal Housing Acts.The Federal government's own SEC gave a blind eye to the leverage that investment banks were increasingly taking advantage of The marriage of banking special interests, Acorn pressure groups, the banking oversight committees of Congress, and the big 3 accounting firms pushed moral hazard on folks as a drug dealer pushes smack. Many became addicted.

Now our own Hoover threw principle to the wind to try to save the Republicans during an election year and then moved back to Texas with his tail between his legs. Our generations very own FDR is in from Chicago, blaming free market principles but not the Federal Reserve, Congressional oversight, or the SEC. No, he proposes even more power to the above culprits; using the the free market name as a stick-on label to Clinton/Bush's managed economy. Free markets - what a strawman !

The proposed solution of government spending is met with the sober "long term public debt is required" warning. History does repeat itself on those that do not learn from it; often cruelly...don't you agree?

What we face this time as a recovery is far different than in the early 1930s. The people do not trust the President for he picks a tax evader as IRS/treasury head and dismisses the "innocent mistake"; they do not trust the leaders of large corporations as they have squandered their stewardship with massive bonus' while driving their companies into the ground ... even after taking bailouts. They do not trust Congress who voted for the bailouts despite the clamor nor the banks with their "trust us" statements just prior to their collaspe. They do not trust the investment community with Madoff and hedge funds exposed when the tide went out.

The people know that the economic and political system is rigged heavily and have no use of supporting it with their savings especially after having lost so much. They have no stomach for the hyped safe diversified mutal funds that lost them 30-50%.

Deflation is the heavy asset selling under financial strain by oraganizations and individuals, but inflation won't wait this time for increased consumer confidence and subsequent spending..it wil be the foreign governments abadoning t-bills that will trigger it.

Europe is seeing unrest in Greece, Spain and the Baltics. Ireland and Britain are about to be downgraded; Iceland's government has fallen.

America wil follow suit (civil unrest) when inflation hits hard- not because of free market principles but, because of the lack of them. The U.S. wears a cloak named free markets but underneath it is Europe-like managed economy that runs the show..



On Jan 21 11:07 AM Deep Thinker wrote:

> We are in unchartered waters here. Traditional economic thinking
> will not solve this one. It is far too complex and we have not seen
> the major unraveling yet.
> Allowing inflation to correct the economy will put us in a worse
> situation than the one we are in. We have been spending more than
> we earn.We are in major debt. Inflation would cause a greater fallout
> and precipitate a groundswell of economic of social problems i.e
> more homeless, more people below the poverty line.
> The improbable solution to this problem is universal bad debt cancellation
> and debt rescheduling . Yes! Every corporation, every individual
> has to write off every bad dollar owed to it/him/herself and reschedule
> others.This has to be then followed by economic reforms. The government
> has to play a much stronger role in regulating and leading the economy.
>
> It is now glaringly evident that a purely capitalist system (free
> market regulated) is unsustainable beyond a hundred year period.
>
> There is a story of capturing a type of monkey by putting a bait
> in a container that allows the monkey's open palm in but prevents
> the clenched fist from coming out. This is our dilemna. We have to
> release the debt in order to be freed. Hard choice, but this is the
> sacrifice we collectively have to make.
> The result will be an easing of the weight of the debt on the majority
> of individuals and significant stimulation to savings and spending.
>
> Mr Merkel allowing Inflation is not the way.

Jan 25 12:48 AM