Believe those who are seeking the truth. Doubt those who find it. Andre Gide


Tuesday, March 8, 2011

Out of thin air?

Have you ever said something like "Let me buy you a beer next week"?
I'm sure you have. We all issue promises of this sort. And we frequently use such promises as a form of currency. For example, we might say something like "Hey, why don't you give me a beer now...and let me buy you a beer next week?"

I have just described a simple credit exchange. Societies rely heavily on promising-making and promise-keeping. It is the foundation of all financial markets.

I'd like to point out something about the promises you make. They are made "out of thin air." The promises that other people make are also made "out of thin air" (including politicians like you-know-who). Oh, some may write the promises down in the form of IOUs or other legal documents. But really, as Chamberlain discovered on his return from Germany, we know the intrinsic value of paper (promises).

The fact that promises are made "out of thin air" does not mean they are worthless. The value of a promise is determined by the perceived (and ultimately, actual) credibility of the promise-maker to make good on his/her promises. The relevant concern of those who rely on financial agencies is the credibility of they claims they make. The fact that financial agencies issue promises "out of thin air" is a red herring. And if the charge is made with exclamation, well...forgive me for suspecting that the motive is to arouse impassioned anger, rather than rational discourse.

The Fed creates fiat money (yes, out of thin air). But fiat money in itself does not constitute a promise against anything in particular (on the other hand, there are those who argue that it is a promise to discharge a tax obligation). In a gold standard regime, a Fed note would constitute a claim against gold. But we do not presently live in a gold standard regime. So what sort of promise underlies fiat money?

Apart from any intrinsic value determined by its ability to discharge a tax obligation, the value of fiat money ultimately hinges on its scarcity. More precisely, it depends on how its supply is managed over time. Or even more accurately: it depends on the expectation of how its supply is to evolve over the indefinite future. This expectation hinges critically on the credibility of the money supply manager.

In our current regime, the Fed is (implicitly) promising to keep inflation centered around 2% per year. The actual inflation rate dipped considerably below this number during the past recession and it is now considerably higher (owing largely to the boom in commodity prices). But if one draws a trend line through these ups and downs, we're basically sitting close to 2%.

Now, we can argue at length about whether 2% is the right number. The Fed calls 2% "price stability," but clearly it is not price stability in a literal sense. The real rate of return on non-interest-bearing money is -2%. This is currency debasement; albeit, at a rather slow rate relative to the 1970s or Zimbabwe's recent experience. Price-level stability requires an inflation rate of 0%. The Friedman rule suggests that a moderate deflation is desirable.

Anyway, back to my main point. Which is that condemnations of the Fed based on charges of creating money "out of thin air" are off the mark. The discussion should instead center on whether the Fed, as currently construed, is an institution that can be trusted to make good on its promises. This is the same question one would ask of any agency, public or private.

And if the Fed is abolished, and then what? What replaces it? A gold standard? Here is what one person wrote to me on the subject:
And yes, a gold standard would be fine by me.  Is there an argument against the gold standard that I don't know about? Also, as an example of hyperinflation, how about when Roosevelt rounded up everybody's gold in 1933, and then debased our currency by 50% ?
I think this highlights a point that I have been trying to make for some time now. The "gold standard" is nothing more than a promise made "out of thin air" by the government. Look at how easily Roosevelt abrogated that promise in 1933. What makes people believe that the same thing cannot happen again? (Related arguments apply to so-called "free banking" regimes.)

Sure, we might say that such acts are or should be prohibited under the Constitution. But the Constitution is also a document that has been fabricated "out of thin air." I have been told by some that the existence of the Fed is itself a violation of the Constitution. So you see how easy it is to violate that venerable document.
   
Imagine that it is somehow possible to make the gold standard credible and absolute. If this is possible, then it must also be possible to make a fiat money standard credible and absolute. Just replace the gold with fiat tokens. As a bonus we would have an efficiency gain (commodity monies are better utilized as commodities, rather than exchange media).

So, please, enough of this "out of thin air!" stuff. It's tiresome for those who know better, and distracting for those who do not. Let's divert attention to more substantive issues.

For example, the Fed has a legislated monopoly over the supply of small-denomination paper. Is this a good idea? What if we keep the Fed as is and allow free-entry into the business of money creation? If an unfettered private money system works well enough, it might drive Fed notes out of circulation. On the other hand, perhaps the demand for Fed paper will remain. Government paper (in the form of US Treasuries) drove out private money (AAA tranches of MBS) in the repo market in the past financial crisis. Now, isn't that interesting?

97 comments:

  1. Hi David,

    Good post. I have used the term "out of thin air" before and I probably will again. Let me explain why.

    Without the Federal Reserve, when the United States issued its debt, individuals with savings must turn that money over to the Treasury in the expectation of having the money returned to them with interest. So, in this case there would be no change in the overall supply of money.

    When the Fed buys government debt, there is no savings that is taken out of circulation, the Federal Reserve creates the money "out of thin air." This alone has a redistribution effect, but as you have mentioned, Congress could redistribute whatever its wants with or without the Fed. However, increasing the money supply also pushes interest rates artificially low, which causes individuals to make bad decisions in long term planning. Look at the housing boom and bust and other bubbles.

    Now, if the Fed just increased the amount of paper money in circulation by 2 or 3 or 4% per year, I probably wouldn't give it much thought, but as of 2008, the balance sheet of the Fed has exploded. When I reference this with others I use terms like "out of thin air."

    So I guess the real question here is: What do you think of the Feds balance sheet from 2007 to present? Do you see trouble in our future as I do, or is there a way this all ends well that I am just missing?

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  2. On Wednesday, November 14. 2007 a gang of FBI agents raided the Liberty Dollar company. They stole hundreds of pounds of silver and kidnapped two peaceful people and locked them in a cage.


    It doesn't take a 140 IQ economist to realize the government should not be doing this.

    http://libertydollararrest.blogspot.com/


    The monopoly on currency creation is enforced by violence. The people enforcing it don't care about economic theories they care about having the power to print money free from competition. Fed economist are propagandist for these thugs.

    Monetary units issued by the Fed to buy bonds are backed by a promise from the government to confiscate the wages of the serfdom.

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  3. Do you support QE3 when oil hits $120/bbl ?

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  4. So you don't deny that the Fed creates money out of thin air, but you don't like the overtones of this statement.

    Is it the questioning of the Fed's ability to keep it's promise that bothers you? Wouldn't that indicated that it's promise (what the fiat represents) might not be worth as much as the Fed claims?

    Seems like this type of commentary coming out of the Fed even if its not official policy and just your personal opinion illustrates why its important to call a spade a spade, no?

    Anyways, interesting commentary and coming from someone who previously did not know better, I'd say that phrase didn't distract me from what is important, but rather led me there. What is important IMO is to question the Fed's ability to make promises backed only with more promises.

    I'd also like to know, if the Fed is able to manipulate the money supply by making credible promises, does it do so in the best interest of the nation, or itself?

    I don't see why the Fed would fall on it's sword by admitting it has made mistakes, do you?

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  5. Edward,

    Not sure if you're aware of this, but the Fed is not permitted to buy Treasury debt directly from the Treasury. It must go through its 20 primary dealers; investment banks and securities brokers. So usually, the Fed doesn't monetize the debt in any serious way and only does so because of annual inflation targeting.

    The question right now is and remains - what are the effects of the exploding balance sheet of the Fed? Much like the Great Depression, I expect research on that to carry on for some time.

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  6. So have you ever tried to lock somebody else in a cage because they promised somebody a beer and you claimed that you were the only guy allowed to do such a thing?

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  7. In a very real way, we do have free banking - in the form of deposits. Now, typically those deposits are in the form of claims to US$. But the interaction between deposit and note issuance is not carefully discussed. The link, of course, is through fractional reserve banking.

    If one looks at the difference in money creation by the Fed and money creation in total, then money creation by the Fed is small potatoes up until 2008 crisis.

    The real influence of the Fed is felt through its setting of the benchmark rate - the fed funds rate. This post isn't about that so I won't go into detail, but slow and steady inflation isn't the problem most here are making it out to be.

    The very interesting conversation is that of adjustment costs. Pursuing positive or zero inflation in the face of increased productivity leads to more adjustment costs than a productivity norm (similar but not the same as the Friedman rule). But for certain types of price shocks, positive inflation is very important so that a money deflation doesn't occur. I would like David to expand his thoughts on that area.

