Monetary Theory: Part Two

In the news this morning Ukraine is reporting hyperinflation, an occurrence that has happened before, not just in Weimar Germany but in South America, most notably Argentina.  A central bank is suppose to prevent high inflation rates and most certainly it is suppose to stop hyperinflation.  So as long as we are talking monetary theory we might take a look at inflation and hyperinflation.  Now we all know what happens when we have inflation, the price of almost everything goes up.  Your house will be valued by the tax man at a higher rate than might be expected.  Let us say that the birth rate is a one percent increase in the population or some mix of birth and death rates, then we might expect to see a simple rise in the value of your house of one percent (this is a bit low, but useful enough).  This would imply a normal growth rate for real estate, that is the number of houses built each year versus the number destroyed.  Keep in mind that housing may be destroyed for such acts as the building of highways, shopping centers, and other public works projects.  So if your house has a current value of $10,000, then next year it should be $10,100, if the growth in population continues the same.  Of course we must consider how many individuals and couples may qualify for a mortgage and a few other factors.  BUt tomorrow you wake up and find the demand in housing has increased dramatically, driving the value of your house up by five percent.  Now the tax man has valued your house, so as not to miss a cent of tax, to $10,500.  If you are paying a one percent valuation tax, your tax just increased five times.  On the other hand a gallon of gasoline may go from $1.00 to $1.05, a five percent rise (yes, that was back in the good old days).  But inflation doesn’t hit evenly.  The average rate of inflation may be five percent but the effective rate per item may be from one to twenty percent.  Why should this be?  Ah, if our inflation rate has risen then we may find that our dollar also buys less in other countries whose currency is mush stronger.  That French Premier Cru of Chateau La Foote just went from $20 a bottle to $100 a bottle.  But since you only drink two buck chuck, what do you care?  For the wealthy, it really doesn’t matter for they will foote la bill as their assets earn more anyway.

But hyperinflation is a different animal.  It is about lack of confidence in the currency.  The civil war in the Ukraine has caused massive dislocation in the supply of goods and services as well as their allocation.  Shortages may be due to lack of transportation, lack of manufacture, lack or wholesalers and retailers, but not lack of customers.  Once prices get bid up to a point where one realizes that the value of the money is so little then one starts to buy what may be called assets. A case of canned good, a carton of baby blankets, anything that can be used in a bartering economy.  One has lost confidence in the currency and can’t get rid of it fast enough.  It now takes suit cases and wheel barrows of it to buy anything.  Even that old, broken down wheel burrow you were going to burn for firewood has a greater value.  Bundles of sticks have greater value than the heaps of currency it takes to buy them.  Pretty soon it is cheaper to warm your house by burning the currency in the fire place.  The market place has broken down and cannot allocate goods and services in an efficient manner.  What is needed is a reset button.  Usually something like martial law is proclaimed and an attempt to provide essential goods to the mass of average citizens.  The wealth have their own sources, thank you.  Of course all this points out that a central bank like our Federal Reserve, has little control over an economy.  Normally the bank thinks of control as setting interest rates to control inflation (notice that when the Fed hiked rates to over 10% in the early eighties it still took a while for inflation to start heading down), and money or currency supply, which may or may not affect the rate of inflation, growth or acceleration of money.  These policies are like a doctor trying to use a sledgehammer to remove a splinter from your thumb.  It may work but a what price to your thumb?  The problem of hyperinflation comes so easily to a fiat currency country.

What is Fiat Currency?  Not an Italian made automobile, although according to all the old jokes about Fiat (Fix It Again Tony, Fiats were known for their lack of quality) that is not a bad analogy.  A Fiat Currency is one in which the central government and central bank both delace the stated value of that currency.  The value is roughly derived through taxes.  If you owe the government $100, then the government must accept $100 of fiat currency to satisfy the tax bill.  If the government wishes to by goods from you then you are paid in fiat currency that the government says is worth your price.  It is very simply to specify the value of a fiat currency in its own country.  The problem comes when you wish to use your fiat currency to buy goods and services across national borders.  then your fiat currency is subject to what others are willing to take in exchange.  These are known as current accounts.  Too much of your fiat currency in the import account and too little of the others’ currencies in the export account and we have an imbalance.  Your fiat currency is now worth less in value abroad.  A central bank has very little control over this market.

