Friday, April 22, 2011

Update on the Inflation Hysteria. This Invisible Monster Is Ready to Devour Us...!

Fabius Maximus...(click this link to see graphs and further links...)

Summary: The boomers lust for inflation. Conservatives fan this fear for political gain. The government hopes for gentle inflation to deleverage the US economy. Evidence suggests that disappointment lies ahead for all. Here we review the evidence.

Most were too young, too poor, too inexperienced to get rich during the Great Inflation of the 1970′s. Some benefited by inheriting their parents’ gains. But for most boomers this is their last chance to win the life lottery. Loaded with debt but able to borrow, ignorant of economic theory and history but eager to speculate, they hysterically warn of the Big Bad Ben causing inflation. Please don’t throw us in that inflation patch they cry, while buying gold and silver — holding short-term debt, buying that third rental property with 10% down, and investing in foreign debt. Most of all, the magic of inflation is their only way to shed debt without drastic cuts to their standard of living in retirement.
Governments use unanticipated inflation as their magic sauce for policy. Slowly accelerating inflation played a big role in evaporating the massive US WWII debt, reducing it from 108% of GDP in 1946 to 25% in 1975.

Now we’re primed and ready for it. Probably to be disappointed, since anticipated inflation has none of the magic we and the government hope for. See this post for an explanation why.

This is an update of the 22 February post More invisible signs of looming US inflation! The situation remains unchanged. Hysteria with little factual basis. Before we start, some important notes about this complex subject:

•There are good reasons to worry about future inflation. And future deflation. That’s a difficult aspect of our situation.
•No known metric reliably forecasts future inflation; data must be evaluated with respect to the overall context of macroeconomic conditions. These things are complex.
•Inflation is a monetary phenomenon. Rising raw material prices are not inflation. Also, raw materials are only a small fraction of end prices (e.g., raw food is only one-third of food costs, approx).
•Wages are a large fraction of end prices, and in real terms, they’re falling! Serious inflation is almost impossible without rising wages (people cannot pay the rising prices without more income).
•Increased private sector borrowing typically accompanies inflation. Outstanding consumer credit is flat (only education loans by the government are rising, much of which are the new subprime — almost worthless courses by for-profit schools). Bank credit is flat.
•The combination of rising sector prices, flat wages, and tight money is deflationary. As it was in 2008 (remember the big inflation scare, ending in a bust). We have the first two today; QE2 prevents the third. Without wage growth, rising food and energy consume more of people’s budgets — so expenditures on other things must drop. This looks like America today. For more see this post and this post.
•Inflation is rising in the emerging world, becoming a serious problem. That’s natural, as they’re growing rapidly (we wish we had such problems!), and many of these nations keep their currencies undervalued (see this explanation by Dave Altig at the Fed) . This divergence between the developed and emerging nations could force the long-expected decoupling, and perhaps a new world order. For more see this post.
Some indicators that can warn of inflation

1.Monetary measures
2.Is the Fed printing money?
3.Measures of the money multiplier and velocity
4.Watch the dollar drop in value!
5.Energy Prices
6.Direct measures of inflation
7.Why the hysteria about inflation?
8.For more information
(1) Monetary measures

In 1976 Milton Friedman was awarded the Nobel Prize for ”for his achievements in the fields of consumption analysis, monetary history and theory and for his demonstration of the complexity of stabilization policy”. Most importantly this, from The Counter-Revolution in Monetary Theory (1970):

Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output. … A steady rate of monetary growth at a moderate level can provide a framework under which a country can have little inflation and much growth. It will not produce perfect stability; it will not produce heaven on earth; but it can make an important contribution to a stable economic society.

Friedman’s insight laid the foundation for modern analysis of inflation. It’s widely ignored in laypeople’s analysis of inflation, of the sort now flooding the media. Let’s look at some measures of the money supply. First, a reminder of some vital details:

•The supply of money is a concept; it’s not like counting apples. There is no one right way to measure it. Like the blind men examining an elephant, we must view it from different perspectives.
•Experts construct alternative versions of these measure to produce new perspectives.
•Private home-cooked versions abound of these measures. IMO most are worthless.
•These variables vary with statistical noise. Only the longer-term moves have meaning (at least, meaning that we can understand).
•Put these numbers in context; compare them to US GDP of $15 trillion per year, and global GDP of roughly $62 trillion per year.
As Friedman explains, the money supply must increase as the economy grows, despite the oft-hysterical warnings that the money supply has increased to a new high. Over time, growth of the money supply should be proportionate to the economy’s rate of growth (in the real world this is a lumpy process). Compare changes in the money supply to that of US GDP: in 2010 M2 was up 3.3% while nominal (current-dollar) GDP increased 3.8% (real GDP grew 2.9%, per the BLS). Totally normal.

