Subtle But Effective Way To Run The Economy Off The Rails

[FRED]

A Subtle But Effective Way To Run The Economy Off The Rails: Lie About The Price Level

by Aaron Krowne

In Frederick Soddy's 1926 tract "Wealth, Virtual Wealth and Debt" (a book I am currently working through), the Nobel laureate argues that the power of money/credit creation should be taken away from banks and placed in the hands of the state. He argued this because in his time, as in ours, most money and credit was in fact created by the banks–not the government–with the long-run result of significant inflation, punctuated here and there by deflationary panics, which are quite unpleasant. The mechanism of this runaway growth, then as now, was banks competitively issuing loans and other forms of securities utterly without limit or restraint.

One can expand this phenomenon to encompass all sorts of other money and money-like securities and to financial entities other than banks; the landscape today is truly breathtaking in its expanse and "creativity"–witness businesses specializing in subprime mortgage lending, and the $370 trillion of derivatives in circulation measured as of the first half of 2006, just for starters.

Soddy argued the state should step in and clean house, by limiting money creation and allowing no more inflation than was needed to optimize production and prevent deflation and its concomitant industrial shocks–which, in turn, bring mass unemployment, which is obviously bad thing for a nation. Soddy proposed using two means of control in this system, neither of which he invented: 1) the reserve requirement, a ratio rule limiting the creation of bank credit by tying it to some multiple of liquid reserves held on deposit (not loaned out), and 2) a price level index to determine how much inflation is present in the economy. With these two tools, the national government could set the reserve ratio according to the measured price level, so that an increasing price level would necessitate a correspondingly-higher reserve ratio, hence making it a "governor" of the system–the apt analogy here is the economy to an engine.

This might sound something like the of system in place in the US today, with its Federal Reserve system playing the role of the "central bank." Unfortunately, while the Fed would like you to believe that is true, there are some key differences that totally undermine Soddy's programme and any sort of working restraint. The first is that we don't use the reserve fraction, almost at all, in the Fed system, the last vestiges of which were essentially eliminated in the early 90s. Instead, the Fed tries to control money/credit creation by "setting" interest rates–intervening in the bond market. In effect, this is an attempt to control the speed of the economy by setting only the price of money, rather than the quantity, even though setting the quantity would naturally lead to appropriate market interest rates.

But there is a second important difference between Soddy's proposed system and the one we have today: we do not have truthful measuring and reporting of the price level. Libertarian-minded readers of this blog probably heard some sort of little voice scream out in protest in the first paragraph where I wrote "placed in the hands of the state." That little voice was saying: "but won't the state also abuse this power, as an inevitable result of political forces?" The answer, as recent history has shown, is "yes."

In rest of this post, I will focus on the price level-measuring aspect of controlling inflation and the speed of the economy, putting aside the more fundamental but perhaps more contentious aspect of how the price level is translated into control of the growth of the money supply. I will show how getting the price level wrong–intentions aside–is not a benign fib; rather, it completely and terminally undermines any economy being run on a basis of structural inflation.

As Soddy said, the price level index should be used as the "governor" of the economy: when it rises quickly, money and credit growth should be decreased. The inverse of this rule also holds.

What Soddy didn't account for was the possibility that those reporting the price index level would lie about it. If they did, I propose this would lead to a "dynamic acceleration," where credit (debt) piles on exponentially in excess of productivity growth, creating a situation irreversible without depression or stagflation (deflation or severe inflation).

In the current economic practice and orthodoxy, productivity is the closest thing we have to a measure of "wealth." The important thing to note about productivity for our purposes is that it maps directly to the ability of society to service debt with future income streams. If society becomes more efficient, its income streams grow, and increasing debt can be paid off.

The "point of no return" is when real productivity growth can no longer cover increasing debt income streams. A critical word in that sentence is "real." This refers to productivity growth adjusted for the actual amount of inflation. Thus, in any system following Soddy's price-level governor, if inflation was to be underreported or productivity growth overreported, this debt overrun point would eventually be reached.

We can illustrate this numerically.

If money/credit growth is running at 2% per year, and productivity is growing at 5%, then we have a 3% productivity "surplus" which can go towards servicing additional debt burden. This surplus will, left alone, manifest as a 3% downward force on prices (deflation). Thus, to avoid deflation (if such a thing is desired), the money supply should be expanded faster -- precisely, at 5% per year, until inflation also increases at this rate and we reach equilibrium–the price level stops falling.