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  8. Prof J,

    The fed buys the bonds indrectly through the primary dealers and it so happens that this technicality results in billions of dollars in fees directly to the mercantilist group of bankers who have the coveted primary dealer status. You might have heard of a couple of them...JP Morgan, Goldman Sachs. The Fed has been monetizing this debt in a serious way the last two years. Perhaps you are not aware the Fed now holds more US debt than China?!? Yes two years ago it seemed there was unlimited demand for treasuries...now it looks like only the Fed wants them.

    I'd say trillions of dollars of purchases are quite "serious". Yes research will go on. My research says that commodity prices will continue to go up until the Fed starts to tighten. The move thus far from $4 silver to $37 is reflective of a declining faith in the dollar. I don't want you guys to tighten, anyone holding US dollars deserves it at this point if you want to be absolutely darwinian about it....just don't think it says much for the prospects for a civil society.

    At what price do you think gold will be when you advocate replacing the dollar with IMF SDRs? and around what year would you expect that to happen.

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  9. gabe,

    Do you want to talk about the Fed generally, or its recent activities?

    Yes, of course I'm aware of who the banks are (in general-the current list isn't public). This is an important source of money non-neutrality in the form of Cantillon effects.

    You speak of research - have you a paper (working or otherwise) available?

    Btw, who is "you guys?" I'm not a Fed economist. I'm a financial economist, in point of fact.

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  10. You say:

    The discussion should instead center on whether the Fed, as currently construed, is an institution that can be trusted to make good on its promises. This is the same question one would ask of any agency, public or private.

    I say:

    The Fed can be trusted to make good on the promises of fellow bankers and insurance companies, such as Goldman Sachs and AIG. And, that's about as far as the Fed can be trusted.

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  11. to Prof J:

    I am aware of that fact. I have many thoughts on that subject but firgured this was not the post for it. It simplified my post to simply say that the Fed buys from the Treasury, which it is doing, indirectly.

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  12. Edward,

    Fair enough. I mentioned because I believe this is a critical feature of the non-neutrality of monetary inflation. It has other implications too, like optimal size of a bank, but, as you say, we'll keep it to the point.

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  13. Prof J,
    My research is not available to the public unless they pay hefty fees to my bosses. However, it isn't anything grand or surprising.

    I'll save you the money. I compute various indices used to represent some form of real short term real interest rates available to the most politically connected.

    I show that when these indices indicate there is a significantly negative real interest rate, commodity prices go up much faster than when real interest rates are positive. I also show that in the past there has been a lag time of 15-30 months.
    big deal right? common sense.

    "You guys" in my post above was referring to people who tend to underestimate the structural damage to an economy and society that accumulates over time when a group like the central bank has the power to manipulate the economy as it does. "you guys" seem to honestly believe that it will be good for the economy to engage in QEn whenever a politically powerful group is in danger of losing money or going bankrupt. I think this situation leads to institutional rot and misallocation of resources in many segments of society. All smart people who want to maximize income gravitate towards the corruption so that we can get in on it. I have seen this in my peer group that went to MIT in the 90's....at the same time that bozos like Bill Gates whine about why aren't we creating more scientists...and obama and Bush think it shows why we need for federal education programs and more taxes for more spending...laughable.

    Want to know who MIT students get excited about interviewing with? Goldman Sachs, JP Morgan etc...for good reason. Career paths to making 500k/yr by the time you are 30 are fairly straight forward. Want to know how big corporations create their business plans..."how can we use mercantilsit concepts to protect and grow our business"..."how can we force people to buy our proudct using the government powers available", "how do we use the government to eliminate competition set up barriers to entry, etc"....this goes on a for a few decades and it makes a prosperous fast growing oak tree into parasite infested rotting oak...yes the oak is bigger than it used to be(as the empiricist are sure to point out!)...but when it falls it will fall quickly. The big oaks may only fal every 2-3 hundred years, but the rot is sure to grow for many decades before the parasites are forced to admit that they eventually will have to find a new home or die.

    I don't understand how an environment where the government arrests people for pressing silver coins could be considered "free banking". If the current environment fits the definition of free banking I guess I'm against free banking.

    "you guys" think QEn and more bailouts through the form of buying securities is going to help the economy when oil hits $120 or $130...go ahead...what conditions would have to be met for you to admit you had the wrong idea about things? $3000 gold? $5000 gold?

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  14. First you talk about explicit promises of individual human beings to deliver beers or coins to other individual human beings.

    Then the next thing you know, you're talking about nebulous "promises" of a central bank to god-knows-whom to manage the cpi denominated in a monopoly currency enforced by violence. Very knavishly Chicago-schoolly.

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  15. QE 3 is now in question. i give it 50/50 chance now.. and any selloff will happen without any announcement, because the crooks at the top know before we do.

    But.. what if there is QE3? then the little guy gets screwed again, missing out on all the stacked up buying before the announcement; before we even get wind the DOW will be at 14,000.

    Why is it people refuse to see the obvious unfairness of the situation?

    You really think people should blindly trust this institution when all evidence points to this being a huge racket?

    I don't even think you are high enough to be on the inside David. You seem like a really good guy. However, there is nothing you can say that will make most of the educated public beliee that "jsut trust us to move markets in a way that will help you in secret" is a fair and good monetary policy.

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  16. Boy the kooks really came out in force today. I'm speaking directly to you, Rudy Dekkers.

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  17. Davide, I will recommend this post to my colleagues who teach macro elements (and maybe intermediate). Nicely done.

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  18. We're basically talking about confidence. Even in a society where the currency is physical gold coins, confidence is still central. Most people can't actually use gold; you can't eat or drink it, build a house with it, burn it for heat or fuel, or fire out of a rifle to kill game. Its sole value is in exchange, and it only retains that value because the people willing to buy it are confident that they themselves will be able to sell it to someone else. Buyers and sellers need confidence in the value of gold.

    Today of course we have a fiat currency, which I think makes confidence in government promises even more important since the money itself is neither made out of a valuable substance nor even backed by it. Yet the United States issues new debt to pay the face value of maturing bonds that constitute old debt; this shakes confidence. The Fed is montetizing vast quantities of U.S. debt such that we somehow owe ourselves money; that shakes confidence. Congress now spends enough that there was a $200 billion deficit last MONTH alone; that shakes confidence.

    In the past you've talked about the congressional mandate of the Fed like it was some set of ironclad shackles, yet In the past few years the Fed has purchased gigantic quantities of private assets—something its mandate does per authorize, and yet it was done anyway. If you want to talk about the important of promises and the ability to keep them, then the Fed does things like that, I would argue that it adds another layer onto the pile of reasons to be worried about the promises that have been made by the various levels of the government.

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  19. That should of course read "something its mandate does not authorize". Durrrrr. And please excuse the rest of the errors, too. I need to proofread my comments better!

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  20. Article 1, sections 8 and 10 give the federal government monopoly power over its currency of issue. So say the courts. End of story. Government can do what is pleases with its currency iaw legislative decisions taken by elected representatives and powers delegated thereby.

    The Fed does essentially three things. First, it is responsible for interbank settlement and acts as lender of last resort to insure that accounts clear. Secondly, it sets the interest rate, that is, the overnight interbank rate for reserves. Thirdly, it is charged with oversight of the financial system. If the Fed were to be abolished, some other means for meeting these responsibilities would have to be substituted. In addition, the Fed also has emergency powers for use in financial emergencies. There would be no cushion if the Fed were abolished.

    BTW, banks also create money out of thin air. They do not loan out either deposit or reserves. Loans create deposits and reserves are obtain afterward as needed to meet settlement needs and reserve requirements. Bank lend against capital to creditworthy applicants demanding loans on mutually agreed upon terms that allow the bank to make a reasonable return.

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  21. @Tom Hickey,

    I'm sorry, Tom, but I'll have to ask you to refrain from posting any more easily understood and factual comments. This debate is limited to frothing-at-the-mouth lunes.

    If you can redeem yourself by posting an incoherent rant on the evil conspiracy that is central banking, then I might reconsider my judgment.

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  22. @ Prof J,

    Do you have any thoughts on the effects of the Fed's balance sheet explosion 5-10 years from now?