(a) The adjusted monetary base

The adjusted monetary base is the monetary measure over which the Fed has the most control. Down 0.3% in 2010; up 142% during the last 3 months (seasonally adjusted, annualized rate). The Fed’s QE2 program frantically pumps money into the economy. So far most of it remains idle in bank reserves (for confirming evidence see the money multiplier and monetary velocity below).

(b) The narrow money supply, aka Money of Zero Maturity (MZM)

Money of Zero Maturity (MZM) is up 1.9% in 2010; up 4.6% during the last 3 months (seasonally adjusted, annualized rate). Quite appropriately growing at the rate of nominal GDP (the economy cannot grow without money).

(c) M2

The M2 was up 3.3% in 2010, roughly the same as nominal GDP. Up 4.2% during the last 3 months (seasonally adjusted, annualized rate). Quite appropriately growing at the rate of nominal GDP (the economy cannot grow without money).

(2) Is the Fed printing money?

We’re told that the Fed’s wildly printing money, causing inflation throughout the $62 trillion global economy. As shown in this graph showing the result, a gentle rise in the size of the Fed’s balance sheet. A few hundred billion since QE2 started — at that rate the Fed will have flooded the world with dollars – in a generation or so.

This expansion of the Fed balance sheet may have had (and be having) large effects on US domestic financial markets. As for the effect on world markets, the relevant measure to watch is the aggregate (total) action of the major central banks. Including the big one, the People’s Bank of China.

(3) Measures of the money multiplier and velocity

Increases in the monetary velocity and money multiplier are indicators of inflation, although explaining them is beyond the scope of this already too-long post. They’re now falling, suggesting deflation (data from the Fed). These might be the most important metrics to watch!

The first graph is biweekly through 6 April; the second is quarterly through Q4 of 2010 (expect Q1 to continue the decline of Q4). The M1 multiplier is the ratio of M1 to the St. Louis Adjusted Monetary Base.

Fed definition: “Velocity is a ratio of nominal GDP to a measure of the money supply. It can be thought of as the rate of turnover in the money supply–that is, the number of times one dollar is used to purchase final goods and services included in GDP.”

(4) Watch the dollar drop in value!

A falling currency can cause inflation. We often told that the US dollar is declining so fast it will soon be trash. As shown in this graph, showing the value of the US dollar vs. that of other nation’s currencies – weighted by US trade with each nation. Note the index is set for .

•After 24 years of decline the broad USD index is down aprox 4% (from January 1987); And down approx 2% since December 2009. Not exactly Code Blue!
•The USD is down big in terms of the major currencies (March 1973 = 100), or rather what were major currencies (and are now far less major).
•There are good reasons to fear that the US dollar might decline or even collapse in value. On the other hand, a large decline in the USD might (painfully) cure our persistent trade balance — making US goods and services again competitive on world markets. But it’s not the ideal medicine. Given the small role of imports, it would take a large decline to put strong pressure on US prices.

(5) Energy Prices

We are told that energy prices are skyrocketing! Here are three problems with this inflationary story.

•Petroleum provides 35% of US primary energy (see this EIA graphic). Natural gas provides 23%.
•The price of crude oil (West Texas Intermediate oil) is aprox $108, the same as in March and September 2008. Up approx 25% from year-over-year (YoY). And down from its spike high of $140+ in Summer 2008.
•The price natural gas is approx $4, unchanged YoY. Down from its 2003-2009 range of $5 – $9. And far below its spike peaks of $12-16

(6) Direct measures of inflation (updated with March)

Like most macroeconomic measures, inflation cannot be counted like apples. It’s largely conceptual, involving choices and assumptions. The Urban Consumer Price Index is a well-designed measure of inflation, implemented by grossly underfunded experts. We get the economic data we pay for, which is one of the great laws of economics. This shows the monthly rate CPI, seasonally adjusted and annualized.

The following graph shows the year-over-year change in the CPI, more akin to what we actually experience. Inflation is running at the low half of the last 30-years range.

(6) Why the hysteria about inflation?

There are few signs of imminent inflation, let alone the hyperinflation we’re daily warned about. Why do so many people feel that prices are skyrocketing?

•We are not mentally equipped to sense tiny changes in economic variables (i.e., 2% over a year), any more than we can sense a 2% change in room temperature if it happens over several hours.
•We grew up with inflation, and believe that it’s the normal state of affairs. So we suffer from confirmation bias. We see prices rising, but not those that are stable or falling (e.g., drugs). See Wikipedia for details.
•Perhaps the major factor shaping people’s perception of inflation: loud voices constantly blaring announcements of inflation RISING FAST. From experience with the now-closed comments section of the FM website, I can testify that no amount of data quenches the inflationistas’ belief of imminent hyperinflation. They seize on any evidence, however bogus, to demonstrate that inflation lies under the bed — about to pounce.
A recent example is the data from MIT’s Billion Price Project. It’s a bold and brilliant concept, probably of great long-term value. But today we buy only a narrow range of goods via the Internet, and almost no services. A survey of internet prices does not well measure consumer prices. Yet disinformation merchants cite it as a better measure of inflation than the CPI. So far the BPP Index tracks with the CPI goods-only index, although it is too new to draw conclusions. See Paul Krugman’s article for details.

