Alarm bells ring at Fed (deflation alert)

It was a conference to mark Milton Friedman's 90th birthday last month, and who should give the toast to the world's most famous monetarist? A governor from the US Federal Reserve, naturally.

The man from the Fed, a monetary expert in his own right, Ben Bernanke, delivered a dense, 10-page tribute to Friedman's contribution to modern economics, then this punchline: "Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton ... regarding the Great Depression: You're right, we did it.

A couple of weeks later, seemingly following through on this pledge, Bernanke delivered an unprecedented speech in Washington DC. The title: "Deflation: Making sure it doesn't happen here."

It was the Fed's emergency plan, the economic equivalent of the The Worst-Case Scenario Survival Handbook

Bernanke laid out the extraordinary measures the Fed could take - including buying assets from private companies - if the US economy fell into that condition people associate most closely with the Great Depression - deflation, a fall in the general level of prices, the opposite of inflation.

If inflation is too much money chasing too few goods, then deflation is too little money chasing too many goods.

Fed chairman Alan Greenspan told anxious members of Congress in October that "we are not close to the deflationary cliff". But how good are his forecasting skills? The Fed, by its own admission, utterly failed to foresee Japan's slide into deflation seven years ago.

And a solid core of serious analysts now believes it to be a very real risk. The Fed's own behaviour betrays a distinct unease. A month ago it cut the key official interest rate by an aggressively large increment - from 1.75 per cent, already the lowest in over 40 years, to 1.25 per cent.

Fed officials have called that move insurance. Although the financial markets think there is little chance that the Fed will cut rates again at its policy meeting this week, "the Fed is, I won't say panicked", says Steve Roach, economist for the investment bank Morgan Stanley, "but it is very much on alert".

The decision by President George Bush to replace his economic team last week is another indicator that American officialdom is alert to the need for decisive action to keep the economy from quicksand.

As the Fed's Bernanke says: "Sustained deflation can be highly destructive to a modern economy and should be strongly resisted."

The broadest measure of price pressures in the US economy - the gross domestic product deflator - is barely above zero. In the year to the end of September, it was up by 0.83 per cent, its feeblest in half a century.

"The essence of deflation is that business leaders know they do not have pricing power," the ability to raise the price of their products, points out Wayne Angell, a former governor of the Fed and chief economist for the Wall Street investment bank Bear Stearns.

And the prices received by US firms overall have declined in each of the past five quarters, the longest run in more than 50 years. For the latest quarter, they were down 1.3 per cent.

At first, and sometimes for years, executives think that this lack of pricing power is temporary, due to a downturn in the business cycle, Angell says.

"They expect that pricing power will return with recovery." With deflation, it doesn't. "This is precisely what is happening in the US economy today."

Consumer prices in the US are still rising - by 1 to 2 per cent a year, depending on the measure. But David Rosenberg, an economist in the Canadian office of the US investment bank Merrill Lynch, points out that the price of 40 per cent of the hundreds of items that go into the basket to make up the consumer price index are falling.

Indeed, all the inflation in US consumer prices is coming from only five areas that make up a quarter of the index - housing, tobacco, car insurance premiums, hospital services and tuition.

"There's a compelling case for deflation," says Morgan Stanley's Roach. "We are in a rarefied and highly dangerous period."

The two top-most international finance officials in Japan last week took the warning even further. They declared that it was not just a danger facing the US - it was a risk to the entire world economy.

In an unorthodox move, the Vice-Minister for International Affairs at Japan's Ministry of Finance, Haruhiko Kuroda, and his deputy, Masahiro Kawai, put their case starkly.

"Monetary policymakers around the word are still fighting the old enemy of inflation, not the new foe of deflation," they wrote in the Financial Times.

"There is an urgent need to switch to global reflation in order to avoid a deflationary spiral." They called on the Europeans, Americans and Chinese to join Tokyo in heading off a global deflation. And the Japanese know something about contemporary deflation - they pioneered it.