    @Tom

    Every thing you said is technically correct, but just because the Fed has the legal right to more than double its balance sheet does not make it a wise decision. I think it will lead, eventually, to very high price inflation, with most of the price increases in commodities. What do you think?

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  23. @Tom Hickey,

    Section 8 authorizes congress to only "coin" money--not print it.

    Section 10 limits the states' legal tender laws by only allowing the states to make gold and silver legal tender. The congress of course in Article 1 is not delegated any such power of making anything legal tender.

    Ron Paul advocates repealing the unconstitutional federal legal tender laws and allowing competition in monetary commodities, by the way.

    So not end of story if you're reading the plain language of Article 1. As for the courts, they've been saying that might makes right and the govt can do whatever it wants and anyone who disagrees is a loon ever since the civil war Legal Tender cases and before.

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  24. Edward,

    I find it difficult to forecast 5-10 years out. We know the Fed's deflation was particularly drastic after 1929 into 1933, but there is less clarity as to the effects of a massive inflation that isn't actually circulating.

    My hypothesis is that if there was a demand for loans, more (I don't know how much) of the money currently in excess reserves would be circulating and we would be seeing much greater price inflation. If the Fed sells securities back to the banks and eliminates those dollars, excessive price inflation is not especially likely. Probably get 4-6% yoy.

    Now, the bigger danger, that is more subtle, is the misinformation caused by the inflation. What I think we'll see is continued increase in the optimal size of a financial services firm, but it's not clear how much of that will be due to "Too Big to Fail" and how is due to being on the list of 20 broker-dealers FRBNY deals with.

    It will also encourage issuance of lower quality assets, since this time FRBNY purchased MBS in addition to Treasury paper. Not a good precedent.

    I have many more predictions, but let me end here and say this: we had a big M in the S&P 500, and we will probably get another leg on that (up and down). 5 years from now, we'll be back in this position, but probably more SOL.

    My optimism is kicking in, though, and I see good citizens arming themselves with knowledge to fight against those who would appropriate their wealth. Not just the Fed - that's the least of it - but all statism.

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  25. @Edward,

    "...just because the Fed has the legal right to more than double its balance sheet does not make it a wise decision. I think it will lead, eventually, to very high price inflation, with most of the price increases in commodities."


    Edward, first let's establish defintions. Inflation is a sustained rise in the general price level. It is not commodity price increases, though inflation generally will also affect commodities, of course.

    I agree that the decision to expand the balance sheet is not obviously the correct one. But I do think it was correct.

    Will the expanded balance sheet raise inflation?

    In order for the expansion in the monetary base to translate to inflation, it will almost certainly have to lead to a rise in the broader aggregates. For the the aggregates to increase, the banks have to start lending their reserves. (Banks can create loans/deposits out of thin air but when the borrower starts to use the money, it will draw down the reserves of the individual bank.) Banks will only start lending their reserves if they can do so at rates that are greater than the rates at which those reserves earn interest at the Fed. So, the Fed can use its ability to pay interest on reserves as a tool to lock up the reserves.

    The Fed can and will reduce the monetary base by selling the assets that it has accumulated and by allowing them to "run off." This will happen as the Fed tightens, which will likely occur over the next few years. It will happen.

    Right now, there is almost no inflation pressure in the general price level. Yes, you can find that there are prices that have increased; you can find prices that have decreased. The overall level of inflation is low, especially if one looks at core, which is more closely related to past policy.

    Long-term asset purchases expanded the balance sheet, which enabled the Fed to shore up disrupted credit markets and drive down long-term interest rates. This increased investment and GDP growth from what they would have been.

    There are no guarantees in life but the relation between the expansion of the balance sheet and inflation is more complex than one might think from undergrad monetary economics. I am confident that the FOMC can and will take appropriate action to maintain a low rate of inflation.

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  26. >I am confident that the FOMC can and will take appropriate action to maintain a low rate of inflation.

    You must be Joking!

    "I too have been a close observer of the doings of the Bank of the United States. I have had men watching you for a long time, and am convinced that you have used the funds of the bank to speculate in the breadstuffs of the country. When you won, you divided the profits amongst you, and when you lost, you charged it to the Bank. You tell me that if I take the deposits from the Bank and annul its charter I shall ruin ten thousand families. That may be true, gentlemen, but that is your sin! Should I let you go on, you will ruin fifty thousand families, and that would be my sin! You are a den of vipers and thieves. I have determined to rout you out and, by the Eternal, (bringing his fist down on the table) I will rout you out"

    (Source: original minutes of the Philadelphia committee of citizens sent to meet with President Jackson, February 1834, according to Stan V. Henkels, Andrew Jackson and the Bank of the United States, 1928)

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  27. What's up with all the 19th century quotes?

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  28. Chris of the Regressions,

    Your definition of inflation is not the only definition. Classical and Austrian economists talk about monetary inflation, or inflationary monetary disequilibria. Such inflations lead to price inflations, but they need not, in fact do not, show up uniformly due to the non-neutrality of money. Thus commodity price increases, asset price increases, and so forth are inflationary phenomena that lead to a misallocation of resources, relative to the no-inflation allocation.

    I understand your position, but I believe the neoclassical/monetarist definition of inflation is overly narrow and thus misses important destructive features of an inflationary regime.

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  29. @Anonymous 9:40,

    Quoting Andrew Jackson is not a reasoned argument; it is unlikely to convince anyone who does not already agree with you.

    As you apparently strongly believe that inflation will take off in a major way, I assume that you are trading the nominal-real Treasury spread. And you've also bought out-of-the money put options on the dollar and Treasuries. You could make an awful lot of money if you are right. I'll bet that you've mortgaged your house to make those trades, right? ...[crickets chirping]... Right?

    @ Prof J,

    Inflation is a sustained rise in the general price level. That is the general usage in the economics profession.

    If Austrians want to use the word "inflation" for something else, then that just confuses the debate. It is difficult to discuss something when we cannot agree on definitions of terms.

    (I will omit the usual quote from "Alice in Wonderland" here.)

    If I were more cynical, I might think that confusing commodity price increases with inflation was a feature of the argument, not a bug. That is, I might think that its use was intended to establish a causal connection between commodities and money without having to actually prove it.

    If Austrians want to claim that increases in money aggregates have a disproportionate effect on commodities, then let them have a go at proving it. (Maybe they will succeed; I am agnostic.) But don't call such commodity price increases inflation. Call it something else. How about "commodity price increases?"

    BTW, I can readily believe that commodity price increases are correlated with the business cycle and also money aggregate growth. I would be surprised if commodity prices were not correlated with business conditions. That is a long way from proving causation, much less causation and significant misallocation of resources.

    PS: I actually have a fair amount of sympathy for certain Austrian arguments about financial stability. But I wish that they would actually join the mainstream debate in the profession.

    PPS: I appreciate the reasoned tone of your response, Prof J, and I intend my own comment to be read in the same civil tone.

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  30. Since all the talk of money, I created my own blog last night, edward-gonzalez@blogspot.com and just linked to an article I wrote a year ago on my obervations on commidity money in the al Anbar Province of Iraq in 2007. I served as an advisor in a number of small villages during the surge. For those of you interested, please give it a read and comment away.

    @Chris the Regression Runner,

    I just read an interesting comment by you that came through gmail but I do not see here. If you repost it I would like to respond.

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  31. of course I meant edward-gonzalez.blogspot.com

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  32. I think one thing we can and should talk about is the Fed's mandate. The "dual mandate" might lead to problems in just one year: We could have unemployment rates above 8% and headline CPI inflation rates uncomfortably greater than 2%.

    I'm not sure if I am in the minority on this, but it's not clear to me the Fed can create employment by printing money. The Phillips curve was not very helpful in the 70s. Why should it apply now?

    If the Fed had one strict mandate which it could essentially acheive, essentially saying "do not devalue the dollar", then the discussions about QE2 etc. would be totally different.

    Morris Davis

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  33. @Edward,

    Sorry, I must have been too wordy. The software zapped it. I will try to be more concise.

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  34. @ Anonymous 9:40 pm,

    If you are convinced that inflation will substantially increase, then I guess that you are trading on nominal-real Treasury spread and buying out of the money puts on Treasuries and the USD. You've borrowed every dime that you can to invest on this theory, right? ... Right?

    You wouldn't pass up a chance to put your money where your mouth is, would you?