Sunday, April 17, 2011

Closing the 'Collapse Gap': the USSR was better prepared for collapse than the US...

An Early Warning... by Dmitry Orlov

The exponential function ez can be defined as the limit of (1 + z/N)N, as N approaches infinity, and thus eiπ is the limit of (1 + iπ/N)N. In this animation N takes various increasing values from 1 to 100. The computation of (1 + iπ/N)N is displayed as the combined effect of N repeated multiplications in the complex plane, with the final point being the actual value of (1 + iπ/N)N. It can be seen that as N gets larger (1 + iπ/N)N approaches a limit of −1. Therefore, eiπ = −1, which is known as Euler's identity...

These ships were commissioned by Wal-Mart to get all their
goods and stuff from China . They hold an incredible 15,000
containers and have a 207 foot deck beam!! The full crew is just
13 people on a ship longer than a US Aircraft Carrier (which has a
crew of 5,000. With its 207' beam it is too big to fit through the
Panama or Suez Canals ..

It is strictly Transpacific. Cruise speed: 31 knots.

The goods arrive 4 days before the typical container ship (18-20
knots) on a China-to-California run. 91% of Wal-Mart products are
made in China ..So this behemoth is hugely competitive even
when carrying perishable goods.

The ship was built in five sections. The sections floated together and then welded.

The command bridge is higher than a 10-story building and has 11 cargo crane rigs that
can operate simultaneously unloading the entire ship in less than two hours.

Friday, April 15, 2011

Deflating Inflation / Inflating Deflation...

Satyajit Das...

Quantitative easing ("QE"), the currently fashionable form of voodoo economics favoured by policymakers in the US, is primarily directed at boosting asset values and creating inflation. By essentially creating money artificially, central bankers are seeking to return the world to stability, growth and prosperity.

The underlying driver is to generate growth and inflation to enable the problems of excessive debt in the economy to be dealt with painlessly. It is far from clear whether it will work
Monetary Phenomenology…

QE is designed to create inflation, at least just at the correct level. Given that one of the objectives of central banks is to keep inflation under control, it is ironic that they now want to create more inflation. Higher inflation would reduce the value of debt. Inflation may also induce more consumer spending, as people accelerate purchases, anticipating higher prices in the future.

The ability of QE to generate inflation relies on Milton Friedman’s observation that "inflation is always and everywhere a monetary phenomenon." The quantity theory of money holds that the supply of money multiplied by velocity (the rate at which it circulates) equals nominal income, the product of real output and prices. Increasing money supply increases nominal income, boosting real output and/ or prices.

The role of money supply in inflation and economic activity is complex. Cause and effect is uncertain - does money supply influence nominal income or does nominal income affect velocity and the demand for and thereby the supply of money? Central banks control the monetary base, a narrow measure of the money supply made up of currency plus the reserves that commercial banks hold with the central bank. The relationship between the monetary base, credit creation, nominal income and economic activity is unstable.

A significant problem is that velocity of money or the rate of circulation has slowed. Banks are not using the reserves created and money provided to increase lending. The reduction in velocity has offset the effect of increased money flows.

The desire to increase inflation is also driven by fear of deflation. Economists measure the economy’s "output gap", the difference between total demand and the economy’s potential to produce goods. When demand exceeds supply, inflation rises. When demand is less than supply, inflation falls (disinflation). In the extreme circumstances it becomes deflation, where prices start to fall.

Deflation makes it difficult to manage excessive debt. Cash flows and earnings fall making it harder to service existing borrowing. Debt must be paid back in money that is now more valuable as it gains in purchasing power. Nominal interest rates fall but after adjustment for inflation rates, real interest rates are high, discouraging borrowing. Falling prices discourage non-essential consumption, as the same item is likely to be cheaper in the future. For a central banker in an economy with high debt levels, inflation is the dream, deflation is a nightmare.

Milton Friedman famously argued that "helicopter drops" of money could be used to encourage spending and avoid deflation. A student of economic history and an acolyte of Friedman, Ben Bernanke restated the principle in 2002 arguing that "under a paper-money system, a determined government can always generate higher spending and hence positive inflation."

The Fed justifies QE as insurance against the risk of deflation. But inflation levels remain modest, particularly if the effect of higher commodity prices is stripped out. In practice, creating inflation or even arresting deflationary tendencies is difficult. After many years and several rounds of QE, Japan still hovers on the cusp of deflation.

Ironically, if QE created the necessary inflation or inflationary expectations, then it would push up interest rates, potentially choking off economic recovery.