Similarly, if the price level is honestly reported, and would be rising at 2% per year with 0% productivity growth, increasing productivity to 2% per year would presumably introduce dynamic equilibrium: inflation would remain 2% per year but price levels would stabilize.

However if real inflation is 5%, with productivity at 2%, then we have a productivity "shortfall" of 3% which is not available to pay down an expanding debt burden. Normally this would be visible as a price level continuing to increase at a rate equivalent to that that 3% shortfall. But what if inflation was being underreported by that same 3% (intentionally or otherwise)?

Now we're in trouble: the price level will appear to be stable, so we think we've counteracted all incipient inflation with an equal amount of productivity growth, but we haven't. The 3% shortfall "builds up" as a corresponding increase in debt burden and demand on income streams every year. At this rate, in about 25 years, this burden will reach a level of about twice what the economy could actually handle (at equilibrium), which means the threat of a sudden, 50% deflation looms.

Unfortunately, I think the final scenario is roughly the situation the United States finds itself in today. Having altered its inflation reporting beginning in 1983 and continuing to dubiously tweak the CPI metric throughout the 90s. The outcome is that inflation is underreported, probably by at least 2.5% per year, which suggests that in the 23 years since 1983 we've exceeded the economy's debt carrying capacity by at least 76%. This means a ~43% deflation is possible, for starters.

In fact, the extent of inflation under-reporting in the US is probably much greater, as the economy shifted to become more financing-based in the 90s, which introduced many sorts of "quasi-financial assets" to a greater extent than before. These assets aren't well-representated in the prevailing inflation measurements. For example, cars, housing and education became more common through financing, but also more expensive. Further, in the early 80s, the government shifted to the structural and ongoing use of bond issuance as an alternative to "printing money," mirroring the consumer's increased use of financing. The resulting growth of the national debt burden relative to the GDP is a measurement of the national productivity shortfall of the whole United States. This can be added to the "productivity overrun" created by the false inflation metrics.

This all surfaces as exponential growth in credit and debt in all echelons of the economy; the $10-11 trillion in public debt, the $13 trillion of consumer credit debt, the $20 trillion in mortgages, the $370 trillion of derivatives, the historically-inflated level of stocks, and so on.

To conclude, Soddy recognized the problem–runaway money and credit creation–but his proposed solution has utterly failed in practice in the United States. Sadly, our government has proven itself incapable of the necessary restraint to prudently manage the core of the economy: money. Whether through intellectual error, delusion or malice, the government has significantly mis-measured and mis-reported inflation over the past quarter-century. This has done no less than completely fail to meet the criteria laid down by Soddy and others to grow an inflationary economy soundly and sustainably.

What we have got as a result is the exact opposite of "sound and sustainable," and the worst consequences of this are yet to come.

Copyright © iTulip, Inc. and Aaron Krowne – AutoDogmatic – 1998 - 2006 All Rights Reserved

All information provided "as is" for informational purposes only, not intended for trading purposes or advice. Nothing appearing on this website should be considered a recommendation to buy or to sell any security or related financial instrument. iTulip, Inc. is not liable for any informational errors, incompleteness, or delays, or for any actions taken in reliance on information contained herein. Full Disclaimer

Biography

Aaron Krowne, M.S., is a computer scientist working at Emory University's Woodruff Library as Head of Digital Library Research. Here he leads the technical development of digital library grant projects, and works for the integration of new technology into library systems. He is the founder and president of PlanetMath.org, a collaborative digital library and virtual community for mathematics.

One of his core areas of practical and theoretical interest is in the economic aspects of commons-based peer production, a ``third mode of production'' that has recently been recognized alongside markets and firms. He has written a number of articles in this area and has demonstrated practical results via PlanetMath. He is also interested in the relationship of mathematics to the market (especially its limitations). Krowne frequently comments on economics on major blogs and his own web site. He has no formal economic training, and is damn proud of it.

