Thursday, January 31, 2013 - Friedman, Von Mises, Adam Smith, and Inflation

Friedman, Von Mises, Adam Smith, and Inflation

by Sinclair Noe

DOW – 49 = 13,860
SPX – 3 = 1498
NAS – 0.18 = 3142
10 YR YLD - .02 = 1.99%
OIL - .49 = 97.45
GOLD – 12.90 = 1664.50
SILV - .56 = 31.56

Let's cover some of the economic news and then I'll try to tackle one of the most pressing questions of our time.

The Commerce Department reports personal incomes rose a seasonally adjusted 2.6% in December, the fastest pace in eight year. Sounds good, but the numbers are a bit of a fluke. Personal dividend income jumped 34.3% in December, pushed forward by concerns about the fiscal cliff. That is income that won't be paid out on a regular schedule, so the big increase will be matched by a later decrease in dividend income. Excluding the dividends and other distortions, personal income rose 0.4% in December. Wages and salaries rose 0.6% in December after a 0.8% gain in November and were up 5.4% year-on-year.

Consumer spending rose 0.2% in December, in line with expectations. With incomes running faster than spending, the personal savings rate rose to 6.5% of disposable income from 4.1% in November. It was the highest savings rate since May 2009.

Initial jobless claims jumped 38,000 to a seasonally adjusted 368,000 in the week ended Jan. 26. A separate survey this week produced by the payroll processor ADP said the U.S. gained 192,000 private-sector jobs in January, the highest in nearly a year. The ADP report is not an accurate indicator for the official government jobs report which will be released tomorrow morning, but it was enough to inch estimates up to 170,000 jobs added in January, with the unemployment rate possibly dipping to 7.7%. We'll wait and see.

We end the month of January with a go-go stock market. The Dow Industrials gained 5.8% for the month, the best January performance since 1994. The S&P 500 index posted a monthly gain of 5.1%. There is an old saying: as January goes, so goes the year. And when we see 5%+ January gains in the market, it usually does relate to a strong year, in the neighborhood of 20%. Dial back the exuberance just a smidgen. We're right up against old record highs and that will probably prove strong resistance. Don't forget fourth quarter GDP was negative, etc., etc.

Anyway, that brings us to today's question: Where is the inflation? Not exactly, the most pressing question of out time, but a good question nonetheless, a question that seems to leave many baffled. The central bankers are printing money at an unprecedented pace, and not just the Fed; it's a global race, and despite targets, there really is no exit plan in sight. All that money floating around should result in inflation, maybe skyrocketing inflation, maybe hyper-inflation. Toss in massive government deficits and we'll need wheelbarrows of cash to buy a loaf of bread. But it hasn't happened. Where's the inflation?

About 2%.

The relationship between money and prices is usually explained by the quantity theory of money, which tries to explain the relation between price inflation and money supply growth. So, when a country like Zimbabwe started printing more and more money, the result was hyperinflation. The basic equation is M*V = P*Y; this is the central equation in Milton Friedman's monetary policy; there are many variations on the equation.

Here's how it works: M is the money supply, times the velocity of money, and that should equal the price level, P, times output – or the GDP. So, you have a pile of money that is circulated at a fast or slow rate and that equals the price level times the output – what gets made with all that money.

The money supply has been increasing by almost 7.5% per year for the past 5 years, and more recently it has increased somewhere between 8.2% and 13.1% depending upon your preferred measure. Compare that to the other side of the equation, GDP, which has been growing around 2%, and went negative in the fourth quarter. The two sides of the equation don't match. In fact we would need to see inflation around 6% to 12% for the formula to work.

Where's the inflation?

Well, Friedman apologists would say that prices are sticky; it takes time to move prices. Well, it's been five years of the Fed printing money with reckless abandon. The other excuse is that the velocity of money has slowed down. Which it did for a while, but it has picked up again. Velocity just means that the same dollar gets spent many times in a period of time, usually over the course of a year. Of course, now we spend more digital money than paper cash, so that debit card transaction is moving around at light speed. The check is no longer “in the mail”, it's already made the trip on fiber optics.

But then there is a big chunk of money, around $1.6 trillion that the big banks are holding in reserve with the Federal Reserve. That money is parked. It doesn't move at all. The central bankers have effectively killed Friedman's monetary theory. And the inflationistas say that if, or when the banks start lending the trillion dollars in reserves the inflation will hit the fan, big time. Of course, this assumes the $1 trillion just comes gushing out, like floodwaters over a broken levee. I think it would be a bit more nuanced.

Another theory comes from the Austrian school of economists, like Ludwig von Mises, and they will tell you that ultra-low interest rates will create an orgy of speculation, in which markets create a huge volume of "malinvestment" - investment that should not economically have been made, and which has less value than its cost. I'll explain the flaw in just a moment, but let's carry the malinvestment idea out to its logical conclusion first.

Eventually, like it did in 1929, the volume of malinvestment becomes so great that a crash occurs, in which all the bad investments have to be written off, huge losses are taken and a wave of bankruptcies sweeps across the economy.

This didn't happen in Japan. The banks went on lending to bad companies, the Japanese economy stagnated and has been stuck for 20 years. In Japan, the politicians have decided to print more money and do still more deficit spending. Japan has debt of 230% of GDP and so it might become difficult to sell more debt. And if the Japanese can't sell their bonds, that would cause the Japanese government to default and will more or less shut down the Japanese economy - the penultimate worst possible outcome. Liquidation wouldn't be confined to Japan, it could encourage the same behavior here, in which case growth will continue at current sluggish rates until the Federal deficit becomes so great that nobody will buy US Treasuries.

Now, here's the flaw with the malinvestment idea; ultra-low rates do not create an orgy of speculation in which markets create a huge volume of malinvestment. Just the opposite; high interest rates lead to malinvestment. Adam Smith, the father of modern economics, wrote in the Wealth of Nations: that if the legal rate of interest was “fixed so high as eight or ten percent, the greater part of the money which was lent would be lent to prodigals and projectors ( the promoters of fraudulent schemes), who alone would be willing to give this high interest... A great part of the capital of the country would thus be kept out of the hands which were most likely to make a profitable and advantageous use of it, and thrown into those which were most likely to waste and destroy it. When the legal rate of interest, on the contrary is fixed but a very little above the lowest market rate, sober people are universally preferred as borrowers, to prodigals and projectors. The person who lends money gets nearly as much interest from the former as he dares to take from the latter, and his money is much safer in the hands of the one set of people than in those of the other. A great part of the capital of the country is thus thrown in the hands in which it is most likely to be employed with advantage.”

And we are seeing the wisdom of Adam Smith today. The higher interest rate environment of 8 years ago led to an orgy of speculation; today, rates are lower but it is tougher to get a loan. And when loans are made today, it should result in greater output, thus counter-balancing prices. It almost looks like Bernanke has created a new monetary ground where he can rapidly increase the money supply without getting inflation. Almost, but not quite.

There is still malinvestment. Closer reading reveals that Adam Smith might have been talking about the derivatives market. Today, the orgy of speculation exists in the OTC derivatives market, largely unregulated and ten times bigger than the global GDP, and it is out of control. Until Bernanke and the other central bankers can rein in the derivatives markets, it will remain the heart of malinvestment; sucking capital out of productive hands; and if the derivatives market collapses, it has the potential to drag down the credit and debt markets in a flash.

At that point, you're likely to get more inflation than you want.