After the Fed launched QE2, long term US interest rates rose sharply, driven by fears of high inflation in the future. The hoped for fall in mortgage rates and generally lower interest rates did not occur to the extent anticipated. Since the announcement of QE2, 30 Year Treasury yields have increased by around 0.60%. The average 30-year mortgage rate has gone up from 4.25% in August 2010 to over 5% by January 2011.

Side Dishes…

Criticism of QE has focused on the risk of Weimar like hyperinflation. Debasement of a currency through debt monetisation can lead to very high levels of inflation.

In reality, the low velocity of money, the lack of demand and excess productive capacity in many industries means the inflation outlook in the near term remains subdued. Inflation will only result if bank lending accelerates and aggregate demand exceeds aggregate supply. America’s output gap is between 5% and 10% and considerably more monetisation would be necessary to create high levels of inflation.

QE’s real side effects are subtle. It discourages savings, drives a rush to re-risk, encourages volatile capital flows into emerging markets and forces up commodity prices.

Low interest rates perversely discourage saving, at a time when indebted countries, like America, need to increase saving to pay down high levels of debt. Low interest rates reduce the income of retirees or others living off savings, further reducing consumption.

Individuals saving for retirement received this piece of quixotic advice from Charles Bean, Deputy Governor of the Bank of England: "Savers shouldn’t necessarily expect to be able to live just off their income in times when interest rates are low. It may make sense for them to eat into their capital ... Very often older households have actually benefited from the fact that they’ve seen capital gains on their houses." In retirement, it seems everyone should sell their houses, take up residence on the streets or in a public park and live off the money released.

Low rates have driven a rush to increase risk, in search of higher returns. In January 2011,

the difference between interest rates on speculative or non-investment grade corporate bonds and investment-grade debt fell to around 3.50%, the lowest level since November 2007. In 2010, companies sold a record $286.7 billion of junk bonds to investors driven by the need for higher rates. The search for yield extends to stocks and also structured products, where investors take on complex returns in return for additional returns.

The rush to re-risk has reduced general lending standards. Practices that contributed to the global financial crisis, such as "covenant lite" loans with low protection for lenders, have re-emerged. Under-pricing of risk is also evident, creating the foundations for future problems.

Financial Fetishes…

Voodoo was originally a religion that developed in America’s South, based on African beliefs syncretised with Christianity. Voodoo incorrectly became associated with exotic superstitions and occult practices. Unscrupulous practitioners made a fortune charging money for fake good luck charms or talismans kept to ward off evil - fetishes.

Voodoo economics, such as QE, resembles fetishes, objects believed to have supernatural powers. Despite evidence to the contrary, these financial fetishes are predicated on the belief that the theories and models are correct, policy makers know what they are doing and the actions will be effective.

In the voodoo belief system, a zombie is a fictional monster, usually a reanimated human corpse with normal appearance but no will of its own, controlled by a powerful sorcerer. Increasingly, the global economy risks entering a zombie phase. The economy appears to be functioning. In reality, it is moribund and stagnant, manipulated by central bankers and policy makers to give the appearance of normality.

In Ferris Bueller’s Day Off , Sloane ask Ferris: "What are we going to do?" Ferris replies memorably: "It’s not what we are going to do! It’s what aren’t we going to do!" As policies fail or prove ineffective, desperate policy makers merely apply them in larger doses or dream up new fetishes. QE2 is likely to be followed by further rounds of QE and other forms of voodoo economics.

If current policies fail to spur growth and inflation, then governments will borrow or print more money to increase spending, transferring funds to households or cutting taxes, building infrastructure or even writing off the face value of mortgages and other debt. If that fails then they can purchase other riskier assets. The Bank of Japan’s strategies now include buying stocks, lending to companies and providing even more money to banks to boost their capital and lending capacity.

In extremis, the central bank could charge people for holding money, forcing them to spend it by placing expiry dates on currency. Policy maker’s actions are shaped by Josh Billings’ observation: "The thinner the ice, the more anxious is everyone to see whether it will bear."

The economic policy debate, at its core, is about the limits to human knowledge of the economy and the ability to control it. The global financial crisis and the policy response are increasingly exposing the limits to both. As author Richard Collier once remarked: "All motion is cyclic. It circulates to the limits of its possibilities and then returns to its starting point."

Economists, central bankers and governments reject limits to their knowledge and powers. Their thinking mirrors the following exchange in The Dark Knight (the latest instalment in the Batman franchise):

Alfred: Know your limits, Master Wayne.

Bruce Wayne: Batman has no limits.

Alfred: Well, you do, sir.

Bruce Wayne: Well, can't afford to know 'em.

Central bankers and policy makers would do well to heed Josh Billings’ advice: "I have lived in this world just long enough to look carefully the second time into things that I am most certain of the first time."