Monthly Archives: March 2013

Recently our blogs have emphasized the incredible expansion of the stock of high-powered money required to monetize our debt-financed ballooning federal deficits.  Further, we have noted the fact that private banks are effectively being kept on the sidelines by onerous capital requirements, federally mandated lending regulations, or interest payments rewarding them for not lending.  The summary picture that emerges is not a pretty one—but it is a sadly understandable one.


We have an usurping government that is trying to co-opt and control the U.S. lending market.  It is apparently less and less a “market” and more and more a political arm of the government and its current political agendas.  The government’s agenda is explained by the area of economics described as “Public Choice Theory.”  Succinctly, this is the view that political incumbents within a government that possesses the power to “steal” from the private sector through borrowing, taxation, and fiat money creation will tend to reward those constituencies that voted for it at the expense of those who voted against it.

At the present time, things seem to be working well for the stealing.  The velocity of money is logically related to the opportunity cost of holding money.  As long as actual inflation and inflationary expectations are low, the government can issue and the Fed can monetize federal debt with reasonable success.  But what happens when the government inevitably becomes too greedy?  When deficits become too big? And when the required monetization becomes too large? And, yes, we would suggest that a trillion dollars a year of high-powered money expansion is too large to be sustainable.  Also unsustainable and intolerable is our current situation in which too much of our economy’s scarce and precious private savings is being steered into inefficient public programs and expenditure.  The federal government’s expanding student loan program is a prime example.

What will happen, of course, is that the traditional banking industry will probably die (it may be an anachronism anyway as we have argued in our recent book Capital as Money).  What else can happen to banks anyway?  They can only make politically approved loans, they are micro-managed and regulated as an arm of the federal government, and by Fed rate manipulation they are constrained to survive on near zero rates of return.  On the present course the traditional banking industry appears doomed for extinction.

When inflation does inevitably surge, a technologically efficient, rational private economy will display a shrinking willingness to be subjected to the sustained imposition of the inflation tax (read Chapter 5 in Capital as Money—the limits of monetary financing).  The empirical support for this conclusion lies in the frequent lament by central banks worldwide that the “effectiveness” of their monetary policies isn’t what it used to be.  Translated, read this as “it isn’t as easy to steal output from the private sector via printing paper currency as it used to be.”  Velocity has become a market-determined variable rather than a technological constraint.  As prices rise because of government’s attempt to increase its funding from inflationary financing, the velocity of money will increase.  Astute individuals will react to rising prices by increasing their transactions speed in an attempt to reduce their holdings of fiat money balances.  And in today’s economy the limit of the electronic exchange of funds is literally the speed of light.

At the same time direct lending between lenders and borrowers (as opposed to bank or brokered lending) will continue to grow (as it already has) and private investment will be starkly preferred on a risk/return basis to holding fiat money or public debt.  If our government pushes too hard and becomes too greedy in fiat money issuance (and based on history, when have governments not?) then inflation will sharply rise, dissatisfaction with fiat money will mount, and the time will be ripe.  Ripe for what?  Ripe for the transition to a private market real money.  It will be time for a real logical medium of exchange and valuation:  Capital as money.

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Businessman putting gas nozzle to his head, screaming.Sometimes it seems that we are examining inflation and its components with the same intensity and in the same absurd, uncomprehending way that Greek and Roman Oracles examined the innards of a chicken to discern the future.  “Include this item, exclude gasoline, assign more weight to IPADs, give zero weight to food.”  The numbers get massaged so that the in the final analysis it is difficult to find any meaning in what is reported.

To really get a handle on inflation, it is important to remember the distinction between inflation and relative price movements.  Inflation refers to the rate of increase of prices in general.  And inflation occurs or accelerates when governments or central banks are issuing worthless currency (fiat money) faster than their real economies are growing.  Hence, it is ironic for the government to wring its hands about inflation, its unfortunate impacts, or the nuances of its measurement.  The government and the central bank are responsible for creating the very inflation whose measurement is so carefully and selectively being fine tuned.

As was mentioned in last week’s blog, when measuring core CPI inflation the government tosses out food and energy, and last month energy prices shot up.  But since energy was removed from consideration, the reported core inflation number was unremarkable.

When reporting inflation, the government’s ignoring of those items whose price went up by the largest amount is absurd.  It is analogous to a guest coming into your home and bringing with them an un-housebroken dog.  After the guest’s dog fouls several of your rooms, the visitor commiserates with you on which rooms were fouled worst.    One can only imagine the conversation as the guest attempts to play down the damage.  “The dog had issues in both the kitchen and in the dining room, but it made an unusually bad disaster out the living room, so I am eliminating that one from our list..…”

In any economy, even an economy with stable prices on average, some individual prices go up and other prices go down.  Relative price movements are always part of economic life—and would continue to be even in an economy that used a private real money such as capital.  Relative price changes occur because of supply and demand for various goods and services and all the things that affect them—wars, droughts, new resource discoveries, fads, trade embargoes, etc.  Overall inflation happens only when fiat currency is rapidly created out of thin air.  And, the government should be reminded that the problem doesn’t disappear by reporting “core” inflation while closing its eyes to those prices that have gone up by the largest amount.

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Today the government released the consumer price index.  The media largely downplayed signs of inflationary pressures, as the month-over-month core rate of inflation was a mere 0.2 percent.  The following quote taken from today’s Chicago Tribune is representative of the overall response to today’s inflation numbers:

“Excluding food and energy, consumer prices rose 0.2 percent slowing from January’s 0.3 percent advance.

The generally benign underlying price pressures should give the U.S. central bank scope to keep pumping money into the economy, despite signs of improvement in labor market conditions.”

 Before we break out the champagne, we think a further look at the numbers is warranted.

When it comes to measuring inflation, the government reports two numbers, one called “core” CPI inflation and the other called “headline” CPI inflation.  (Ironically, it is the “core” CPI inflation number that usually grabs all the headlines.) 

Headline CPI inflation is measured by considering all the items purchased by a typical household, and seeing how much the prices went up on average.  Makes sense, doesn’t it?  And when you examine today’s headline CPI inflation, prices went up month-over-month by an amount of 0.7 percent.    

By way of contrast, core CPI inflation is calculated by looking at a typical household’s purchases, but then tossing out food and energy.  So the core CPI inflation rate might be meaningful to a person who doesn’t use any gasoline, electricity, natural gas, or eat food.  For the rest of us, it is the headline CPI that matters. 

Naturally, lots of us wonder what the government’s rationale could possibly be for excluding two of the most important items in any household’s budget from the calculated “core” rate of inflation.  To skeptics, the reason is simple:  the inflation rate appears lower if you exclude those items whose prices are going up.  But perhaps we are being too harsh on the government by presenting only one side of the story. The government’s own economists would tell you that core inflation is more relevant than the headline number because food and energy prices are really quite volatile.  By excluding food and energy, they will argue, we get a better picture of underlying inflationary pressures in the overall economy. 

Well, OK, maybe food and energy prices are volatile. All that tells us is that the thing we are trying to measure, which is inflation, is volatile!  Putting your head in the sand and ignoring two of the largest items in any household’s budget may allow for bureaucrats and central bankers to conclude prices are rather stable, encouraging them to continue creating more money.  But for shoppers a low core rate of inflation means zilch.

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money changing handsMilton Friedman famously observed “inflation is always and everywhere a monetary phenomenon.”  This aligns with simple intuition—if money is printed too rapidly, then the prices of goods and services will surely rise.

The Federal Reserve is presently expanding the monetary base at an unprecedented pace.  But inflation, at least as reported by U.S. government statisticians, appears to be modest (more on reported inflation statistics in future blogs).   How do we explain this apparent anomaly?

As was previously discussed in our March 4, 2013 blog, one relevant factor pertains to the difference between the monetary base and the money supply.  It is the monetary base that is directly impacted by the Federal Reserve’s ongoing policy of purchasing boatloads of government bonds.  The monetary base consists of bank reserves and cash in the hands of the non-bank public.  But expanding the monetary base does not necessarily correspond to expanding the money supply.  The money supply (M-1) consists primarily of checking account balances and cash held by the non-bank public.  An expanding monetary base may not result in more checking account balances in an environment where commercial banks are reluctant to loan and are holding lots of excess reserves.  And the Fed’s policy of paying banks interest for clinging to reserves is having a negative impact on bank lending.   Thus, the money supply is not growing nearly as rapidly as the monetary base.

Still the money supply is growing.  For the 12-months from January 2012 to January 2013 the money supply (M-1) grew at an annual rate of 11.8 percent, while (M-2) grew at 7.5 percent (source:  So, why is there little (reported) inflation?

