Austrian economists face an apparent paradox that has engendered criticism regarding their views on money and inflation: the money supply has been rising in all of its measurable forms, but prices don't seem to be rising.
As the following chart shows the U.S. M2 money supply has skyrocketed over the past decades.
In particular over the past few years the Federal Reserve has increased the monetary base from about $850 billion in 2008 to $3.5 trillion today, and it is increasing at $85 billion/month, or about $1 trillion annually.
On the other hand prices have apparently failed to reflect both the increase of the monetary base or the increase in broader measures of the money supply (M2, M3) that include credit.
This is especially noticeable since the spike in the monetary base that began in 2008: while the monetary base is up 4-fold, the CPI is up just 9.7%.
If an increase in the money supply doesn't correlate to rising prices then it would seem that Austrian economists have a serious problem, and their entire economic outlook needs to be re-evaluated. This lack of correlation has been used recently to argue that Austrian economics and its proponents are flawed.
In this article I argue that investors who are dismissing Austrian economics, given the aforementioned discrepancies, are looking at a simplified picture of the circumstances that lead us to the above statistics and their apparent conclusions. There are two reasons for this.
First, the CPI is misleading--it understates the real rate at which prices are rising. While the author in question points out that this is a point argued by his Austrian straw-man--Peter Schiff--he glibly dismisses it by claiming that there are other statistics that support the accuracy of the CPI. He should have investigated the claim more thoroughly before rejecting it. I have discussed the BLS's misrepresentation of price increases in detail in another article, which I summarize below. In essence I found that not only is the cost of essential products rising at a far greater rate than the CPI, but that there is a method for, and a motive in depressing this statistic.
Second, rising prices are a result of both the supply and demand of money, whereas stimulus only impacts the supply side of this equation. Because prices are rising at a lower rate than the money supply, it follows that there is compensatory demand for dollars. This is, in essence, the answer to the "paradox" that I propose above. This is a point that critics of the Austrian school typically overlook, and yet it is a phenomenon pointed out time and again by the schools most prominent proponents including Ludwig von Mises.
Is this sustainable? That is to say, is it possible for this demand to perpetually overcome the increase in supply leading to a lower rate of dollar depreciation than the increase in the money supply? For all practical purposes the answer is "no." During the age of globalization foreigners have been accumulating "excess" dollars so that they cannot be used to bid up prices in the United States as much as they otherwise would have, and the real impact of monetary stimulus will be felt when the demand for dollars overseas declines. This is already happening insofar as there have been several trade agreements amongst foreign nations that stipulate that trade will take place in other currencies of global significance (i.e. the Euro or the Renminbi), local currencies, or even in gold.
Further supporting the value of the dollar and dampening price increases is a demand for dollars amongst Americans, despite the increase in supply, as a result of the need to pay down debt, higher un(der) employment, and a mistrust of risk assets such as stocks. But as foreign nations begin to use other currencies (as they already have) for trade and for reserve accumulation, dollars will come back to America, drive up prices, and counter-act this demand. At this point not only will the supply of dollars be increasing, but the demand for dollars will be decreasing. The result is that prices will rise at a rate that is greater than that of the money supply. Thus without rejecting the fundamental notion that supply/demand fundamentals drive price, it is inevitable that very high inflation is in our future.
1: Inflation and the CPI
The CPI, which is the Bureau of Labor Statistics' measure of how rapidly prices are rising, has been suggesting that there is very little inflation for quite some time--over 30 years. This "fact" has been used time and again to dismiss Austrian economists. But not once in these criticisms have I found any rigorous analysis of the CPI. In doing my own I have found that it grossly understates inflation. The above cited article is a perfect example of how this piece of statistical chicanery has been used to dismiss Austrian economics. The author has the following to say in response to Peter Schiff's claim that the CPI misrepresents inflation.
