``Many false arguments are used to defend inflationism. Least harmful is the claim that a moderate inflation does not do much harm. This has to be admitted. A small dose of poison is less pernicious than a large one. But this is no justification for administering the poison in the first place. It is claimed that in times of a grave emergency the use of means may be justified which in normal times would not be considered. But who is to decide whether the emergency is grave enough to warrant the application of dangerous measures? Every government and every political party in power is inclined to regard the difficulties it has to cope with as quite extraordinary and to conclude that any means for combatting them is justified. The drug addict, who says he will abstain from tomorrow on, will never conquer the drug habit. We have to adopt a sound policy today, not tomorrow.”-Ludwig von Mises, Interventionism: An Economic Analysis, Inflation and Credit Expansion
It’s pretty naïve for any expert to suggest that governments won’t be inflating away their liabilities. That’s principally a function of “Post hoc ergo propter hoc” (after this, because of this) fallacy. That’s also because they have retrofitted on their selected facts to their argument which leads to their preferred conclusion-deflation.
First, such argument betrays the incontrovertible avalanche of evidences from the current actions of policymakers.
And most importantly, the primary sin of such flawed argument is that it basically ignores the political nature of governments and its inflationary tendencies.
For instance, the US Federal Reserve continues to expand its balance sheet this week. According to the Wall Street Journal Blog, ``The Fed’s balance sheet expanded again in the latest week, rising to $2.072 trillion from $2.069 trillion, but the expansion highlighted the recent shift in the makeup. The increase came solely from purchases of mortgage backed securities, Treasurys and agency debt.”
Figure 3: T2 Partners: Why There Is More Pain To Come
Possible reasons for these current actions by the US Federal Reserve:
One, the US Federal Reserve could be positioning against expected losses arising from forthcoming mortgage resets from Alt-A and prime mortgages (see figure 3) as well as potential bank losses from the struggling commercial real estate mortgages.
And second, the US Federal Reserve could be providing “liquidity” (euphemism for inflating the system) in anticipation of the seasonal weakness for the stock market.
Or most likely it could be a combination of both factors.
Policy Support For Stock Markets
While the Fed Chairman Ben Bernanke doesn’t explicitly declare that Federal Reserve policies are meant to directly/indirectly support the US stock market to paint the impression of recovery, we must be reminded that Mr. Bernanke sees the stock market as playing a very crucial role in the macro economy which, for him, deserves support.
As he wrote in 2000, A Crash Course for Central Bankers, ``History proves, however, that a smart central bank can protect the economy and the financial sector from the nastier side effects of a stock market collapse.” (bold highlight mine)
So ignoring the policy biases, if not the underlying ideology which undergirds such biases, of the incumbent authorities would seem like a major misdiagnosis.
Mr. Tyler Durden of Zero Hedge provides us with very convincing evidence (see figure 4)
Figure 4: Zero Hedge: Correlation Of S&P 500 Performance With Fed Monetization Activities Since Start Of QE
Notes Mr. Durden (bold highlights mine), ``since the launch of the Fed's Quantitative Easing, aka Monetization, program, the value of the Total Securities Held Outright on the Fed's Balance Sheet has increased by $917 billion- from $584 billion to $1.5 trillion. This has been accompanied by an almost linear increase in the S&P 500 Index, from 721 at QE announcement on March 18 to 1033 yesterday. This $917 billion in extra liquidity, instead of igniting an inflationary spark, as the QE program was designed to do, is now (metaphorically) sloshing around bank basements.
``As a reminder: the most recent reading of Total Deposit Reserves was... $886 billion dollars: An almost dollar for dollar match with the increase in Securities Held Outright of $917 billion. And instead of this excess money hitting broader aggregates such as M2 or MZM, it is held by the banks, who proceed to buy securities outright on their own, either Treasuries or Equities. Apply the proper "money multiplier" to get the monetary impact on the S&P 500, as a result of the banks not lending these excess reserves, and instead simply speculating with it, and you will likely get the increase in the market cap of the S&P since the launch of QE.”
So like in China, where the explosion of bank lending have seeped through the real estate markets and stock markets, it is likely that the extra reserves provided for by the Federal Reserve to its banking system has equally powered the US stock market to its present levels.
As you may observe, the political decision making process (choosing to support one industry over another) is vastly intertwined or deeply entrenched with the performance of asset pricing dynamics.
Political Nature of Inflation
Will the US refrain from inflating away its system?
Harvard’s Professor Kenneth Rogoff gives as a clue, `` Government backstops work because taxpayers have deep pockets, but no pocket is bottomless. And when governments, particularly large ones, get into trouble, there is no backstop. With government debt levels around the world reaching heights usually seen only after wars, it is obvious that the current strategy is not sustainable…
``We are constantly reassured that governments will not default on their debts. In fact, governments all over the world default with startling regularity, either outright or through inflation. Even the U.S., for example, significantly inflated down its debt in the 1970s, and debased the gold value of the dollar from $20 per ounce to $34 in the 1930s.”
So the US is faced with two choices, either inflate or default.
Yet the most attractive choice for the current crop of policymakers would likely be the inflation route.
Aside from economic ideology, the immediate triumphalism from present policies as manifested in the market actions will unlikely prompt for ‘policy exit’ soon. Why stop the party when everything has gone groovy?
The party has to go on, even if policymakers today chatter on “exit strategies”.
