Harry Long's  Instablog

WIth the Federal Reserve worried about its independence (finance.yahoo.com/banking-budgeting/arti...=), it has a Faustian bargain to make: keep its independence, or keep interest rates low.

Essentially, many in Congress would like to see the Fed keep interest rates lower for longer than it might if left to its own devices, in order to stimulate employment. It is a frightening prospect that pressure is being brought to bear on Chairman Ben Bernanke to keep monetary policy loose--the same Chairman who once wrote that the Fed could drop money from helicopters, if necessary, to prevent a severe deflation.

If the purpose of Fed independence is to keep monetary policy independent from politicians, who always prefer inflationary policies, it is essential that Ron Paul's bill, which seeks to audit the Fed (a necessity) is not used as a backdoor method by Congress to gain control over monetary policy.

Bernanke is in a tough position. He wants to maintain the Fed's prerogatives to set monetary policy. However, to do so, he may be tempted to bend to the will of Congress and keep interest rates lower than he might otherwise in the absence of external pressure.

If power is the ability to influence, then Congress, in practice, has huge power over the Fed if it's Chairman allows himself to be tempted to make the Faustian bargain of keeping interest rates low, in return for the maintenance of Fed independence. If Bernanke does not show backbone, Congress would not even have to pass a bill giving itself more power over monetary policy. It would simply have to threaten to do so every time it was unhappy, holding the Fed hostage to political whims. To his credit, Ronald Reagan supported Paul Volcker's inflation fighting stance, however unpopular with Congress. Chairman Bernanke should be similarly supported by President Obama in the area of monetary policy independence.

Distrubingly, the New York Times' Edmund Adrews noted on Novembor 11, (finance.yahoo.com/banking-budgeting/arti...=)

In the folk tale Hansel and Gretel, the children's stepmother convinces their father the woodcutter to abandon them deep in the forest so they cannot find their way back home.

Hansel can only leave a trail of breadcrumbs from the bread he has for lunch. Unfortunately, the birds of the forest eat his trail of breadcrumbs, causing Hansel and Gretel to become lost and eventually at the mercy of an evil witch who plans to fatten up the children, then eat them.

Unfortunately, U.S. politicians have left the citizenry in a similar predicament. In the folk tale, the stepmother wants to abandon the children, because she fears starvation. In the past year, low equity to asset ratios at U.S. banks have caused bankers to fear insolvency.

Bankers' response to insolvency has been to lobby for policies which increase the money supply and impoverish ordinary Americans. Quite literally, much of the public has been abandoned in an economic sense by the very elected representatives who are supposed to look out for their interests.

The breadcrumbs are a basic knowledge of economics, and the birds of the forest are the forces of ignorance and propaganda. Like Hansel, perhaps we can plant a trail in stone.

The classic Monetarist view is that all inflation is a monetary phenomenon, related to increases or decreases in the quantity of money.

Intuitively, this makes sense. For instance, in a simple example, if we have a family with a budget constraint (income) of $50,000 and a spike in energy prices causes expenditures related to energy to go from $3,000 to $6,000 a year over a period of 2 years:

In year 1, the family had $47,000 to spend on all goods other than energy ($50,000 - $3,000).

In year 2, the family only has $44,000 to spend on all goods other than energy ($50,000 - $6,000).

It is impossible for the average price level of all goods other than energy to increase, when there is less money to spend on such goods. Therefore, the average price level of all goods must stay the same. The energy price spike is actually deflationary to the prices and quantity demanded of goods other than energy. We can see this in retail sales figures, etc during energy price spikes.

Therefore, the only real way to get the average price level for all goods to increase is to increase the supply of money.

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A simplified economic Monetarist framework is:
 

M x V = P x Q

M is the quantity of money
V is the velocity of money (which is assumed to be constant).
P is the price level during the period.
Q is real output (which is assumed to be constant).
 

With some simple math, we see that:
 

P = M x V / Q

Since Velocity and Real Output are assumed to be constant, when the government increases the money supply, it only leads to an increase in prices.
 

In other words, the government can seriously affect prices, but it cannot affect output by increasing the money supply.

Q = M x V / P

Since Velocity stays constant, Money Supply (M) and Prices (P) increase together, so Q (Real Output) does not change.

What are we left with? Not economic growth, or increases in Real Output (Q), but instead, inflation.

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Of course, like Hansel and Gretel being fattened for slaughter by the witch, the rapid in increase in money supply initially looks like a demand increase to business people of all stripes. But then, as input costs rise, the reality that prices are increasing (rather then real demand increasing) eventually sets in. Input prices increase, and profits do not.

Of course, the above is a coarse, simplified equation, with many built in assumptions. However, the stagflation of the 1970's has empirically proven the point that many of the equation's assumptions are roughly accurate. As Lord Keynes said, “It is better to be roughly right, than precisely wrong.”