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  35. @ Prof J,

    The economics profession defines inflation as a sustained rise in the general price level. It is difficult to discuss things if we cannot use common definitions.

    (I will omit the usual reference to "Alice in Wonderland" here.)

    If Austrians want to discuss a rise in commodity prices, that is fine with me but they should call it something else, not "inflation." Maybe they should call it "commodity price increases."

    If Austrians want to argue that monetary policy has disproportionate influence on commodity prices, they should go out and prove it, rather than defining commodity price increases as "monetary inflation."

    I am agnostic on the question myself. I could be convinced but they need to go out and convince me. BTW, correlations between commodity prices and other business cycle variables won't do it.

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  36. @ Morris,

    Morrs said: "The Phillips curve was not very helpful in the 70s. Why should it apply now?"

    The distinction is that the Fed tried to keep unemployment below its natural rate during the 1970s, which led to accelerating inflation.

    Today, unemployment is almost surely about its natural rate and core inflation is below the Fed's 2 percent target. Hence, accomodative monetary policy is called for. By keeping short and long term interest rates temporarily low, the Fed changes marginal investment decisions and output and employment are higher than they would otherwise be.

    I would also take issue with the idea that the Fed is "printing money." There is more to QE than printing money. In fact, I would agree that "prnting money" would likely do very little.

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  37. Regression Chris,

    That's my point. Inflation is defined overly narrowly by the "profession." As a member of the profession, I feel comfortable stating this.

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  38. Of all the people posting and emailing, I am probably the person furthest removed from the study of economics. But to me, our financial sector is a unique blend of federal and free market banking. And we have just experienced the collapse of the entire sector - with plenty of blame for both federal and free market banks.

    Our free market banks have done an appalling job of managing risk. They've turned investment into a craps game and when their businesses tanked, they took all the money the Fed had to offer and paid themselves handsome bonuses. Concurrently, the economy took a terrifying dive into the worst recession since the Depression.

    The free market is as equally to blame as the fed for the devastation of our economy. If they bear no responsibility at all, then we need to stop paying people in the banking sector astronomical sums of money for their expertise and brilliance if they function solely as tools of the fed.

    So to fix it, we need to do more than focus on a very old debate - keep or get rid of the central bank. We need to find an answer for our needs today.

    [I always find it intriguing when people use Thomas Jefferson to bolster their banking arguments. When he died in 1826, he owed approximately $100,000 - in 1826 money, so imagine what that sum would be today! Much of that debt went to finance his never-ending construction on his home - making Jefferson the first modern American, reliant less on self and more on debt to cover his expenses... and finding his home to be a major drag on his financial situation.]

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  39. @Chris the regression-runner,

    Terms are tricky. Austrians usually use terms like monetary inflation vs. price inflation. One is an increase in the money supply, the other being a general increase in prices. I will use those terms now, but if there is a better term for what I call monetary inflation, I will be happy to use it.

    Austrian Theory, to the best of my knowledge, states that monetary inflation causes a misallocation of capital. It causes unproductive bubbles that eventually have to be liquidated once reality sets in. Good modern examples are the dotcom boom and housing boom. Both crashed. This may or may not manifest itself in price inflation.
    The great Austrian economist Ludwig von Mises predicted the 29 stock market crash in the U.S. by noticing a huge increase in investment and production, but a steady price level. His theory told him that a huge increase in production should have resulted in lower prices. It didn't so he called it an artificial boom which it turned out to be.

    The problem with investing using this theory is that you have to be able to ID the bubbles before they are big bubbles. Even if Austrian theory is correct, you could lose money by betting for or against the wrong assett class.

    I do put my money where my mouth is. If the fall of 2008, when silver dropped below $10 an ounce, I became a big silver investor. Yes I have made a lot of money recently, but silver will eventually crash. I am still long but watching closely.

    I am considering shorting U.S. Treasuries at thins point, but I am not quite there yet. I probably will in the future.

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  40. @ Prof J and Edward,

    Terms are not necessarily tricky. Words have meanings. (How very retrograde of me, I know.)

    An increase in the money supply is not the same as an increase in the general price level. Therefore they require different terms.

    The term "monetary inflation" connotes a connection between a rise in the money supply and a rise in the general price level. They are not the same thing. That is why we need different terms for them.

    If Austrians want to argue about the effect of monetary policy on financial conditions, I am 100% in favor of having that discussion. The Austrians might be right. But they can't make up their own vocabulary--which assumes connections not in evidence--and then expect the rest of us to accept it.

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  41. Chris,

    That's why I'm careful to say monetary inflation (or better yet: inflationary monetary disequilibrium) and price inflation.

    But take care: Austrians weren't the ones who changed the meaning of inflation. In classical economics, inflation meant increases in the money supply that then led to decreases in the purchasing power.

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  42. @ Prof J,

    My understanding is that the classical economists defined "inflation" as excessive money (currency) growth. The "excessive" part of the definition was ill-defined without reference to price levels. So--even 100-150 years ago--inflation referred to price levels to the extent that it was well defined.

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  43. @David

    I would still like to hear your thoughts on the Feds action 2007 to present. What do you think of the doubling of its balance sheet and QEII? Is there a realistic way to unwind the balance sheet. My feeling is no but I would love your thoughts.

    ReplyDelete
  44. Another good post David

    In this part;

    "The Fed creates fiat money (yes, out of thin air). But fiat money in itself does not constitute a promise against anything in particular (on the other hand, there are those who argue that it is a promise to discharge a tax obligation). In a gold standard regime, a Fed note would constitute a claim against gold. But we do not presently live in a gold standard regime. So what sort of promise underlies fiat money?

    Apart from any intrinsic value determined by its ability to discharge a tax obligation, the value of fiat money ultimately hinges on its scarcity. More precisely, it depends on how its supply is managed over time. Or even more accurately: it depends on the expectation of how its supply is to evolve over the indefinite future. This expectation hinges critically on the credibility of the money supply manager"


    You seem to be dismissing the Chartalist claims as just a theory about moneys value and then deem the monetarist view as virtually unassailable. You act as if money is just another commodity out there driven by scarcity. I would suggest that there is much more support for the Chartalist view through history. Not that the sole driver of a fiats value is taxation (not what Chartalists say but what many Chartalist critics seem to hear) but that assigning a tax and being able to collect it will immediately assign a value to a previously worthless piece of paper,
    in other words it gets the ball rolling. Certainly much more must occur within a currencies "area" than just simple tax collection in order for a currency to be sought by more and more people.

    ReplyDelete
  45. from Chris-the-regression-runner:

    "The distinction is that the Fed tried to keep unemployment below its natural rate during the 1970s, which led to accelerating inflation.

    Today, unemployment is almost surely about its natural rate and core inflation is below the Fed's 2 percent target. Hence, accomodative monetary policy is called for. By keeping short and long term interest rates temporarily low, the Fed changes marginal investment decisions and output and employment are higher than they would otherwise be."

    Sure, that's the stock Neo-Keynsian response.

    But the Neo-Keynsian model has nothing to say about financial crises, since there are no banks and no role for finance in that model.

    So, practically speaking, what is the "natural rate" after a financial crisis? Is it the same as the "natural rate" before a financial crisis? Or the "natural rate" after an oil-shock? Or what about the "natural rate" after the invention of the computer?

    How do we know that we just don't need time to reorganize activity after a large shock? And that no amount of printing money can expedite this organization.

    Prior to the financial crisis, economists inside the Fed were estimating the slope of the Phillips curve to be just about 0.

    The point is that if we (a) don't know the natural rate, whatever that is and (b) don't know the slope of the Phillips curve and (c) we tell the Fed to do something about unemployment that we have the possibility of creating a sustained rise in the price level with no other positive outcome.

    And I mention this because if inflation DOES happen again, and it might, the argument to shut the Fed down will be persuasive than it is currently.

    So, one alterative to this is to simply rewrite the Fed mandate so that it focuses on inflation.