There is simply no evidence for that. For instance, the online prices captured by the Billion Price Project at MIT (see here for more on that) is only marginally higher than the official CPI. If reality clashes with your theory, you should investigate the assumptions of your theory, not explain reality away.
The author is basically corroborating the CPI by using another set of statistics and then claiming this to be reality. In his last sentence he should replace the word "reality" with "statistical representation" because that is all the CPI and the MIT Billion Price Project are. Corroborating one set of statistics with another is a scientifically untenable approach to dismissing Austrian economics. This point is especially true given that the author makes no attempt whatsoever to explain the methodologies employed by either the BLS or MIT. This is what is really at issue, not the neat little number that comes out at the end of an obscenely long algorithm that has so much sway over economic thought.
In my article on inflation and the CPI--The Truth About Inflation: Prices Don't Deceive, The CPI Does, I assume the burden of proof that the CPI dogmatists are placing on the dissenters. I don't provide a rigorous calculation of the rate at which prices are rising, but I show more or less that the CPI must be significantly understating inflation given the cost increases of a few essential items (and a few non-essential items just for fun). Here is some of the data that I came up with (the data starts at the beginning of the 21st century and goes to 2011-2013):
- Housing: an annual increase of 3.2%
- Retail Gasoline: 9%
- Electricity: 3.8%
- Food: 6.7%
- Healthcare: 8.4%
- NY City Subway Ride: 4%
- Superbowl Tickets: 12%
- Movie Tickets: 3.6%
When we compare these figures to a CPI annual increase of 2.7% during roughly the same time-frame there is little doubt that the CPI must be incorrect, and basically worthless in its ability to represent the true rate at which prices are rising for those things that people need the most: food, shelter, and energy.
(As a side note the author of the above cited article uses GDP figures to show how wonderfully the US economy is doing--up more than 4% since before the financial crisis. Of course GDP is corrected for inflation. If the BLS data reflected the above figures it is very likely that the +4% number the author cites would be very much negative--if we assume a 6% rate, which seems reasonable based on those figures, then the +4% figures needs to be corrected by over 3% per year for 5 years, which would put the figure at best -10%.)
Not only is there a disparity between the CPI and the annualized price increases in essential (and non-essential) goods and services, but the BLS has a motive--which is unstated--and a methodology--which is openly stated and explained--that can conceivably get us from the inflation rate that is implicit in the above-stated figures and the CPI.
Let us look at the method first. The BLS uses two statistical tricks that reduce the CPI:
- Hedonic Adjustments, which account for part of the price increase in products by claiming that they are due to "improvements" in these products.
- Substitution Biases, which remove products (wholly or partially) from consideration as a result of their prices rising and substitutes them with products that have risen in price at a slower rate.
As I explain in my previous article the academic merit of these changes are dubious, yet they clearly serve to reduce the stated inflation rate.
The final point I make in that article is the motive behind the BLS's understatement of inflation. Of course it is virtually impossible to prove intent to manipulate the data without some corroborating documentation to that effect. Still, the motive should be sufficient for investors to doubt the validity of the data in making investment decisions.
Why manipulate the inflation figure downward? I see three primary motives that the BLS has in manipulating the data downward.
- The lower the CPI is, the stronger the dollar appears to be, and this creates demand for dollars that wouldn't be there were the CPI higher.
- Social Security and pension COLAs, as well as Inflation-Protected Treasury coupons are based on the CPI, and so a lower CPI directly benefits the federal government financially.
- The GDP calculation is corrected for inflation, and a lower CPI makes the economy look better.
While it is very easy to brush off such claims as "the CPI understates inflation" as conspiratorial, or a lame excuse to justify a defunct economic theory, doing so without at least analyzing the BLS's data and methodology more thoroughly is methodologically dishonest.