[Jim Nickerson]

Re: Subtle But Effective Way To Run The Economy Off The Rails

Aaron Krowne wrote, "Unfortunately, I think the final scenario is roughly the situation the United States finds itself in today having altered its inflation reporting beginning in 1983 and continuing to dubiously tweak the CPI metric throughout the 90s. The outcome is that inflation is underreported, probably by at least 2.5% per year, which suggests that in the 23 years since 1983 we've exceeded the economy's debt carrying capacity by at least 76%. This means a ~43% deflation is possible (for starters)."

Nice article, Aaron.

Most people at iTulip, who I am convinced know a whole lot more than I personally know, seem rather convinced that a significant deflation will not be allowed to occur in the US--I hope I am not mischaracterizing the gist of my perceptions.

You suggest based on your calculations that an "approximate 43% deflation is possible(for starters)". So what, if any, conclusions do you draw beside "the worst consequences of this are yet to come"?

Do you believe that what is needed is a 40+% deflationany period, and we won't get that, but rather we will get misdirected efforts to avoid such deflation with the result being runaway inflation?

Or do you see something other as to how this morass will play out?

[akrowne]

Re: Subtle But Effective Way To Run The Economy Off The Rails

Thanks, Jim.

First let me say that the 43% number is probably extremely conservative and serves only as a baseline. If this derivatives mess were to implode, frankly it would be pointless to calculate how much deflation had happened: the whole system would simply be wiped away (the entire financial system would be bankrupt).

I also agree that the Fed, especially this Fed, will do everything in its power to prevent deflation. But even if they did not, we're soon facing the "baked in the cake" inflationary pressures of the public debt (look at what happened with inflation after every war in the past), Social Security running short of revenues by 2012, Medicare, housing collapse relief, etc.

So I don't think the government really has much choice but to inflate in response to the crisis. We may in fact be seeing as much broad deflation as we will ever see under the present currency regime (which Eric has accurately labelled "disinflation"). Look at the median CPI, by the way -- it hasn't budged a notch despite the energy pullback, and the rumor is that the Fed is now using this metric to justify continued hawkishness. The Fed can see the dollar index slip, and I think they know what must be coming.

So I think deflation and inflation go hand-in-hand. An interesting and useful observation is that, regardless of which prevails, precious metals, foreign currencies and equity markets, and real assets become desireable relative to the currency being deflated/inflated. One must globalize one's view of the economy these days (a mistake I think Greenspan made in 1995): yes, deflation means that each unit of currency becomes relatively more valuable domestically, but it also means capital flight from the economy in question -- and there is much more money outside any particular currency zone than inside it.

[Spartacus]

substitutions, and incentives to make them

do you have any notion what the incentives are in the post office to find cheaper alternatives?

For people living on fixed incomes, I can imagine that a 42% difference in inflation is causing severe hardships and a very hard, maybe desperate search for cheaper substitutions.

Especially when combined with historically low bond yields.

DAMN, what an amazing double-whammy.

(not questioning the validity of the analysis, just wondering on a personal level how this is unfolding in the real world)

[Jim Nickerson]

Re: Subtle But Effective Way To Run The Economy Off The Rails

Thanks, Jim.

First let me say that the 43% number is probably extremely conservative and serves only as a baseline. If this derivatives mess were to implode, frankly it would be pointless to calculate how much deflation had happened: the whole system would simply be wiped away (the entire financial system would be bankrupt).

Thanks for your comments, Aaron.

I thought there was a good opinion piece in online.wsj 12/30/06 which unfortunately if you don't subscribe requires that you do to read it. It explains in some simple fashion a few things about derivatives. http://online.wsj.com/article/SB1167...ays_us_opinion

Some exerpts.

"Derivatives can be very complex, but they are fundamentally a tool for hedging financial risk."

"Through this basic mechanism, all kinds of risk in an economy can be shifted around, often to everyone's benefit."

"The sum of a myriad of these transactions over the economy means that everything moves a little faster. Credit becomes marginally cheaper and more plentiful. Risk is dispersed to those who feel they can better afford it. Thus does the supposedly non-productive financial sector of the economy provide fuel for future growth. Seemingly obscure transactions lower the cost of capital to businesses and consumers and spread risk in a way that decreases the danger of catastrophic financial accidents."

"None of which means financial accidents won't happen. Market players sometimes bet wrong -- there are always two sides to a transaction, and one party can always miscalculate its ability to withstand an adverse event. Just ask the investors in Amaranth Advisers, which bet wrong on energy prices."