    Morris Davis

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  46. zackchomsky@yahoo.comMarch 12, 2011 at 3:29 PM

    Any system that is based on debt-money, which is via the Fed conjured into existence solely through borrowing from a private entity, for which at any point there requires massive growth to sustain interest payments alone, is a system of control and doomed. Note the dangerous aspects

    - DEBT BASED. This is the elephant in the room, money should be backed by an asset not by debt. That is why a gold standard is solid because it returns sound money. While someone who works for the Fed would argue about "barbarous relics", it seems central banks are pretty interested in keeping some of those on hand (wink wink). It is ridiculous that in a single day the treasury issues 513% more debt than it receives in assets. Say your tax liability is $10,000USD to break even with debt issuance that $10,000USD tax liability would have to go up to $51,321USD.
    There is no reason to pay tax really with these types of deficits. It is just a reminder of who's boss. When in truth most of everything is debt and inflation. A perverse sequence of events had kept this going beyond the usual currency failure of the system, such as China hording treasuries so the US consumer would fund their development of a manufacturing state; oh and having that reserve currency status helps to... Of course, this is no longer sustainable, every elite knows this, Ponzi would be proud.



    - PRIVATE (responsible stewards, ha!) Who just expanded their balance sheets by trillions to suck out the private debt in a debt collapse and who will footed the bill? We don't need those old arguments "What if it was in the hand's of Congress" - um Congress has its own issue and of course uses debt to enable various forms of theft (bailouts), intervention, and capital misallocation.

    In 2008, while private hands wanted to wash away their hands of the toxic stuff, the Fed allayed them MOSTLY WITH NO OVERSIGHT BY CONGRESS - a few threats of Martial law by WallStreet banker Paulson and company and a bailout was passed. Trillions in garbage taken in for hotels, homes, credit card loans etc etc....

    The Fed is a barbarous relic, who has never ever ever achieved a sound currency. BY DESIGN. This is not to give a pass to the US govt which colludes with the bankers so it can fund its expansion and suffocation of the people.

    We all know where this is heading, currency collapse.

    Until - or rather when the event horizon returns for us to do so - we must return to sound money. Money as debt is just faith on faith. It is ponzi-nomics. All of this talk by David Andolfatto and his Fed colleagues is just like two savants swapping prime numbers, useless idle talk of academic savants.

    I dare Mr. Andolfatto to talk directly to the issues at hand (I haven't even begun to mention how the political system has been effectively taken over by bankers and corps to enable the looting and deregulation), and not hand wave or use a flippant tone ("its all out of thin air, stop it guys").

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  47. A few quick points to counter the propaganda in this article:

    Monetary expansion is a tax, as even Keynes admitted. Whether the government consumes what the market produces directly by paying for it with money conjured into existence "out of thin air", or whether it first expropriates money from it's citizens prior to consuming, matters only in terms of who is taxed and how. Real goods and services get consumed by a non-productive entity.

    Monetary expansion is a regressive levy, affecting the poor and middle class disproportionately, as they hold a larger share of non-interest bearing currency and demand deposits against their total net worth.

    The author tries to conflate the creation of debt with the monetization of debt, when clearly the former is secured by the backs of the taxpaying public, and the latter is again merely a tax by a quasi-private central bank. While congress is responsible for our massive debt, the Fed enables much of it through monetization.

    The intrinsic value of fiat money is literally the value of the paper it is printed on. It has extrinsic value due to legal tender laws, and the fact that it is coerced into circulation for the remittance of income and other forms of direct taxation.

    The gold standard failed to prevent the monetary expansion that led to the roaring twenties and the subsequent contraction that exacerbated the great depression. This is not evidence for the use of fiat or even fiduciary money, but rather evidence for the use of constitutional commodity money. When monetary expansion isn't limited by naturally scarce money or statuatory limits, human nature and the vast profits of seigniorage dictate that it will grow unabated, as a technically unlimited form of taxation.

    Government sponsored price indices are both cooked, so as to reduce entitement payouts, and wholly inadequate for measuring the inflation due to the absence of asset prices. Even in the absence of substantial CPI inflation, the perpetual Fed bond subsidy is a thinly veiled transfer of wealth to rich bond and stock holders.

    Lastly, you laud the Fed's takeover of bond markets as if it is somehow a noteworthy achievement. If I had the exclusive right to conjure money "out of thin air", I could crowd out other lenders too. The reasons for this are entirely uninteresting, as are most of the tired arguments formed from lies, half-truths, and blatant omissions that you have made.

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  48. I don't believe in Austrian BS. Mises, Rothbard, Hayek were all wrong and didn't understand how the real world works.
    However I do believe in America(despite living in its former enemy)
    Government/central bank intervention is needed for stability in the system.
    Central banks and banking system create employment and provide credit to small businesses that wouldn't be available in free markets. Consumer credit is necessary for higher standards of living that needed to prevent social unrest.
    Income inequality and unemployment were real causes of Great Depression not government intervention(and yes they were caused by free market)
    Now income inequality is as high as it was before Great Depression. However standards of living are also much higher. Therefore most people don't actually need redistribution of wealth they need stability.
    If Libertarians want to be taken seriously in 2012 they should stop promoting austrian voodoo economics and start to teach american working class to tolerate higher income inequality.
    However if you interested in discussion of pure free market system without central bank that can actually work in real world visit my forum http://freemarketfascism.org

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  49. Tippit: I do not remove posts. This blog site occasionally traps posts in a spam file. I have to check that file every once in a while to release the trapped posts. I am not sure why this happens.

    But I have to say, with a comment like this:

    Lastly, you laud the Fed's takeover of bond markets as if it is somehow a noteworthy achievement. If I had the exclusive right to conjure money "out of thin air", I could crowd out other lenders too. The reasons for this are entirely uninteresting, as are most of the tired arguments formed from lies, half-truths, and blatant omissions that you have made.

    I could have removed it without loss to the accumulated stock of human wisdom.

    My claim is that when politicians use the phrase Out of thin air! with exclamation, they are promoting fear and misunderstanding for political gain; not for the purpose of promoting reasoned debate. I'm not sure what you post has to do with this observation.

    And if you are going to accuse me of lying, please point to the offending passage. You seem to like making claims without supporting evidence.

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  50. one thing that is missing from this post is the idea that is not well understand -- a flexible supply of money has the potential to create more stable prices than a fixed supply of money.

    In "bad times", people want to shift from risky to less risky assets. People try to sell stocks in exchange for bonds and currency. If the quantity of stocks, bonds, and currency are fixed, the outcome is that the stock prices fall, and bond and currency prices rise. (Not unlike the current financial crisis!) When the price of currency rises, this is "deflation".

    In "good times", when people want more risk in their portfolio, they try to buy stocks and reduce their holdings of bonds and currency. If the quantity of stocks, bonds, and currency are fixed, the outcome is that the stock prices rise, and bond and currency prices fall. When the price of currency falls, this in inflation.

    So, to keep prices stable, the Fed should increase the quantity of money (relative to trend nominal GDP) during financial crises and reduce the quantity of money (relative to trend nominal GDP) during booms.

    (The big question is the "exit strategy" -- does the Fed have what it takes to remove money as the economy recovers, or will we have inflation?)

    If money was backed by gold, we wouldn't be able to keep the dollar stable like this.

    Morris Davis

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  51. Morris: "Sure, that's the stock Neo-Keynsian response."

    Chris: That's the stock response from a wide variety of models with market frictions.

    Morris: "But the Neo-Keynsian model has nothing to say about financial crises, since there are no banks and no role for finance in that model."

    Chris: Go read Bernanke and Gertler (1995).

    Morris: "How do we know that we just don't need time to reorganize activity after a large shock? And that no amount of printing money can expedite this organization."

    Chris: Very likely that the economy would eventually "reorganize." M policy might not "expedite" this process but it might raise welfare anyway. In any case, the Fed's congressional mandate doesn't say that it has the luxury to wait.

    Morris: "Prior to the financial crisis, economists inside the Fed were estimating the slope of the Phillips curve to be just about 0."

    Chris: Who? Where? Short-run? Long-run? Why should we believe one estimate?

    Chris: Are they saying that M policy cannot affect real activity? That would be a very strong claim.

    Morris: "The point is that if we (a) don't know the natural rate, whatever that is and (b) don't know the slope of the Phillips curve and (c) we tell the Fed to do something about unemployment that we have the possibility of creating a sustained rise in the price level with no other positive outcome."

    Chris: (a) We have some uncertainty. It is not infinite. A natural rate of 7% is more likely than a natural rate of 98%.
    (b) Expansionary M policy probably increases Y and employment over what it would have been. (Call me crazy.)
    (c) Possible but very unlikely that all M policy expansion translates directly to price increases with no other effects.