2: Demand For Dollars
Even if we were to assume that the CPI were correct this does not imply that Austrian predictions of high inflation are unfounded. The Austrian tradition defines "inflation" as the rise in the money supply, while rising prices, which is what the CPI and similar data points measure, is a function of both the supply of and the demand for money. This concept is often misunderstood, and as a result it is derided and insulted rather than appropriately analyzed. As one author put it:
Austrian economists actually change the definition of inflation to serve their own ideological needs. In Austrian economics inflation is not the standard economics concept of a rise in the price level. Inflation in Austrian economics is just a rise in the amount of money. This leads to all sorts of emotional commentary, the most common of which is the idea that the USD has declined 95% since the creation of the Fed in 1913 (which is true).
Making claims such as the Austrian concept deviates from the "standard" definition, or that it evokes "emotional commentary" is inherently argumentative and not analytical. What is important is not who has the "right" definition of inflation, but the concept's ability to explain phenomena in the context of an economic theory. So rather than stating that the Austrians are rebellious and emotionally driven, as the author would have you believe, let us look at the distinction between the two concepts at hand.
- Inflation, in the Austrian sense, is an increase in the supply of a particular currency.
- Inflation, in "standard" economics, is rising prices, but it is also a fall in the value of a particular currency.
Conflating rising prices with "inflation" in the Austrian sense is sort of like conflating "mass" and "weight" in Newtonian physics. The two are certainly similar and we experience them in much the same way, but weight is a figure that is subject to a far more complex dynamic. The same can be said about rising prices. Inflation in the Austrian sense is just one factor in the phenomenon of rising prices, or a falling value of the currency. The result of such an analytical approach to these terms, as opposed to the above argumentative one, is that we have two related yet distinct concepts that lead us to another problem: if prices are rising at a slower rate than the money supply, where is the increased demand for money coming from? If we continue to mix up these two concepts then we can never arrive at this crucial question.
I say this question is crucial because a thorough answer to it will provide us with an understanding as to why we haven't yet seen prices rise to the extent that the money supply figures suggest that they should. Furthermore it can show us what to look for in determining when we might actually see an acceleration in the decline in the value of the dollar. While I have shown that prices are rising faster than the CPI suggests they are still not rising as quickly as the monetary base (28% annually) or the M2 money supply (14% annually). While Keynesians and Monetarists would love to be able to jump from this fact to a refutation of Austrian economics altogether, it simply implies that there is some demand for dollars that is missing from the equation.
Anybody with a basic understanding of the global economy can name these demand sources:
- Foreign company's selling products to Americans
- Central Banks, sovereign wealth funds, or hedge funds/pension funds who want to hold dollars as "reserves"
- Those who want to do business with OPEC, or similar foreign/international organizations that trade something for dollars
- Black market participants who often sell their goods (e.g. drugs, weapons, slaves, stolen goods...etc.) for dollars (since data regarding this demand for dollars is questionable and difficult to come by I will not address this issue further).
- American citizens/corporations who believe in the value of the dollar, or who just need some working capital to live their day-to-day lives
Most of these sources of demand are outside the United States, and this is the primary source of demand for dollars that are keeping prices from rising as rapidly as the money supply. However it is possible to see the same phenomenon (i.e. prices rising more slowly than the money supply) for a currency that is not ubiquitous outside its nation of origin's borders. In fact this is precisely what happened in Germany from 1914--when Germany went off the gold standard--until the beginning of the collapse of the Reichsmark in 1920-1. Murray Rothbard addresses this in his book The Mystery of Banking:
The German inflation had begun during World War I, when the Germans, like most of the warring nations, inflated their money supply to pay for the war effort, and found themselves forced to go off the gold standard and to make their paper currency irredeemable. The money supply in the warring countries would double or triple. But in what Mises saw to be Phase I of a typical inflation, prices did not rise nearly proportionately to the money supply. If M [Money supply] in a country triples, why would prices go up by much less? Because of the psychology of the average German, who thought to himself as follows: "I know that prices are much higher now than they were in the good old days before 1914. But that's because of wartime, and because all goods are scarce due to diversion of resources to the war effort. When the war is over, things will get back to normal, and prices will fall back to 1914 levels." In other words, the German public originally had strong deflationary expectations. Much of the new money was therefore added to cash balances and the Germans' demand for money rose. (p. 68)
While international ubiquity makes the U.S. dollar's situation more complicated than that of the Reichsmark, we can certainly see parallels between the situation regarding the dollar and the Reichsmark, namely that both saw rising money supplies without a parallel rise in prices.