Indeed, the 1970's proved furthermore, that in the real world, when prices increase, people (especially the unemployed) can afford less quantity of goods and services, and the economy is actually dramatically hurt.

When the Fed increases the asset side of its balance sheet by buying up toxic debt, the liability side of its balance sheet automatically increases. What are these liabilities? Dollars. However, without a gold standard, there is effectively no true liability, per se, merely an automatic increase in the money supply of dollars.

Intuitively, if the amount of real goods and services stays constant in the short term, there are now more dollars “chasing” the same goods and services and prices rise. Since there are more dollars, each dollar is less valuable. No new value has been created in the real economy of supply and demand for real goods and services.. The price level has merely risen.

Why do bankers like inflation? What are they thinking (I use the term liberally)? First, they needed more capital. What's the abstract (for most people) promise of higher inflation in the future next to their need for capital now? Remember, the government basically handed the banks capital. Who cares if the creation of more money hurts everyone else's savings, increases the general price level, and hurts the standard of living of those on fixed incomes? Second, accounting in the U.S., unlike in some South American countries such as Chile, is done in nominal terms, not adjusted for inflation. If house prices reflate, bankers do not have to write-off as many loans. Inflation covers all manner of banking sins.

But what we have, make no mistake, is the phenomenon of replacing financial expertise with political “expertise”. The average bank may not have diligent banking practices, but it does have the ability to buy votes. Since most Americans' wealth is held in dollars, banks are quite literally lobbying (in effect) to make the average taxpayer's dollars, and hence wealth, decrease in value.

Why are we socializing the cost of stupidity with affirmative action for the formerly rich and stupid? Why are we putting our society at the mercy of the witch of inflation? Why have we given politicians the power to dramatically affect the value of money—a power which recent events have proven they are prone to abuse under the influence of banking lobbyists?

If the goal of certain less competent market actors (Bank of America, Citigroup, etc) is to gain access to the public purse in order to secure their prosperity, the answer is to shrink the public purse, moving the scope of government action to the private domain.

Without government handouts, banks would be forced to raise capital in the private markets, or get taken over by the FDIC and have their deposits moved to less leveraged, more responsible banks.

Banking lobbyists have painted the false choice as one between governments bailouts to shore up equity capital and financial collapse. Multiple firms, such as Indymac, have had their deposits sold off to more responsible banks under the auspices of the FDIC, without any loss of depositor funds. The FDIC did lose almost $11 billion on insuring Indymac's deposits, but this pales in comparison to the cost the government would have incurred to increase Indymac's equity capital. Even large FDIC-led solutions are possible. Washington Mutual, with over $307 billion in assets was acquired by J.P Morgan Chase, in the year's largest deal arranged by the FDIC. These transactions have a clear track record of success vs. government handouts which keep problem banks in business.

The government can still accomplish the essential function of safeguarding depositor funds, without handouts to problem banks. These handouts don't safeguard our financial system--they safeguard bankers' jobs and hurt the rest of us with the resulting inflation. There is no net gain to society from these bailout. There is a net loss to society as the incompetent are rewarded with taxpayer funds, inflation takes hold, and deficits increase the interest paid to foreigners on ballooning government debt.

Nothing good will come of it. If we continue to prosper, it will be in spite of dumb decisions surrounding the money supply, not because of them.

DIsclosure:
No positions in any companies mentioned. That may change at any time.
 

"[L]ow interest rates often have the opposite of their intended effect. Extremely low interest rates can vacuum liquidity out of nations. Japan has been referred to as a nation where loose monetary policy was like "pushing on a string." There was no push. It was a pull. Liquidity was sucked out of the country as the Yen became the world's carry trade currency of choice. Borrowing in a currency is the opposite of investment. It is liquidity-draining to the carry trade currency nation. For all of the talk about using monetary policy to dampen the business cycle, no result could be more damaging or procyclical."

The test of such a statement would be a country which is raising interest rates, while the rest of the world keeps them low. This week, Australia has provided us with such a test (http://finance.yahoo.com/news/Australia-rate-hike-a-good-apf-2390114046.html?x=0). Their central bank has raised interest rates, and so far, Australian equity markets have moved higher

I would argue that their central bank's decision to raise rates will incentivize capital to move from countries with anemic interest rates to Australia, which will (everything else being equal) benefit their economy and equity markets. Currently, central banks around the world operate under the erroneous assumption that anemic interest rates are stimulative. I have argued that ultra low interest rates increase asset prices rather than stimulate the real economy. Australia should benefit from its rate increase. Of course, only time will prove the point.

Hopefully, the world's central bankers and economists are taking note.

Disclosure: Long EFA. Positions may change at any time.

In The Unintended Effects of Bad Policy (May 18th), I wrote that: