Sunday, September 23, 2007
On Gary North's curious deflation call
My opinion was requested on Gary North's analysis that the Fed is deflating, contained in How Bernanke has snookered us all,so I went to his site to check out his views. To my surprise, Idiscovered that he now charges for his views (fortunately I still get atwice weekly blast, including the article in question from the Daily Reckoning).The cynic in me says that a shift to fee based commentary tends toengender overstated simplistic analysis and the argument that the Fedis deflating when growth in the monetary base is slowing but stillpositive seems to me an oversimplified overstatement.
But I'lladd my two cents worth anyway, and given that my views are still freeto you, 2 cents worth for nothing seems like good value to me. Ofcourse, those 2 cents don't buy what they used to.
I assume thatMr. North argues within the framework of the quantity theory of money,i.e. crudely put, more is inflationary and less is deflationary. Hisconclusion of deflation also assumes stable money multipliers such thata decrease in the monetary base leads to decreases in broader money. Ifthe MBase can fall while broader money supplies rise, the MBase willnot be a good predictor as was the case when the money multipliersbroke down when the Fed was aggressively adding reserves in the early90s with little increase in inflation.
Of late the multiplier between the MBase and M2 is rising. Assuming John Williams' Shadow Stats are correct, that between what used to be M3 and the MBase is rising even faster, which suggests, a la, Doug Noland, that things are a bit out of the Fed's control.
I tend to agree with Mr. Noland's view that the monetary system is out of control,although I take a more narrow view of the transmission mechanism.During the Asian crisis, the Asian CBs, once they were forced to admitthey had a problem, tried hard to tighten, but resolution of theirinternational deficits swamped their efforts. Their currencyovervaluations had first to be resolved before the tightening couldhave an effect. Thus we saw a large almost one step spike in inflation,as a result of previous monetary easiness and currency overvaluation,followed by a normalization.
The problem, in my view, withtraditional quantity theory is that it was based on a far more autarkicmodel, or at least one in which international imbalances would tendtowards balance, as IMF policy requires. Open capital accounts makesuch analysis much more complex in the event, such as exists now withthe US, when international imbalances are large and growing.
Ilike to think of the accumulated foreign official sector holdings ofUS$s as "stored deflation" in that it gives these foreign CBs bonds tosell (the quantity of which, in toto, is far in excess of what the Fedcurrently holds, btw) which, when sold, will withdraw liquidity fromthe market, other things equal.
If and when the accumulation ofthese holdings goes into reverse, as they must, assuming the currentsystem isn't changed, the Fed will face a similar dilemma as the AsianCBs. If they want to stop an inflationary spiral, they will need totighten internally while the international markets are tightening forthem. That is, US bonds will need to find their clearing yield based onprivate sector preferences, a yield I believe will have 2 digits, not 1.
Butthe Fed faces a problem the Asian CBs didn't have to worry (much)about, the derivatives monster. A spike in interest rates will push thebig banks' derivatives books into insolvency, and as the derivativesbooks go, so do the banks themselves.
Assuming the Fed doesn'twant that to happen, they will need to be the buyer of last resort inthe bond market. That is, in order to keep the financial systemfunctioning reasonably smoothly, without letting interest rates spike,the Fed will need to take these foreign official sector holdingsreleased into the market on its balance sheet, which means the monetarybase will rise.
In a sense, this is almost the reverse of theproblem Greenspan faced in the early 90s as foreign holdings started torise dramatically. The buzz phrase back then was "pushing on a string",the Fed let the MB grow by double digits for years without much effecton inflation. Now, using the same metaphor, if the Fed pulls on thatstring, it will break.
The underlying problem is this- bondyields are, due to years of public sector intervention, way too low toattract private sector interest. Somebody has to eat this loss, and inthe event, as I suspect, this somebody is the Fed, Gary North will seethe monetary base expand rapidly (as he notes at the end of hisanalysis, with agreement from me) and inflation will be the result,whether Bernanke likes it or not.