Why would interest rates influence the growth of an economy?  In a closed economy, the only way there is any economic growth is through population growth.  One does not grow a manufacturing company by producing more, one grows by selling more and producing only what one can sell.  Recessions occur because the economic system has been disrupted by too much production of the wrong good, the ones people aren’t buying.  And rather than trying to prop up everyone by allowing more government spending, The over producers need to eliminate their inventories, change over to new products, and otherwise pay attention to what people want and are willing to pay.  A recession, if it is not interfered with by a stupid government and central bank will carry out the desired reallocation of goods and services.  And yes, some individuals and corporations, companies, partnerships and sole proprietors will be hurt, that can’t be helped.  So back to the question of interest rates.  A business expands to increase production of goods and services by either reinvesting a portion of profits (a profit is thus sen as the cost of doing business in the future for it pay for the maintenance and the expansion of that business) in new equipment, new processes, more employees, or a mixture.  However, few economies are closed or self contained.  Thus growth will come at some other economy or economies’ expense.  This usually means an expansion in manufacturing, imports, exports, and all other manner of growth.  This growth has been advanced in the past by savings that has been turned into investment in the form of stock ownership, bond and debenture ownership, and loans.  These loans may be mortgages, which are secured by assets of greater value than the loan amount.  And there are many other ways of securing loan money, from liens against cash flows to naked and unsecured promises.

The creation of credit is suppose to be one of the item under the control of the Federal Reserve System and yet, the Fed has exercised very little control in this area.  I would suggest that the Fed really does not understand what credit is, and that is the creation of money.  Credit spends just like money but it is not counted as such by the Fed’s own measurements.  Ah, the reason why is because it was not taught that way in all those university courses, therefore it can’t be money.  Now we understand.  The authority of an economist as head of the Fed says one thing and the authority of the Market says another, which one will you believe?  Now the Fed is still the lender of last resort and the banking system is the membership of the Federal Reserve System and keep deposits in their accounts at the central bank.  The deposits earn interest although today that interest is almost nothing, a quarter percent.  So if you are a bank, where will you make any money to pay your depositors who may only make an eighth of a percent on their money?  As a bank you have your own bills to pay.  So you chase alpha, higher yields on your investments.  There use to be a time before the Fed started to fool with the rates when a bank could earn a decent return on US Treasuries of different durations.  Banks, insurance companies, pension funds, and so forth have been pushed into high yield, high risk investments.  In fact, AAA corporate bonds and paper rates are so low that in order to try and make their needed returns many of these types of investors have resorted to the junk bond market.  The investment grade debentures I had bought for my brothers account had been paying 6 and 3/8 percent, the corporation who issued them five years ago redeemed them last December.  I would have to buy junk or bonds that are rated less than B and take my chances of default.

Supposedly, by lowering interest rates the Fed creates opportunities for lowering unemployment by job creation through greater investment in business.  But looking at the rate of labor participation in the adult population group, it is the lowest in 29 years.  How were more jobs created when fewer adults are working relative to the labor pool of working age adults?  Well, people retire and drop out of the labor force.  I suppose if you are old enough to retire and can’t find a job then that might be a legitimate reason.  But he unemployment rates for 18 to 25 year old workers is extremely high, double digits.  Oh, well, all those kids are in college and don’t count.  Meaning they are running up student debt, living with mom or dad and being a burden because they cannot find employment.  Right, good job Mr Chairman, insult intended.  How long have we had these extremely low interest rates?  Our GDP should be going to the moon.  Oh, that’s right, we sent most of our manufacturing and a large part of our services to foreign countries where the labor rates are far cheaper.  And we lent them the funds to construct factories and public facilities such as docks, harbors, and ports as well as airport and railways.  Wait a minute, isn’t that credit creation?  That credit didn’t go into the creation of manufacturing and services here.  We didn’t build any more harbors and ports.  I see no evidence that any major railway systems were built.  If anything I see major railroads being merged, all for the public good, just like the Penn Central merger.  And on top of it all, we have had one asset bubble after another not only in this country but around the world and it is because the various central banks have lowered interest rates as an incentive to spur economic growth, reduce unemployment, and pay off national debt.  Has any of this happened?Are we and the rest ofthe world any better off than we were in 2006?  Every time the Fed has done is quantitative easing it has created more and bigger bubbles in assets.  This will not end well.  Depressions come when the credit bubbles all pop and no more credit can be given.  We simply cannot spend out way to growth and wealth, not by debt.

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