"More broadly, danger always exists from abrupt government policy shifts, especially from monetary mismanagement; think of the Asian crisis of the late 1990s. Another such danger can come when government subsidies push too much risk from a single sector such as housing into just two companies (Fannie Mae and Freddie Mac). Two of the biggest current risks, in our view, are the chance of U.S. tax increases and that the Fed may still have underestimated the inflationary pressures it let loose in 2004 and 2005."

"But these are not reasons to fear derivatives and other financial innovations. Risk is still out there. But as we leave a successful financial year and enter a new one, take comfort in the fact that all that buying, selling, swapping, trading and securitization of risk has actually made the financial system less risky." [JWN emphasis.]

Does the above ring true, or was it a Wall Street groupie trying to calm all those readers' nerves who reside in the hinterlands that Wall Street has everything in hand? Not to worry, Joe Average whoever you are.

[akrowne]

Re: Subtle But Effective Way To Run The Economy Off The Rails

"But these are not reasons to fear derivatives and other financial innovations. Risk is still out there. But as we leave a successful financial year and enter a new one, take comfort in the fact that all that buying, selling, swapping, trading and securitization of risk has actually made the financial system less risky." [JWN emphasis.]

Does the above ring true, or was it a Wall Street groupie trying to calm all those readers' nerves who reside in the hinterlands that Wall Street has everything in hand? Not to worry, Joe Average whoever you are.

Wall Street groupie.

I had a belated realization recently: The Wall Street Journal divulges its biases up front, right in its name. That's not to say it isn't the source of any insights or good (like breaking the stock options backdating story), but the ideological biases are quite apparent, especially in the more editorial content. Besides, it would probably be almost suicidal for the WSJ to argue that, e.g., executives shouldn't be paid nearly so much, or that Goldman Sachs "bankers" really didn't "earn" those bonuses. That'd be the end of the WSJ as "required reading" in the finance world.

Anyway, to respond directly to the argument: I think derivatives are not bad in themselves; they are only a tool. It's how they are used that matters. And therein lies the problem: derivatives have been overtly misused to sweep risk "under the rug" rather than transferring it to parties that can truly bear it. This has happened at the same time as historically-low risk premiums, which are likely both a cause of and outcome of derivatives like credit default swaps (in a vicious cycle).

It is easy to see how this might naturally evolve: if defaults have been low lately, it is easy to convince a counter-party to accept your "cheap insurance" as covering the risk inherent in some security. You collect more profits, the counter-party collects more profits. This activity in aggregate further lowers defaults and risk premiums, engendering even larger derivatives but also making the case for them stronger.

Meanwhile the system is never really tested--both LTCM and Amaranth were "bailed out" in backroom deals, not through the normal mechanisms of the financial markets. And we don't really know what the "financial system" is anymore -- hedge funds and other private equity entities seem to have inserted themselves between every type of interaction, yet they rely on ample credit from banks and other lenders (even other hedge funds), and closing the web of interdependency is the fact that banks now rely on hedge funds and derivatives and proprietary trading activity for most of their profits! Everybody is behaving the same way, behaving as if risk is nonexistant because "the other guy" is supposedly the least-cost bearer of it, using massive quantities of leverage, and not thinking of how the entire system would hold up if the good times ended.

In a simplistic view, it would seem to me that the most sound implementation of a default-event derivative is to back it with reserves. Of course, in the present system, reserves are considered a weakness or unnecessary evil (they lower profits, after all), so more derivatives are used to "guarantee" the availability of capital or in-kind securities in the "unlikely" event that defaults happen and the capital is suddenly needed. But therein lies the rub: what if the provisioner of the derivative-qua-reserves cannot deliver? If they've simply done the same thing, then somewhere down the line someone won't be covered, and the default event will cascade outward.

I think we are being setup for failure here in a way similar to the way misreporting the price level "builds in" an inevitable correction -- because debt grows "too quickly" to the extent inflation is being misreported. If risk is similarly mis-priced, then too many derivatives are built on top of too little reserves and income streams, so when it is realized risk is actually higher, there aren't enough participants capable of "paying all that insurance".

So no, I can't quantify the systemic risk. But I challenge anyone to prove that this system is sound.