If we can explain the demand sources then we don't need to scapegoat a perfectly good theoretical model that will enrich those who are able to see through the indefensible attempts to demonize it. This is fairly simple: we have already seen the source list in a generic form.
A: Foreign Exchange Reserves and Foreign Demand for Dollars
The biggest source of dollar demand comes from foreign entities buying currency reserves. The following chart shows that demand for U.S. dollars among foreign entities is still growing, although it does appear to be rolling over somewhat.
The rise in foreign currency reserves reflects several of the categories of dollar demand that I mention above, including demand from sovereign wealth funds and central banks, demand from overseas corporations vying for American dollars in exchange for goods (reflected in the negative trade balance, discussed below), and demand for dollars in international trade outside the United States.
A': Demand From Foreign Trade With The U.S.
Many of the dollars used in foreign trade end up as currency reserves. Despite the recession in the U.S. and signs that Americans are tightening their belts, the balance of trade in the U.S. is decidedly negative, and this means that dollars are leaving the hands of Americans and going into the hands of foreigners.
B: American Demand For Dollars
American demand for dollars is not as great as foreign demand, although it exists in many forms and is evidenced by many data-points. I list some of them below to illustrate the point.
B': U.S Commercial Bank Demand Deposits
People and corporations typically put their money in the bank when they want it to be "safe." Despite the enormous rise in money supply since the financial crisis, the fear that it has instilled has lead to a surge in demand deposits denominated in U.S. dollars.
B'': Corporate Savings and Time Deposits
While corporate savings and time deposits did not see the spike that demand deposits did there is still clearly a demand for dollars among non-financial corporations, as the following chart shows.
B''': American Savings
Despite a culture of consumerism, Americans are net savers, even if it is on a small scale: this generates some demand for dollars.
3: Collapse in Overseas Demand for Dollars, and the Fall of the Dollar
The above data suggests that demand for dollars, particularly overseas demand, is a long-lived phenomenon. Why, then, is a decline of this demand inevitable? It seems that so long as demand continually increases then the value of the dollar can be kept elevated and the Austrians appear to be incorrect.
But dollars are simply claims on American goods, and while the value of goods produced by Americans is generally increasing, this rate of increase is greatly outpaced by inflation as measured by the M2 money supply as the following two charts clearly show. The first is industrial production. The second is a reprint of the M2 money supply chart.
Since 1980 industrial production has merely doubled, while M2 money supply is up 6-fold. The reason for this is that rather than dollars pushing up prices in the United States (hence pushing up the value of America's production in terms of dollars), these dollars went overseas in exchange for foreign goods from Middle Eastern oil to Japanese televisions.
Once these dollars went overseas they remained overseas. While overseas demand for dollars is still strong this demand is slowly abating as foreign nations decide to trade and save using other currencies. As countries from China, to Brazil, to Australia sign trade deals stipulating that trade will be conducted in other currencies, any dollars that these countries have will have fewer potential outlets, and they will ultimately find their way back to the United States. Furthermore, as the Federal Reserve increases the monetary base, and as the broader money supply continues to escalate, these countries which were once sources of demand will no longer be such sources, and more dollars will remain in the United States to bid up prices.
This is a slow and drawn out process, but there is ample evidence that it is occurring: the dollar is slowly losing its "reserve currency status." This is perhaps best quantified in the decline in the ratio between U.S. dollar reserves and total currency reserves. However drawing conclusions from these trends is impossible given that the data available is questionable insofar as $5.07 trillion of the $11.14 trillion of the world's currency reserves according to the IMF are "unallocated," and so we can only guess as to the details. However, as the following chart shows the share of U.S. dollar reserves has been steadily declining.
