Inflation, Fed Policy and the Liquidity Trap

While many believe that Federal Reserve policy over the past year has been inflationary, there is clear evidence that money supply is falling in real terms and there is a strong monetary bias to deflation and GDP shrinkage.  In February, 2008 I was on FOX Business Network and discussed the implications of deleveraging the financial system and the unintended side effect of money supply shrinkage.  As it turns out, my predictions were correct.  This was one time I wish I was wrong.  There is no “joy in Mudville” from being correct about the events that have unfolded since February and the serious systemic risks that remain.

There is a popular misconception that when the Federal Reserve lowers interest rates inflation results. Inflation is only indirectly connected to interest rates and is instead determined by money supply. While a falling Federal Funds rate usually means that money supply is rising (and therefore inflation results because there is too much money being created to chase a too few goods and services), there isn’t a direct connection between interest rates, inflation and money supply. In the first half of 2008 the expected relationship between interest rates, inflation and money supply has not materialized. Moreover, in real terms the money supply has actually started to decline which is an early indicator of a liquidity trap and potential deflation that is reminiscent of the 1930’s.

The Federal Reserve “head faked” most economists when it dropped interest rates but didn’t increase money supply at an inflationary rate. In fact, the latest Federal Reserve monetary supply statistics suggest that money supply has had a deflationary bias for the last several months. Economists and business leaders that scream every day in the media for higher interest rates are wrong and are sensationalizing a very dangerous problem. They sound like the “liquidationists” of the late 1920’s and 1930’s who bowed to the theoretical god of “monetary discipline” and avoidance of “moral hazard” and argued the United States right into the Great Depression.

As banks and financial institutions “deleverage” they are in fact shrinking money supply. Every dollar of deleveraging is at least a dollar that is leaving the system. Without the strong Federal Reserve action of the last 9 months, money supply would be plunging at an uncontrollable rate.

The United States faced this sort of liquidity trap in 1929 and the early 1930’s.  By allowing the money supply to be destroyed as a result of a banking and Wall Street crises, the Federal Reserve helped engineer the Great Depression. Ben Bernanke is a student of history and is trying to avoid the mistakes of the Depression era Federal Reserve.

The amount that money supply is falling because of the banking crisis can be easily estimated. As banks recognize losses they must shrink approximately 10x the amount of after tax losses that aren’t replaced with new equity. The actual amount of shrinkage maybe a little higher or a little lower than 10x but for estimation purposes 10x is a pretty good multiplier. Assuming after-tax net losses of banks are $200 billion, then without aggressive Federal Reserve intervention, money supply will shrink by approximately $2 trillion. In late February, 2008, several academics wrote about the “$2 trillion shrinkage” in a paper that received little to no media attention.  And, also about the same time, the WSJ wrote a blog about the paper and the “$2 trillion question.”

$2 trillion of money supply shrinkage is an enormous amount. To put it in prospective, the entire amount of M2 is approximately $7.7 trillion and the amount of total assets of FDIC insured institutions is approximately $13.4 trillion (if the Federal Reserve hadn’t discontinued the compilation of M3, many of these banking assets would have been reported in M3).

As of the latest Federal Reserve release on money supply, M2 only increased 1.2% during the three months from March until June 2008. That growth rate in monetary stock is significantly below the inflation rate and is an indicator of both recessionary and deflationary conditions.  It reflects the net effect of “shrinkage” and monetary policy that is designed to counteract the effect of deleveraging.   

On February 21, 2008, I was a guest on FOX Business Network and discussed the problems that the Federal Reserve was facing in keeping money supply from falling. I discussed the potential for the $2 trillion shrinkage in money supply and how the Federal Reserve is fighting to avoid an economic catastrophe by trying to prevent such shrinkage. My appearance on FOX predates the WSJ blog and the academic papers referred to above and was before the Bear Stearns meltdown.  Set forth at the bottom of this blog entry is one of several video clips from February’s FOX appearances, and the comments of Liz MacDonald and Peter Barnes.

Yesterday, the Telegraph (a London newspaper) reported that “the lifeblood of countries’ economies is draining away - with grim consequences for us all…money supply data from the US, Britain, and now Europe, has begun to flash warning signals of a potential crunch. Monetarists are increasingly worried that the entire economic system of the North Atlantic could tip into debt deflation over the next two years if the authorities misjudge the risk…” The article continues to discuss the similarities between current economic conditions and the beginning of the Great Depression. The article quotes the Senior Economist at Northern Trust who ominously states that money supply is crumbling in the US because of deleveraging. It’s a great article by the Telegraph and is what I predicted would happen in my February FOX appearances.

Unfortunately, I don’t believe that the Federal Reserve is winning the fight against a catastrophic liquidity trap. The Federal Reserve isn’t necessarily losing the battle but by the same token it isn’t winning. The problem is that the Bush administration and the ECB are forcing the Federal Reserve to fight by itself. Yesterday’s failure of IndyMac (IMB), the meltdown of Freddie Mac (FRE) and Fannie Mae (FNM) and the collapse of confidence in Lehman (LEH) are indicators of the deepening liquidity crises and of very serious systemic risks.

If the Bush administration understands what a liquidity trap is, how the US fell into the Great Depression and how we can learn from history and avoid a similar fate they have a strange way of showing it.  And, if I could accurately predict in February what the Telegraph reported yesterday, why didn’t Treasury Secretary Paulson read the economic research and get out in front of this problem?

I hope that the next administrations’ leaders understand economics better than the Bush Administration and after the Presidential election join the fight with Mr. Bernanke. The United States is the greatest country in the world with the most dynamic economy. Let’s hope that poor Washington leadership doesn’t destroy our way of life.

Disclosure: None