The mainstream of US forecasters does not foresee deflation in the US. But then again, the mainstream does not have such an enviable record of forecasting - the consensus of US economists conspicuously failed to foresee the length of America's boom of the 1990s, and completely missed its 2000 bust.

What of Milton Friedman's school, the monetarists, whose believe that the supply of money is the key to inflation and deflation?

A respected US monetarist, Allan Meltzer, professor of political economy at Carnegie Mellon University and author of a new book, A History of the Federal Reserve, dismisses the possibility of deflation as nonsense.

"It's just bad thinking by badly trained Wall Street economists," Meltzer says. "I don't think any competent economist can make the case for deflation with M2 [the base money supply] growing at 8 per cent year on year and the economy expanding.

"You hear it from that Morgan Stanley guy, and his policy is being able to say, if something goes wrong, 'See, I told you so!', and he hopes that people forget the 800 times he was wrong."

"I don't want to call a guy like Allan Meltzer simplistic ... but he's pretty consistent with his monetarist framework.

"With all due respect to him, the money supply may be growing, but there's no guarantee that it will go into consumption or prices. It's a circuitous route, at best - especially in an overindebted economy.

"Money can go into debt or saving; if you print enough of the stuff it will eventually spill over, but it's a long and arduous path."

It should also be pointed out that Roach's forecasting record is quite good, and better than most.

But even if you disbelieve the case for deflation, the most persuasive case for vigilance comes from the Fed itself.

An important research paper by 13 Fed staff economists, titled Preventing Deflation: Lessons from Japan's Experience in the 1990s, says: "Japan's deflationary slump was not anticipated. This was true not only of the Japanese policymakers themselves, but also of private-sector and foreign observers, including Federal Reserve staff economists.

"Moreover, financial markets had no better handle on the economy's prospects ... The failure of economists and financial markets to forecast Japan's deflationary slump in the early 1990s poses a cautionary note for other policymakers in similar circumstances: deflation can be very difficult to predict in advance.

"In consequence, as interest rates and inflation rates move closer to zero, monetary policy perhaps should respond ... to the special downside risks - in particular, the possibility of deflation."

Deflation is not necessarily a bad thing. The world economy has enjoyed booms while prices were falling, during the 1920s, for example.

But it looks malign at the moment for two main reasons. First, there is a kind of good deflation that happens when productivity is high and the economy is robust. This is not that kind of deflation. Today's deflationary pressures come from excess supply of goods and industrial capacity.

Second, deflation is especially dangerous now because the US has unprecedented proportions of debt. Why does this matter?

In an inflation, money loses value, so the inflation-adjusted value of debt shrinks as the years go by. So inflation is kind to borrowers.

But in a deflation, the opposite holds. Because prices are falling, the real value of money goes up in a deflation. So the value of debt actually rises, and borrowers are punished.

This can create a debt trap, forcing firms and families into a spiral of cutbacks to service a growing burden of debt - even though they're not borrowing a cent more. This pattern of retrenchment and bankruptcy can create recession and depression.

"We've already got debt deflation stories - we do have quite a large number of firms that are facing those kinds of pressures from unexpected sort of deflation already," says former Fed governor and leading forecaster Larry Meyer.

"And, as slack builds up in the economy, we're likely to see inflation fall below the implicit target" of the Federal Reserve, says Meyer.

"And, we know in those situations, again, following the lessons of Japan, that the policy authorities have to be particularly even more aggressive about pushing inflation back [up] to its target."

The Fed's contingency plan includes drastic options. If the key official interest rate should hit zero and the Fed loses its ability to stimulate the economy in the customary way - the current rate is already at 1.25 per cent - it could

buy up masses of government debt, even private corporate debt and private real estate, as a way of pumping liquidity into the economy. Fed governor Bernanke also points out that big devaluations of the US dollar have helped defeat deflation in the past.

Ultimately, "the US government has a technology, called a printing press ... that allows it to produce as many US dollars as it wishes at essentially no cost ... Sufficient injections of money will always reverse a deflation", he says.