    Morris: "And I mention this because if inflation DOES happen again, and it might, the argument to shut the Fed down will be persuasive than it is currently."

    Chris: Neither would be good for the country.

    Morris: "So, one alterative to this is to simply rewrite the Fed mandate so that it focuses on inflation."

    Chris: Write your congressman. No one here can change the mandate.

    Chris: Even if the Fed had a single mandate, it would still have been very accomodative over the past 3 years.

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  52. Dave,

    Why was Wilt Chamberlain in Germany? Did he play a little euro-ball before the NBA?

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  53. Morris: "Sure, that's the stock Neo-Keynsian response."

    Chris: That's the stock response from a wide variety of models with market frictions.

    Morris: "But the Neo-Keynsian model has nothing to say about financial crises, since there are no banks and no role for finance in that model."

    Chris: Go read Bernanke and Gertler (1995).

    Morris: "How do we know that we just don't need time to reorganize activity after a large shock? And that no amount of printing money can expedite this organization."

    Chris: Very likely that the economy would eventually "reorganize." M policy might not "expedite" this process but it might raise welfare anyway. In any case, the Fed's congressional mandate doesn't say that it has the luxury to wait.

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  54. Morris: "Prior to the financial crisis, economists inside the Fed were estimating the slope of the Phillips curve to be just about 0."

    Chris: Who? Where? Short-run? Long-run? Why should we believe their estimates?

    Chris: Are they saying that M policy cannot affect real activity? That would be a very strong claim.

    Morris: "The point is that if we (a) don't know the natural rate, whatever that is and (b) don't know the slope of the Phillips curve and (c) we tell the Fed to do something about unemployment that we have the possibility of creating a sustained rise in the price level with no other positive outcome."

    Chris: (a) We have some uncertainty. It is not infinite. A natural rate of 7% is more likely than a natural rate of 98%.
    (b) Expansionary M policy probably increases Y and employment over what it would have been. (Call me crazy.)
    (c) Possible but very unlikely that all M policy expansion translates directly to price increases with no other effects.


    Morris: "And I mention this because if inflation DOES happen again, and it might, the argument to shut the Fed down will be persuasive than it is currently."

    Chris: Neither would be good for the country.

    Morris: "So, one alterative to this is to simply rewrite the Fed mandate so that it focuses on inflation."

    Chris: Write your congressman. No one here can change the mandate.

    Chris: Even if the Fed had a single mandate, it would still have been very accomodative over the past 3 years.

    Chris: None of my responses are intended to be rude. Please read them in the friendly tone that I intended.

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  55. "Chris: None of my responses are intended to be rude. Please read them in the friendly tone that I intended."

    No problem. I like a good debate.
    Morris Davis

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  56. Claiming that fiat money has intrinsic value, because of the fact that it can satisfy tax obligations is a half-truth.

    Claiming that the real issue isn't the ability of the Fed to levy the inflation tax by monetary expansion, but rather whether it hits it's "inflation target" as measured by some bogus government index is a lie.

    Claiming more or less that the US constitution is irrelevant because it has been ignored, and because it is "venerable" is a lie.

    As far as the value of my post as it relates to the stock of human wisdom, one could say the same about your blog.

    Do you have any rebuttal to my claims, specifically the fact that inflation is a tax, and that it is regressive?

    When politicians use the term "out of thin air" as it refers to the ability to conjure money into existence, they are referring to the practice of taxation by inflation, the exchange of nothing for something. What illegal counterfeiters do, the Fed has institutionalized, and yet you would attempt to misdirect us away from this fact.

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  57. Tippit:

    Your contributions on other posts of mine have, for the most part, been constructive. Not sure why you seem so angry here (pop open a can of beer, man...relax a bit before typing).

    I am not sure what you intend to gain by calling me a liar. If I am mistaken on point, please correct me with supporting evidence. Otherwise, save your breath.

    I responded to your inflation tax question in an earlier post (Money and Inflation).

    To the extent that people value hard-to-counterfeit small denomination paper notes, the government is not offering "something for nothing." They are supplying an exchange medium that people value.

    I am sure that you will now construe this last statement as my unqualified support for the Fed, for central banks, for powerful central governments, and the end of freedom as we know it. Or perhaps you'll have a sip of beer and think through things more calmly. Up to you.

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  58. http://www.cnbc.com/id/42130406
    US Cost of Living Hits Record Passing Pre-Crisis High

    By John Melloy
    Executive Producer Fast Money
    Published: Thursday, 17 Mar 2011 4:09 PM ET

    One would think that after the worst financial crisis since the Great Depression, Americans could at least catch a break for a while with deflationary forces keeping the cost of living relatively low. That’s not the case.

    A special index created by the Labor Department to measure the actual cost of living for Americans hit a record high in February, according to data released Thursday, surpassing the old high in July 2008. The Chained Consumer Price Index, released along with the more widely-watched CPI, increased 0.5 percent to 127.4, from 126.8 in January. In July 2008, just as the housing crisis was tightening its grip, the Chained Consumer Price Index hit its previous record of 126.9.

    “The Federal Reserve continues to focus on the rate of change in inflation,” said Peter Bookvar, equity strategist at Miller Tabak. “Sure, it’s moving at a slower pace, but the absolute cost of living is now back at a record high in a country that has seven million less jobs.”

    The regular CPI, which has already been at a record for a while, increased 0.5 percent, the fastest pace in 1-1/2 years. However, the Fed’s preferred measure, CPI excluding food and energy, increased by just 0.2 percent.

    “This speaks to the need for the Fed to include food and energy when they look at inflation rather than regard them as transient costs,” said Stephen Weiss of Short Hills Capital.
    “Perhaps the best way to look at this is to calculate a moving average over a certain period of time in order to smooth out the peaks and valleys.”
    [remainder snipped]

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  59. Jesus Christ. I used to be a hardcore Ron Paul type Austrian libertarian. The responses to your past few posts have been absolutely embarrassing. Too many damn kooks.

    From what I can tell from following your blog you would fit into the "right wing camp" if there was a "right wing camp". And not just any "right wing camp" either. Mankiw and Taylor are in that camp but they're also Keynesians. But you aren't. You've spoken favorably about the more purist RBC stuff in the past and spend a considerable amount of time arguing against Keynesians.

    Serious, respectable economics that is an alternative to Keynesianism comes from places like Minnesota and Chicago. It's not this anachronistic wacky Austrian garbage. It was cool 70 years go. Now it just looks like a collection of quasi-white nationalists and tinfoil hat militia types that can't do math.

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  60. Anonymous: Well, what can I say? Try not to let the rantings of a few kooks put you off studying the great econ writers of the past; be they Austrian, Keynesian, Monetarist, or whatever. In truth, I do not like any of these labels. The only labels I find useful are "good science" and "bad science." And we can find examples of each in all schools of thought.

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  61. Yeah, fair enough. I got carried away there.

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  62. Anonymous: Don't worry...I know the feeling!

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  63. David,

    Nice blog here. I made my way over via EPJ when Wenzel posted a link.

    Now, I'm an anarchist because of what I consider philisophical and moral reasons making government illegitimate, and have moved into reading about anarcho-capitalism and economics in general. I've never taken an econ class, outside of CLEP testing out of intro to micro/macro. That said, the Austrian ideas on the fed speak to me, and here's why.

    The fed's management of the interest rate, whether directly or indirectly as described above, changes the way people place their money into the market. By keeping rates artificially low (by artificial I mean lower than they would be set without their intervention) it forces people to take on increasingly higher forms of risk to make a decent return.

    A saver that wants little to no risk, he only wants to keep what he has earned automatically loses due to the 2% "wanted" inflation(out of thin air ;))

    An investor that wants to take some risk but with a smallish return will have to push further than he otherwise would've to find an edge, increasing his risk.

    A person seeking a high return on a very risky investment would be even more likely to find the hairy edge of risk to search for their rate of return.

    All of these are malinvestments. None of them would've done what they did if not for the Fed's intervention into the marketplace. Once the Fed tries to flatten everything back out these people had better have gotten out of their positions of risk, otherwise they will fail. This is the bust.

    I realize that being a lay person this all comes across as very simple, but isn't that the beauty of it? This is probably why the Austrian models are gaining in popularity. It's also pretty sound deductive logic. Can you point me to something that is on my sort of level that refutes this, outside of telling me to go to college? :). That has to be the worst investment any of us can make right now...