The scary thing is, I think it would take only 1 or 2% worth of failures to cascade and cause the whole thing to come crashing down. It is that tightly wound. This is why I have my eye on the home builder and mortgage lender financial picture very closely. So much money "disappears" very quickly when these "outside events" happen: just look at Lennar, who is going to swing from a predicted $1.30-$1.60/shr profit for the fourth quarter to $.88-$1.28 losses on $400-$500 mln of land write-downs. That land went into book value as a speculative, inflated market value, which in turn contributed to inflating the builder's stock price (which is still inflated; technically the business is a net money-loser now, and likely will be for at least a year or two in my estimation).

There are two more interesting and telling aspects of the Lennar story that surface in the article above. One is that Cerberus capital bailed out of the Lennar joint venture. Cerberus is a hedge fund. What were they doing there? Well, they're a hedge fund, so apparently no one questions their being involved with anything and everything, in this case a home builder. Did they lose money on the deal? Maybe; maybe not -- maybe they bailed out in time; maybe they sloughed most of the loss onto Lennar. But eventually hedge funds in similar situations will take heavy losses.*

The second interesting thing is who Lennar has dumped the majority share of the same joint venture onto now: "MW Housing", which happens to include CALPERS (the California state pension fund) in some capacity. How much, I don't know, but interesting nonetheless.

The point is, this might beautifully illustrate the actual least-cost bearer of risk in this system: the general public.

*It is worth being clear about the relationship here. For this and other similar Joint Ventures (JVs), Lennar teamed up with a hedge fund, Cerberus, which put up its own capital and potentially raised more capital, such that Lennar could take a minority position. This allows Lennar to keep the JV off the balance sheet, and book future cash flows as pure profit with no corresponding liability. But it also shows that what is really going on: Lennar is using a hedge fund as a bank, which essentially extends leverage, so that Lennar can speculate on the housing bubble. When the whole sordid relationship is put this way, in terms of what is fundamentally taking place, one can immediate see the problem: leverage means that one can lose more than one put in. That can mean defaults. And because the counter-parties are banks and hedge funds, it means they too may be facing more defaults than they'd like to admit. Banks have the special status of potentially losing three-times-over: once from the capital they have put up, once from the hedge funds they've financed, and once from the hedge-fund and securities market profits (including MBSes) they've abetted.

[akrowne]

Re: substitutions, and incentives to make them

do you have any notion what the incentives are in the post office to find cheaper alternatives?

For people living on fixed incomes, I can imagine that a 42% difference in inflation is causing severe hardships and a very hard, maybe desperate search for cheaper substitutions.

Especially when combined with historically low bond yields.

I assume regarding the first question you're referring to my argument that the postal rates are indicative of "real" inflation in some sense (at least, some sense more meaningful than the CPI).

I think the key question is whether the post office has any incentive to get more efficient, which would suggest it is raising fees slower than broad inflation. My guess is "yes".

While the post office has no overall incentive to do so in terms of a profit motive, I suspect the management structure rewards cost savings as usual, so it still happens. There is also the fact that the post office does compete with private parties for some portion of its services, and the progression of these prices has been comparable to the private, profit-driven alternatives.

But if the post office does get more efficient, then postal fees represent a mere lower bound on actual inflation. I selected the post office just to establish an uncontroversial lower bound, which nevertheless pits one bureau of the government against another. I can't even begin to imagine the implications for the government and the economy if this disconnect were to actually be openly addressed and resolved at this point. The whole system would probably just collapse, having seen behind the Wizard of OZ's curtain.

It is quite clearly true that people on fixed incomes, especially pensioners, have been ailing. You can't live on social security. There's a reason that this segment of society has been catered to of late with "Senior Citizen Discounts", and can be found disproportionately at low-priced buffets and thrift stores -- as well as not being able to afford things like registration fees for superfluous voter IDs or even transportation to get them for free.

[DemonD]

Re: Subtle But Effective Way To Run The Economy Off The Rails

Aaron - unbelievable analysis. Sometimes reading itulip I wonder if there are people in back rooms of big companies that have any clue of what they are doing both to their company and their effect on the "financial system" in general?