Morgan Stanley's Roach says that the Fed's speech and its actions "are all very carefully orchestrated; they are shaping policies as if deflation is going to happen - and that's a good thing, because it is such a dangerous time".

1. The long period you discuss is not one that can be shown to have benefitted by the Gold standard. While it is true that the growth rate over the whole period was substantial you ignore that fact that it was the result of increased population and increased resources brought into the Union. Without the investment from GB this growth would have been much lower since specie was drained from the country by the adverse balance of trade. This had occurred during the 1780s as well and was one of the major reasons Hamilton devised the National Bank. Its creation laid the groundwork for the growth of the 1800s. It instantly (by capitalizing the word of the federal government) created millions of dollars of capital. Hamilton's brilliance has been obscured by the vilification of the leftists centered around Jefferson (whose economic and financial beliefs are idiotic at best.)

2. Look at English history. Every time a war broke out the Gold standard was ditched. Thus, from 1750 to 1815 there was almost always a war going on and the Bank of England was used to finance the debt incident to it. A gold standard does indeed cripple government but it also cripples the societies which cannot exist without government. During the Civil War the Union could not be on a gold standard and finance the struggle necessary for national survival. WWI, WWII all show the same tendencies. Even the Vietnam War forced the U.S. off the semblance of convertibility. It is not in the interests of a nation to allow its money supply to be held hostage to the fashion dictates of women or to random discoveries of a pretty metal.

3. It is false that today's money is unconstitutional but follows from the ability of Congress to coin money and regulate the value thereof. Merely because it does not agree with your ideology does not mean it is unconstitutional. Since the government regulates the value of money it can drive non-federal money out by that means. While states could theoretically coin money which meets the constitutional prerequisites none will because of Gresham's Law. Section 10 does not apply to the federal government only states.

4. Apparently your knowledge of and understanding of the National Banks is overwhelmed by your ideology. Democrat-Republican theory called for elimination of the National Bank for the entire time of its existence. Madison had changed his mind about it but Congress refused to recharter it and forced the Bank to cease operations. Economic dislocations were so intense that the Republicans rechartered the Bank because of the devastating effects its demise had in the West and South. Those areas were immediately drained of specie when the Bank was removed. Since it went to New England and NY these areas were not in favor of a new Bank. The depression in the 1830s followed Jackson's decision to kill the Bank. It had nothing to do with the rechartering decades earlier by Monroe. Even after the Bank was de-chartered its notes still traded at face value throughout the nation.

5. For the Wildcats there was no federal involvement at all. These were all state chartered and routinely issued far more script than they had reserves for.
There was no need to suspend convertibility by the government there was often nothing there to convert to. Saddlebag Bank for example issued its notes based on the capital brought into Zanesville, Ohio in saddlebags. But the lack of liquidity had reached such a crisis that not only was the number of state chartered banks increased by over 230% within two yrs. after the 1st Bank was destroyed but paper currencies were issued by municipal corporations, individuals, factories, tradesmen's associations and unchartered banks. The financial chaos resulted in the call to recharter the National Bank. 100% backing returns an financial system to the liquidity deficient condition nations suffer under the gold standard. It will never happen and for good reason.

6. Just from useage as currency gold loses at least 2% in quantity per year. The best estimate is that there would be less than 1% increase in gold supplies per yr. This would ensure that the world economy would barely grow. Per capita amounts of gold would shrink even under the best assumptions. The inadequacy of liquidity has driven American political history since the nation's inception. Even areas where gold and silver were produced had shortages since it was drained to the East. During the Populist era in the 1880s the demand for a National bank reasserted itself. It was opposed by the Money Center Banks in the east (where there was plenty of liquidity) for fear it would reduce their power until the Panic of 1907 convinced them that private individuals would not be able to stem them in the future. J.P. Morgan had stopped the one in 1907 but it was so close to disaster that even the bankers realized that the government had to step in in the future.