The equation of exchange, explained fully in Capital as Money, provides us with an answer.  The equation of exchange relates the money supply (M), the velocity of money (V), the average price of a good or service (the price level, P), and the physical units of output produced in our economy (real GDP, Y).  The equation is a simple identity, and is shown below:

M V = P Y

At the present time our money supply, as measured by M-1, is growing at about 12 percent per year.  Meanwhile, real GDP (Y) is sputtering, with an annual growth rate of about 2 percent.  Likewise, reported inflation is somewhere in the neighborhood of 2 percent.  What is going on?  The answer is found in V, the velocity (or turnover) of money.  The velocity of money represents the number of times a dollar is spent on goods and services during a year.  And it has been declining.  A rapidly falling velocity of money can offset any increase in the money supply.  An examination of the equation of exchange suggests an economy will experience falling nominal GDP (which is P Y on the right-hand-side) whenever velocity (V) is going down more quickly than the money supply (M) is going up.

Now, here is the problem with velocity:  It always tends to go the wrong direction.  When an economy is entering recession prices tend to fall, and people are motivated to hoard their money.  Holding on to your cash makes a lot of sense if prices are going to be lower tomorrow than they are today.  This tendency can be seen in data provided by the Federal Reserve Bank of St. Louis (  The velocity of money M-1 as of the fourth quarter of 2007 stood at 10.367.   By the fourth quarter of 2008 it fell to 9.202, and has steadily declined since.  As of the fourth quarter of 2012 the velocity of M-1 is a lowly 6.547.  The declining velocity has been sufficient to offset a growing money supply, resulting in rather tame reported inflation.

As was stated above, forces are at work to make velocity move in the wrong direction.  When inflation heats up, it entices people to spend money more quickly.  After all, who wants to hold cash when prices are rapidly rising?  Better to quickly spend your money on real goods and services; don’t wait until you have to pay more.

Right now inflationary expectations seem to be modest, and people are willing to hoard cash.  When inflation appears—and it will—the mindset will reverse.  Rising prices will trigger a rush to spend, and velocity will go up.  The rise in velocity further reinforces rising prices, which again increases velocity, and so on.  Such is the nature of an inflationary spiral.

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Vault with Safe-deposit Boxes InsideSince the fall 2008 financial meltdown the Federal Reserve has engaged in open-market purchases of the highest order.  Open market purchases refer to the buying of government bonds to keep bond prices high and interest rates low. 

At the present time the Fed’s program involves the monthly purchase of $85 billion of government and government-agency bonds.  This monthly amount, when multiplied by 12, gives an annual figure of just over $1 trillion, which is roughly the size of the federal government’s current budget deficit.  The implication is that the Fed is ultimately financing the budget deficit by creating new money, which is referred to as “monetization of the debt.”  And we have frequently argued that the end result of all this monetization is bound to be inflation.

But why is inflation not soaring right now?  With such a rapidly expanding monetary base, why are prices not also sky-rocketing?  The issue of inflation, and its measurement, is something we will take up this month in a series of blogs.  However, to begin our analysis, we note that there is a difference between the money supply and the monetary base (see Capital as Money for a thorough explanation).  The monetary base includes commercial bank reserves, and it has grown at a much more rapid rate than the money supply.  And it is the money supply that ultimately impacts on consumer spending and prices. 

Why isn’t the money supply soaring in the face of all the Fed’s aggressive bond purchases?  The answer is in part due to another Fed policy, enacted in October 2008, of paying interest to banks for holding excess reserves. 

Take a minute to digest what you just read:  Starting in the darkest days of the financial crisis, the Fed enacted a new policy of rewarding banks with interest payments for NOT making loans!  The Fed’s paying of commercial banks to hold excess reserves, while at the same time buying bonds at a feverish pace appear to be contradictory policies.  Bond purchases by the Fed are designed to increase the monetary base, which normally expands the money supply.  Paying banks to hold excess reserves discourages lending and works to decrease the money supply.   Why the contradictory policies? We are not exactly sure why the Fed would head down these two conflicting roads.  Perhaps it is because the Fed wants to finance reckless government spending through massive bond purchases, while at the same time keeping a bit of a lid on the growth in the money supply.  If and when banks do start making more loans there is ample fuel in the form of a gargantuan monetary base to cause a dramatic surge in the money supply and in consumer prices. 

The Fed suggests that increased inflationary pressure, when it manifests itself, will be readily subdued by increasing the interest rate the Fed pays on reserves.  When prices start to rise, the Fed will promptly increase the rate paid to banks from 0.25 percent to some higher number, stopping inflation dead in its tracks.  Time will tell.

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