    In general, I only want to live my life free of outside forces hampering my standard of living. The fed allows for inflation year after year, harming my yearly raise by at least half, and 1 to 1, at least, now that the economy is crap. I dislike that the banks have all these excess reserves that they just park and collect interst from the Fed. That's probably envy, but in reality their "management" does directly affect everyone of us.

    Thanks in advance.

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  64. Kyle,

    You're missing the point that inflation cannot be set independently of the nominal interest rate, at least not over long periods of time. Thus, your 2% inflation means a 2% premium over the real return, so nobody is "losing" anything unless, as David puts it, you save by hiding money in your mattress (in which case could you let me know where you live and the times you generally aren't home). There are costs of expected inflation (shoe leather type stuff, perhaps some price dispersion effects), but they aren't what you're talking about and aren't what Austrians yap on about either.

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  65. Kyle, there is no such thing as "by artificial I mean lower than they would be set without their intervention." Central banks all over the world "set interest rates" by varying the amount of money versus short-term government bonds in the hands of the public.

    Both money and government bonds are government liabilities but they have different liquidity/return characteristics. Central banks simply make a portfolio decision on behalf of the government. Therefore there is no "without intervention". Governments have to choose how much of different kinds of liabilities to issue. Even if the government fixes the money supply forever, that is still a decision they must ratify each period.

    Savers are getting low returns right now because a big player in the market -- the govt's agent, the central bank -- chooses to issue a lot of liquid liabilities and purchase illiquid assets with higher returns. At other times, savers will get higher returns when the central bank chooses the opposite strategy.

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  66. Two more quick points, Kyle.

    1) Your wage is set in real terms. If you negotiate with your employer for a 3% raise at a time when inflation is 2%, then you and your employer have agreed on a 1% real raise. If inflation were 0%, your employer would only be willing to offer you a 1% real raise. (I know that there are lots of folks who won't believe that, but there are mountains of evidence that it is true.)

    2) The reserves that the Banks have parked at the Fed are the result of the Fed purchasing illiquid but higher yielding assets from private agents. You can think of it as a trade. The Banks get liquid assets with low returns, the Fed gets illiquid assets with higher returns. The Banks still desire to hold excess reserves that pay very low rates of interest because they are still fearful.

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  67. Anonymous said...
    "Kyle,

    You're missing the point that inflation cannot be set independently of the nominal interest rate, at least not over long periods of time. Thus, your 2% inflation means a 2% premium over the real return, so nobody is "losing" anything unless, as David puts it, you save by hiding money in your mattress (in which case could you let me know where you live and the times you generally aren't home). There are costs of expected inflation (shoe leather type stuff, perhaps some price dispersion effects), but they aren't what you're talking about and aren't what Austrians yap on about either. "

    The above is a lie. When the Fed conjures money into existence, be it paper or electronic bits, it reaps the profits of seigniorage, just as I would if I counterfeited notes in my basement. Whether CPI moves or not is irrelevant, as factors of production can serve to offset the monetary expansion. This is a regressive tax. The losers are anyone who holds money in any form for any period. The fact that creditors are compensated for this by offering credit at higher interest rates means only that this is passed on to the borrower.

    An analogy would be a burgler who robs an insured home. If the burglar gets away scot free, he profits by the value of goods he stole. The homeowner is insured, so he receives a claim hopefully in the amount corresponding to the value of what was stolen. Presumably everyone is happy here, but what really happened? The burglar received value for which he exchanged nothing, and the home owner was made whole, so who lost? Every insured homeowner did, because the social cost of burglary is reflected in higher insurance premiums for everyone. The costs of monetary inflation are similarly insidious.

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  68. Thanks for the replies. A few questions:

    anon: why shouldn't a saver get to keep full value of his money in his mattress? Or his safe deadbolted to his basement floor? His purchasing power would go up due to industrial advancements and goods becoming cheaper as the methods to produce them get better. Because of inflation, he is nudged into rushing it out into whatever is available to buy today istead of saving for future returns.

    Masked:
    Let's assume that I work in a place that places a cap on raises (I do. used to be 4% now it's 2.5% for merit raises) the amount I'm getting raised year over year varies drastically depending upon inflation, does it not? I also do not get to enjoy the fruits of deflation since the Fed aims to purposefully inflate by 2%, or whatever, yearly. This is a major drag. Why don't you point me to a molehill of those mountains of data? :)

    Also how were interest rates decided throughout history when there was no central bank? Just because there is no "without intervention" currently surely does not mean it is impossible.

    Thanks.

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  69. "Let's assume that I work in a place that places a cap on raises .. the amount I'm getting...varies drastically depending upon inflation, does it not?"

    No, cause the cap depends on inflation. If inflation was running at 50% or -20% the cap would not be 4%.

    "I also do not get to enjoy the fruits of deflation since the Fed aims to purposefully inflate by 2%, or whatever, yearly. This is a major drag."

    No free lunch: Your wage would also go down with the price level.

    If that did work, we would have a money machine and we'd all be in favor of maximal deflation (-99.9999) all the time.

    The reason that the Fed chooses 2% inflation rather than 0% inflation is so it can set the real interest rate (nominal rate less inflation) negative when the economy is in recession, like now.

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  70. "Why don't you point me to a molehill of those mountains of data? :)"

    This is actually a very good question. Economists tend to take long-run neutrality of money as given because there is so much evidence for it.

    The easiest way to show it would be for me to scatterplot average inflation rates vs. average long-term bond rates (or average nominal income increases) across countries. Then you could clearly see the positive relation. Unfortunately, I can't do that on this comment. I suggest that you go to the library and borrow Mankiw's macro textbook. I don't have a copy handy but I bet that he will have some evidence on long-run monetary neutrality.

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  71. "Also how were interest rates decided throughout history when there was no central bank? Just because there is no "without intervention" currently surely does not mean it is impossible."

    Another excellent question. For much of history, countries tended to operate gold or silver standards. This essentially meant that the money supply changed close to randomly, depending on gold discovery and world demand. (For the economists out there, I mean it was a strongly persistent but probably mean-reverting process.)

    For people who think that a gold or silver standard would free us from the vagaries of central bankers, I'd point out that there was modest inflation and deflation under metallic standards, some times for decades at a time. But it was ultimately close to random.

    And countries broke their pledges to stick by the metallic standard when it suited them to do so. (See the United States in 1933.)

    There were bubbles and financial panics under metallic standards, even without an evil central bank. But there was no central bank to provide extra liquidity during times of stress.

    This system did set a term structure of interest rates, of course, and interest rates did tend to vary with the business cycle. Government (and other) borrowing also did affect the term structure, so it wasn't free from "interference" even then.

    Of course, all major developed countries have had central banks or something similar (i.e., a currency board) for many decades, so we don't know how a modern financial system would work without one. I'd prefer not to live in the guinea pig.

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  72. "No free lunch: Your wage would also go down with the price level."

    I'm talking about price deflation due to products becoming cheaper to make. Such as denim jeans becoming cheaper due to a new process of staining, or whatever, and the producer then passing that saving along to the consumer in the form of cheaper prices. With inflation, the best thing that can happen is that it stays neutral or thereabout, harming the saver.

    I will look into Mankiw (I've seen mention of him before but as I'm a n00b I've yet to read anything). Thanks.

    "The reason that the Fed chooses 2% inflation rather than 0% inflation is so it can set the real interest rate (nominal rate less inflation) negative when the economy is in recession, like now."

    Ever think the bust is because the previous 5 or 10 years of 2% inflation induced malinvestment is coming home to roost? Pushing the interest rate negative just makes it worse, reinflating the bubble and ensuring a larger collapse later down the road. It will lead to either sovereign default or destruction of the dollar.

    "This is actually a very good question. Economists tend to take long-run neutrality of money as given because there is so much evidence for it."

    Money is not neutral because the people who get the money first don't suffer from the inflation.
    I realize that's why you say long-run, but that still doesn't help those who aren't in the power position of gaining the inflationary funds first.

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  73. Also if money is truly neutral, why inflate at all?

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  74. "With inflation, the best thing that can happen is that it stays neutral or thereabout, harming the saver."

    No, you still benefit equally from productivity improvements with or without a small amount of inflation. If a given rate of money growth would produce a 3% inflation rate under 0% productivity growth, it would produce a 2% inflation rate under 1% productivity growth and your nominal wage would reflect inflation + productivity growth.