This has been general the theme from the officialdom seen from Canada’s Prime Minister Stephen Harper, China’s Premier Wen Jiabao, Governor Mervyn King of the Bank of England, Subir Gokarn, a candidate for the for the deputy governor’s post at the Reserve Bank of India, European Central Bank President Jean-Claude Trichet, and US Federal Reserve Vice Chairman Donald Kohn.
Yet it would take humongous amount of money (or debt/credit) to sustain the present system.
Mr. Doug Noland of the Credit Bubble Bulletin estimates that $2-2.5 trillion of new or fresh credit is required to support the financial system.
And with markets dependent on government backstop, the only principal source of credit creation would likely emanate from the US government.
Mr. Noland writes (bold emphasis added), ``In this post-Wall Street Bubble environment, only government and government-related Credit retains sufficient “moneyness” in the marketplace. Systemic reflation today depends on a massive inflation of this government helicopter “money.”…
``As I have stressed repeatedly, in the neighborhood of $2.5 TN of non-financial Credit growth is required to stem systemic implosion – a massive Credit expansion with only our federal government up to the challenge. It is this fundamental facet of Bubble economies – a maladjusted economic structure sustained only through ongoing Credit excess – that prohibits Washington from extricating itself from very public “private sector” intrusions. Fixated on the notion of sustainable recovery, policymakers will not be Dialing Back from massive borrowing, spending, or market backstopping endeavors. And this gets to the core of the unquantifiable costs of failing to rein in Credit and asset Bubbles during the boom.”
For global governments (especially for those havocked by the bubble) working to extend their presence over the marketplace reveals of the operating political nature of the inflation process. The G-20s recent move to “strengthen financial regulation” is an example of such manifestation.
The more the government intervention becomes entrenched into the system or the marketplace, the greater their perceived need for inflation.
As Professor Thorsten Polleit explains (bold highlights mine), ``Under a regime of government-controlled money, it is a political decision whether or not the money stock changes — that is, whether there will be ongoing inflation (a rise in the money stock) or deflation (a decline in the money stock).
``Governments have a marked preference for increasing the money stock. It is a tool of government aggrandizement. Inflation allows the state to finance its own income, public deficits, and elections, encouraging a growing number of people to coalesce with state power.
``A government holding a monopoly over the money supply has, de facto, unlimited power to change the money stock in any direction and at any time that is deemed politically desirable.”
Hence, where the marketplace operates under the iron visible hands of governments, the understanding of the role and the incentives driving governments’ policymaking is pivotal to the analysis of asset pricing dynamics.
Ponzi Financing Requires The Intensive Use Of The Printing Press
Nonetheless it would probably take increasingly more than $2.5 trillion of credit to sustain the present system going forward, as the marketplace has been operating under Ponzi financing dynamics.
Policymakers appear to be in admission that the current conditions of the global economy seem operating under the backdrop of rising asset prices instead of a vigorous economic recovery, hence their alleged aversion to withdraw stimulus programs presently in place.
This phase is otherwise known as Ponzi financing.
The credit cycle as defined by Hyman Minsky constitutes 3 stages: Hedge financing, Speculative financing and Ponzi Financing.
As we described in September 2008 article, Global Markets: From “Minksy Moment” To The “Mises Moment”, ``Minsky’s model actually basically depicts of the credit cycle underpinning the business cycle, where credit transforms from a function of HEDGE financing (ability to pay principal and interest) to SPECULATIVE financing (ability to pay interest only, which needs a liquid market to enable refinancing and debt rollovers) and finally to PONZI Financing (basic operations cannot service both interest and principal and strictly relies on rising asset prices to service outstanding liabilities).”
In other words, the key to sustaining the credit cycle of Ponzi financing means sustained elevation of asset prices. It commands the feedback loop mechanism of collateral values and lending activities.
To quote George Soros, ``When people are eager to borrow and the banks are eager to lend, the value of the collateral rises in self-reinforcing manner and vice versa. Thus the act of lending activates a reflexive relationship.”
And that means a pyramiding scale of credit growth in order to maintain the momentum or trend of rising prices.
Yet this serves as another characteristic of the inflation process.
As Professor Hans F. Sennholz wrote (bold emphasis mine), ``But as certain as there must be a readjustment, just as determined are our planners to stave off the day of reckoning. And it is true that this can be done — temporarily. The consequences of policies of inflation and credit expansion, as far as the trade cycle is concerned, can temporarily be postponed through an intensification and acceleration of the depreciation process.
``That is to say, our monetary planners can temporarily avert the inevitable decline and readjustment through an intensified operation of the printing presses. As all political parties are dead set against any economic readjustment, they are all ready and determined to resort to this tasty but tragic medicine in case the boom economy should taper off during their tenure of office.”
Thus, the printing press will continue to be the key towards asset pricing dynamics.
Essentially, deeply embedded mainstream economic ideology, policy biases, the political nature of governments, the incentive (political benefits) of governments to inflate, privileges (minimal costs) from seignorage and the preference for credit driven economic growth or Ponzi financing are the principal factors that would influence governments to favor inflation as a means of addressing over-indebtedness.
As we concluded in The US Dollar Index’s Seasonality As Barometer For Stocks, ``Bottom line: Inflation is a political process. It would be difficult, if not suicidal, to take a contradictory stand against US authorities, when we recognize that the policy thrust has been to use the technology known as the printing press, to achieve a substantially reduced purchasing power for the US dollar.”
It wouldn’t be prudent to resist, oppose or contradict the general market trend and or of governments adamantly pursuing the inflation route.
That would be tantamount to standing in front of a speeding truck.