What I don't understand at all, and haven't for some time now, is the lack of a reserve requirement. It just doesn't make any sense. Without any reserve requirement, and shmuck who can sign his name can start "lending" money to anyone else. What's the point of having any financial system at all if you are not going to require reserve fractions?

And, indeed, isn't this pretty much what has happened?

The question is, what happens if, in 2007, these defaults get pushed back again. Because if credit is that loose and cheap, wouldn't it be possible to continue pushing it to the future? Of course, this would then cause worse pain in the future...

But I wouldn't be surprised if 2007 is like 1999. 1998 was a banner year for the stock market, and tech was definitely a bubble by 1998, but it went up even astronomically more in 1999. I almost sort of hope we do have some kind of pain ASAP because it seems like, as you mentioned Aaron, the more credit that gets put out there more it can come crashing down.

I would be interested to see if you have any predictions on what will happen in the coming calendar year.

[akrowne]

Re: Subtle But Effective Way To Run The Economy Off The Rails

Sometimes reading itulip I wonder if there are people in back rooms of big companies that have any clue of what they are doing both to their company and their effect on the "financial system" in general?

Some do, I think; e.g., Bob Nardelli resigning today (with a nice $210 mln golden parachute). Others are heavy drinkers of their own spiked punch, and have allowed themselves to be convinced that rich awards of back-dated options mean they're doing a good job for their companies and, heck, even society.

What I don't understand at all, and haven't for some time now, is the lack of a reserve requirement. It just doesn't make any sense. Without any reserve requirement, and shmuck who can sign his name can start "lending" money to anyone else. What's the point of having any financial system at all if you are not going to require reserve fractions?

Right, you would think that with no scarcity, capital wouldn't "work right". And it doesn't. All the more amusing as China and India continue to vocally use their reserve fractions to control growth. These guys seem to know that interest rates are only secondary. One day the US Fed's method of directly intervening in internest rate while ignoring money/credit supply will looked back on as a farce.

And, indeed, isn't this pretty much what has happened?

Yes. The government is even positioning itself to officially eliminate the reserve requirement in entirety. I don't think it will matter much, because that is effectively what has already happened, but it shows you what the official thinking is.

The question is, what happens if, in 2007, these defaults get pushed back again. Because if credit is that loose and cheap, wouldn't it be possible to continue pushing it to the future? Of course, this would then cause worse pain in the future...

But I wouldn't be surprised if 2007 is like 1999. 1998 was a banner year for the stock market, and tech was definitely a bubble by 1998, but it went up even astronomically more in 1999. I almost sort of hope we do have some kind of pain ASAP because it seems like, as you mentioned Aaron, the more credit that gets put out there more it can come crashing down.

I would be interested to see if you have any predictions on what will happen in the coming calendar year.

I would be surprised if the market could totally ignore the continuing housing collapse and recession which seems to already be visibly beginning. But the market looks to now be in Weimar Germany territory: liquidity is being directly poured into it, so it doesn't seem to matter what happens in the real world. We're not even having trading pullbacks or corrections anymore. So I can't predict with any sort of precision what the market will nominally do; it's just chaos from here (it will keep going up until one day it snaps, and who knows when this will be).

One thing is for sure: it can go up in nominal terms through unlimited liquidity, but it can't go up in real terms (the market's 2006 performance, adjusted for the dollar's decline on the exchange and ignoring intrinsic inflation, was about 5%). My bets are on real assets, which are relatively on sale now, and secondarily, foreign markets and currencies.

I am experimenting with some housing and financials related shorts for a minority of my portfolio, but I think this is very risky given the chaotic state of the market now.

I think there's a high probability of a financial system shock in 2007, possibly early. The default rate is starting to creep up.

[spunky]

Re: Subtle But Effective Way To Run The Economy Off The Rails

Thank you for the effort on the article

[aD Neal]

Re: Subtle But Effective Way To Run The Economy Off The Rails

Aaron - unbelievable analysis. Sometimes reading itulip I wonder if there are people in back rooms of big companies that have any clue of what they are doing both to their company and their effect on the "financial system" in general?

DemonD, I work for a public company and have often interacted with bankers on securitization-related deals. Every time I've ever asked them how asset securitizations affect their reserves, I get some response that, "I can't say I know much about how that works." They're all just a bunch of stooges blind to the system they support and perpetuate.