I don't have time to reply to all of this right now (what with xmas and all; still have to go finish shopping) so I'll just do a little at a time throughout the season until I'm finished.

1. My original post dealt with deflation and the effect on the price level that specie had. I did not ignore the fact that immigration and foreign investment had an influence on the nation's growth because that wasn't what I was really talking about. However, I will reply to some of your comments none the less.

I do not deny the fact that the balance of trade affected the level of specie in the country. But I think what you forget is that gold and silver were the "lawful" money of the time, both here and abroad. If GB wanted to invest here, was not what they paid in ultimately gold? The draining of specie from the country had more to do with the fixing of the silver-to-gold exchange rate. Gresham's law kicked in because the government artificially overvalued silver in relation to gold, thus causing the gold either to be horded or flow overseas.

Hamilton set up his bank for two reasons: he wanted a way to pay off the national debt and he wanted to make money; his bank was mostly a private affair and that alone I think would make it unconstitutional as only Congress has the right to coin money and regulate it's value. I personally believe he was a very smart man, but I also think he was a crook. Anyway, the debate on a National Bank was pretty fierce, and Washington was not convinced either way whether it was constitutional or not. However, he assumed that Hamilton, as Sec. of Treas., knew what he was doing and therefore allowed it. So what happened? The number of chartered banks went up dramatically under his Bank of the U.S. and all began to pump out ever faster depreciating bank notes; inflation was horrible. And finally, I'm not sure where you get the idea Jefferson was a leftist? He was a pseudo-libertarian, with several major character flaws I admit. But who doesn't have those?

Okay, I have to run so I'll post again when I can. To you and every other Freeper I wish a very Merry Xmas and a Safe and Happy New Year.

1) It appears to be fairly obvious that the gold standard prevents prices from rising (except in the case of massive influx of g/s such as followed Spain's importation of metals from the New World which did indeed ignite a century old wave of inflation throughout Europe.) The reason for this is that it supresses economic activity because of lack of liquidity. This is the reason it never has been used for any but special periods of time. Much of the history of the U.S. during the 1800s revolves around the lack of money in areas outside the East. It was a CHRONIC condition and led to the foundation of several political parties.

2) You apparently know little about Hamilton if you believed he set up the National Bank for personal profit. While that may have been the case with the Bank of New York which he helped establish as a private individual earlier as a government employee he was known for throwing away all opportunities for personal profit throughout his life even when any conflict was only apparent and his financial integrity was impeccable. He died a poor man because he refused to compromise that integrity while Sec. of the Treasury. This baffled his friend Talleyrand who obversed "he made his country rich while making himself poor." The clearest exposition of H.'s financial program is in the biography by Forrest MacDonald.

The expansion of the banking system came principly during the Adams and Jefferson administrations. It is false that the National Bank set off a round of inflation though any step up from the Depression of the 1780s would have caused prices to rise somewhat. One of the reasons the Bank was formed was to prevent the inflation and depreciation which had occurred with the Continental and State paper. If I had to guess I would say that the vast majority of English investments within the U.S. was through notes not specie.

Washington was unconvinced about the constitutionality of the Bank until he had Jefferson, Randolph and Hamilton submit their opinions about the subject. Hamilton's paper destroyed the arguments of the other two and convinced Washington that it was indeed constitutional. This paper is one of the greatest State Papers ever written on what the constitution and government were about. Anyone who wants to comment on the Constitution should read it. Hamilton was the greatest expositor of the Constitution who ever lived. Even John Marshall admitted as much and much of his groundbreaking opinions came from Hamilton's writings. H. would have been on the Supreme Court if he could have afforded to accept W.'s appointment. But he had to decline since government service had bankrupted him and prevented him from accumulating a great fortune which he would have gained as the nation's leading lawyer. No man ever sacrificed more for this nation than Alexander Hamilton and for this he gets called a "crook."

Jefferson's support of the French Revolution and Democracy makes him a leftist. Not even the Reign of Terror brought him to his rhetorical senses.

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