True, there is evidently a leveling off visible over the past few years as questions regarding the Euro's viability have arisen, and the Swiss National Bank eliminated the appeal of the Swiss Franc as a currency holding by pegging its value to the Euro. However we should also note that these figures do not include gold, which many central banks have been accumulating in lieu of paper currencies. Russia is an excellent example, as it has been aggressively accumulating since about 2005.
China is another example, although China's last reported gold holdings came in 2009, in which it claimed to have just over 1,000 tonnes.
This figure has been soaring, despite the fact that there is no official report, as the People's Bank of China purchases the gold produced within the nation's borders. The following chart gives the reader an idea of China's gold holdings, although keep in mind that information extracted from it is "unofficial."
More generally foreign central banks have been buying gold aggressively.
Despite the recent price drop in gold prices, the price has substantially outperformed all of the major fiat currencies that central banks hold as reserves.
Thus it follows that the decline of the dollar as a reserve currency is occurring at a much more rapid rate than the <1% decline in the percentage of dollar holdings with respect to total reserves: net dollar reserves are still rising, and this accounts partially for the rising dollar demand I mention above, but longer term trends indicate that this is just a temporary situation.
Another crucial piece of evidence that suggests a coming decline in dollar demand is the rise in international trade deals that eliminate the dollar in lieu of other currencies. China has been the primary instigator. Some of the more significant trade agreements made between China and other nations are as follows:
- Australia: In April 2013, China and Australia announce direct trade between the Australian dollar and the Chinese renminbi, eliminating the use of U.S. dollars as an intermediary in transactions between the two countries.
- Brazil: In June 2012, Forbes reports that China and Brazil agree to allow the exchange of up to $30 billion worth of real or renminbi in order to facilitate trade between the two countries.
- Japan: In December 2011, China and Japan sign an agreement whereby the two countries trade using yen and renminbi, eschewing the U.S. dollar as an intermediary in transactions between the two countries.
China also recently announced that it is no longer in its best interest to add to currency reserves, with the dollar being the most heavily accumulated currency by China.
China is not the only country that is beginning to abandon the dollar. Last year a trade agreement was signed between India and Iran that stipulates that the former will buy oil with gold.
Such deals are relatively small considering the amount of demand for dollars in global trade. However they are extremely important for the message that they send, namely that these nations are preparing to operate in an economy that doesn't use dollars as a medium for trade. (Of course representatives of these nations don't appear to have the courage that Putin does when he claims outright that the world should abandon the dollar.).
Investors should take away the following points from this article:
- Despite a large amount of money creation on the part of the Federal Reserve and private banks there has apparently been a lack of inflation and monetary chaos. Since this goes against predictions of Austrian economists, dissenters have used the lack of correlation between money supply and prices to dismiss the Austrian approach to economic analysis. However rejection of Austrian economics is the result of an overly simplistic view of data and what is really happening regarding the money supply.
- The CPI misrepresents the rate at which prices are rising for most Americans. Several essential products such as housing, food, energy, and healthcare are increasing in price at a faster rate than the CPI indicates. The BLS has incentive to understate the CPI, and it has techniques that look like they are academically valid but which serve to lower the CPI.
- Even though the CPI is lower than the rate at which prices are rising, the money supply is rising faster still. The reason for this is that prices depend both on the supply and demand for money. The discrepancy leads us to search for sources of demand, which can be found primarily overseas.
- While there is demand for dollars now, there is strong evidence that this demand is waning. Foreign central banks are buying other currencies and gold. Furthermore, foreign nations are beginning to seek trade mediums outside of the dollar.
Given these points it makes sense to begin preparing for an inflationary environment (I outline my strategy here).