    There is an equation, called the Quantity equation, that says essentially that

    money growth + velocity of money growth = inflation + real output growth.

    So, if we hold velocity constant, then money growth determines nominal output growth = inflation + real output growth.

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  75. "Ever think the bust is because the previous 5 or 10 years of 2% inflation induced malinvestment is coming home to roost?"

    No. I've no idea why 2% inflation would induce significant malinvestment. There have been loads of countries with 2% (or so) inflation over long periods, including the US for most of the postwar era.

    Reasonable (and some unreasonable) people do make the argument that Fed policy was too easy over the past few years. I won't comment on that. That is a complex issue.

    "Pushing the interest rate negative just makes it worse, reinflating the bubble and ensuring a larger collapse later down the road. It will lead to either sovereign default or destruction of the dollar."

    Monetary policy does not drive or enable fiscal policy. If a country spends too much or taxes too little and defaults, that is a political issue for the elected representatives. Write your congressman. Not a problem that monetary policy can fix.

    I am not too worried about destruction of the dollar.

    "Money is not neutral because the people who get the money first don't suffer from the inflation."

    That is the most repeated fallacy of the whole discussion. When the Fed buys bonds to increase the money stock, it buys them at a competitive, market price that have an expectation of inflation built into the prices. When the bond sellers get money for the bonds, it is depreciating in real terms at the same rate as any other money in the economy. (You could sell bonds and get money at the same price in the market.)

    The only way to make sense of this idea is to note that unexpectedly high inflation benefits bond sellers (borrowers) and hurts lenders. On the other hand, unexpectedly low inflation benefits bond buyers (lenders) and hurts borrowers.

    A low (possibly zero) and predictable rate of inflation is best.

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  76. "Also if money is truly neutral, why inflate at all?"

    Money is neutral in the long run. In the long run.

    In the short run, central banks can affect real interest rates which affects real consumption, savings and investment decisions.

    Ideally, by varying interest rates in line with economic conditions, central banks can use monetary policy to smooth out a business cycle that is at least partially caused by nominal rigidities--situations in which money is not neutral in the short run.

    There are certainly reasonable people who question various aspects of this line of argument.

    But there are also some unreasonable criticisms based on a misunderstanding of basic monetary economics.

    I wish you luck in your studies and career.

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  77. "Also if money is truly neutral, why inflate at all?"

    Money is neutral in the long run. In the long run.

    Money can affect real activity in the short run. The Fed has considered 2% measured inflation more desirable than 0% measured inflation for two reasons:

    1) The measured inflation rate probably modestly -- by perhaps 1/2 % -- overstates the true inflation rate because it doesn't completely take into account improvements in products.

    2) With an inflation rate of 2%, the Fed can get the real interest rate (nominal rate less inflation) negative, rather than just zero. This allows the Fed to stimulate the economy more during recessions, like now.

    There are reasonable and knowledgable people who would prefer a 0% measured rate of inflation. But this has been a minority opinion so far.

    Good luck to you, Kyle.

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  78. Someone not named tippitMarch 21, 2011 at 1:17 AM

    My comments aren't being posted again...

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  79. I think the blog man has been put on a leash by his employer and is no longer allowed to post on his blog...

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  80. Cosmo: Ha ha. (Oh, and can I have your autograph?)

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  81. I have never understood why anyone considers economics to be a science.

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  82. Anon: Who cares what label we attach to methods employed by those who study human interaction? Social scientists endeavor to achieve best possible practices. It is a tricky business. But those best practices would still remain best regardless of what we choose to call them (science, art, or whatever).

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  83. Yet the Fed’s mantra seems to be “don’t worry, be happy.” Said Fed chief Ben Bernanke recently, “the most likely outcome is that the recent rise in commodity prices will lead to, at most, a temporary and relatively modest increase in U.S. consumer price inflation.”

    But any increase in prices is bad news for those whose incomes are not rising commensurately — meaning most of us. Once they are up, prices rarely come down. As I pointed out in my column of Jan. 18, during the past decade the dollar has lost 20% of its buying power; since 1990 the overall loss is nearly 30%!

    Central bankers would be aware of this if they shopped regularly like the rest of us, instead of sitting in their ivory towers looking at their iPads.

    http://www.marketwatch.com/story/feds-love-affair-with-easy-money-must-end-2011-03-22?link=home_carousel

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  84. Anon (Irwin):

    One would not expect a Fed Chairman to scream "we are all doomed!"

    Your statement that any increase in prices is bad news for those whose incomes do not rise in proportion is true, but suggests that the Fed is responsible for this. The "problem" is the increase in *relative* prices. The Fed has no control over global forces that increasing the relative price of food and energy.

    I read your column and disagree with you about what the TIPS spreads are saying. See my post here: http://andolfatto.blogspot.com/2011/03/us-inflation-and-inflation-expectations.html

    I am not sure what the purpose of your concluding sentence is. I assure you that I shop and watch my pennies like everyone else.

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  85. http://www.cnbc.com/id/42209447

    US Approaching Insolvency

    Fisher: "If we continue down on the path on which the fiscal authorities put us, we will become insolvent, the question is when," Dallas Federal Reserve Bank President Richard Fisher said in a question and answer session after delivering a speech at the University of Frankfurt.

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  86. Just give me the power to create the "fiat tokens" and I will have no problem with that system.

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  87. Anon: I'm sure you consider that statement a profound contribution to the debate. (Btw, you are free to issue all the worthless promises you want).

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  88. @ Anonymous (March 22, 2011 12:01 PM)

    The notion that the US Federal government, the sovereign monopoly supplier of a managed non-convertible, free-floating (flexible) currency, faces some sort of insolvency risk like a household or nation that uses ANOTHER'S currency is laughable. (And nothing but a political statement to appease/support austerity proponents.) That a senior FRB official states as much in public is deeply troubling. The government spends by crediting reserve accounts at the Fed and destroys money by debiting reserve accounts at the Fed. It neither has nor doesn't have money. It's the ISSUER of the currency, the scorekeeper. How could it possibly run out of units of currency aside from a voluntary self-limit? That's like saying the scorekeeper can run out of points or the alchemist can run out of gold. Pure nonsense.

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  89. "US Approaching Insolvency

    Fisher: 'If we continue down on the path on which the fiscal authorities put us, we will become insolvent, the question is when,' Dallas Federal Reserve Bank President Richard Fisher said in a question and answer session after delivering a speech at the University of Frankfurt."

    The notion that the sovereign monopoly issuer of a managed non-convertible, free-floating fiat currency faces any solvency risk is highly laughable. Does Fisher believe the US federal government is operationally constrained like a household, state, or currency union member? Come on! It is scary and pathetic that a senior Fed official would publicly state such bullsh*t. A purely politically-based comment peddling to austerity proponents and deficit errorists. Mid-level Fed officials tend to understand monetary operations pretty well, but it would be good if we could get senior Fed officials (including the political appointees) who realized we're not on a gold standard anymore!

    http://moslereconomics.com/2011/03/24/us-approaching-insolvency-fix-to-be-painful-fisher/

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  90. I knew the central bankers have a long history of funding both sides of a war, but the just released news that the Fed was lending billions to Gadaffi is still a bit of a surprise to many.

    Now we know one reason the Fed didn't want to disclose the documents.

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  91. The academics like to pretend that self interest of the power structure and the top guys never plays a part in fed decision making. As if it were all totally objective and the result of peer reviewed scientific research...well I'd sure like to know what formula made you guys decide to support Gaddafi?

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  92. Gabe: Evidently, you like to pretend you know what you are talking about. I would recommend that you stop and think before your next post. They are becoming increasingly silly.

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  93. Dollars are not valued because they they are scarce, per se. They are valued because they are created in tandem with a promise from a bank -- a promise to exchange newly created dollars for the collateral interest of the loan.

    The bank simultaneously creates new paper and agrees to exchange it for a car or home in the future.

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  94. The Fed likes to exaggerate its power (which of course feeds into anti-Fed paranoia). Inflation is ultimately under the control of Congress. The Fed is in the business of tactical fine tuning. It can act faster than Congress.

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  96. So, please, enough of this "out of thin air!" stuff. It's tiresome for those who know better, and distracting for those who do not. Let's divert attention to more substantive issues. buy from china

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