Inflation vs. Hyperinflation
April 16, 2008
I've often said that I doubt we're in for a Weimar- or Zimbabwe-style hyperinflation, or even an Argentina 1989-style inflation with price inflation hitting 2000% to 3000%. However, I may have to eat those words. The Wall Street Journal, among others, is floating trial balloons urging that we "print money directly" to "monetize the banks" and reliquify the economy:
The Inflation Solution to the Housing Mess
I never in my wildest dreams thought I'd see this, but there it is. There's a twisted little voice in my head that whispers that these op-eds are appearing to get people used to the idea that printing money will be a better solution than facing the pain of allowing asset markets to normalize. The only people to benefit by this irresponsibility will be the bankers and brokers who have the huge mortgage-based liabilities, so you can draw your own conclusion as to what's behind this article.
The great majority of readers will see right through this reprobate, but just in case:
My opinion of Mr. Makin, based on this article, is that he's a contemptible fool. The only thing I can say in his favor is that he probably does not understand the harm caused to consumers and wage earners through inflation. And that lack of understanding disqualifies him from writing editiorials, especially in the Wall Street Journal.
Here are just a few problems with Makin's proposal: First of all, the "Inflation Solution" is not a solution at all. It merely shifts the damage from one sector to others, from those responsible to the masses.
"Yes, use reflation to soften the pain for Main Street and Wall Street", says Makin. Reflation will merely ease Wall Street's pain by transferring it to Main Street. The Fed's deliberate inflation policy is the reason diesel fuel is over $4/gal. Main Street never created a single credit derivative, and no Wall Street bankers have been forced to relinquish the huge bonuses they paid themselves for engineering fraudulent "profits" that have since evaporated.
He says, "If we let house prices fall another 25% to 35%, it's almost certain Washington will end up nationalizing the mortgage business."
In fact, the median house price needs to fall until it's affordable for the median wage earner, unless Makin is prepared to have Washington print money to give to homebuyers. Which is essentially what he's proposing. His inflation solution allows home prices to stay flat in nominal terms, while falling in real terms because the dollars they're priced in are becoming much less valuable. Once again, savers and investors are punished while spenders and borrowers are rewarded.
He doesn't even know what he's talking about when he says Fed auctions have added insufficient liquidity to bank reserves. He argues that fed credit injections have been "sterilized" by the Fed's selling of treasury securities. Makin says, "The Fed has been selling these securities to keep the fed funds rate at the level targeted by its Federal Open Market Committee directives."
That's completely wrong, and backwards. The FOMC lowered the target rate. The Fed lowers the target rate not by selling, but by buying Treasury securities from the 20 dealer banks, thus increasing the banks' available credit capital. They sell Treasurys when they want to raise the targeted rate and decrease available credit.
Once again, it's not a liquidity problem. It's a solvency problem. The only way the Fed can fix the bankers' problems is if they actually buy the failing mortgage bonds from the banks instead of accepting the worthless bonds as collateral against loans.
Fed credit can't erase the bankers' losses--to do that, the Fed must monetize them fully. Anything else just postpones the day of reckoning, because the market for that junk is never coming back. Never.
Almost everything he writes is wrong. Like this: "on March 16, the fed funds rate was an extraordinary 250 basis points above yields on three-month Treasurys. This corresponded to a "10 sigma" event." The reason the fed funds rate was 2.5 percentage points above Treasury yields was not that the funds rate had skyrocketed. It was because Treasury yields collapsed. They collapsed because money poured out of financial stocks into the safe haven of short Treasuries, driving the 90-day yield below 1%. There wasn't anything remotely 10 sigma about that spread. It was predictable.
An event that lies 10 standard deviations from the mean is extremely rare. It looks like a huge outlier to him because he's only comparing to the last few years, when universal cheap credit drove defaults to zero and compressed all yield spreads. Even the junk-to-treasury spread fell to 250 basis points, whereas junk bonds have historically been forced to pay a 1000 bp, or 10 percentage point, premium over treasury bonds.
"The Fed should announce its intention to add to its holding of Treasury securities in order to provide additional liquidity." This level of stupidity makes me want to take this cretin by the throat and shake him. Adding to its holding of Treasury securities will do less good than swapping the T-paper for the bad mortgage derivatives. The Fed is already the largest holder of Treasury debt by far in the entire world, and just as the $310 billion in TAFs has had no effect on the bank crisis, neither will hundreds of billions more. All this ploy would accomplish is to accelerate inflation drastically; it's just more of the same.
The real problem is simple, but he refuses to address or even acknowledge it. The Fed created a valuation bubble in the housing market by taking the funds rate to 1% and leaving it there, until the availability of cheap credit fueled an orgy of speculation in houses, and suckered many renters into buying houses they couldn't afford while homeowners "traded up" out of all proportion to their income. House prices remain inflated, and need to deflate until they are in line with wages and salaries.
Instead of allowing house prices to normalize, Makin hopes to keep them inflated with more cheap credit, while inflation destroys the purchasing power of wage earners, thus rendering them even more unable to handle their mortgage payment because they're paying 50% more for gasoline and 35% more for food than a year or two ago.
He goes on to argue that while inflation "may rise for a time, monetization is more easily reversible than nationalization of the mortgage market". I beg to differ. Monetization of stock market losses gave us the housing bubble. Mr. Makin proposes to keep house prices afloat with increased "liquidity"; once issued, any attempt to withdraw that liquidity will result in the recession that he's trying to avoid, and it will be worse because he proposes blowing the credit bubble up even bigger than before.
Here's his final blunder: The dilemmae of "very unattractive policy alternatives....underscore the rationale for having the Fed target asset prices – in a world where asset markets affect the real economy more than the real economy affects asset markets."
No, no, no. It was allowing the Fed to target asset prices in the first place that created this topsy-turvy world where the everyone borrowed freely to consume because they felt house-rich and stock-rich. The Fed has no business targeting asset prices. It has no business targeting interest rates. The Fed has no business picking winners and losers. The Fed serves no purpose but to continually steal purchasing power from workers and savers to give to bankers and governments.
John Makin is a scoundrel. I can tell you what will happen if he gets his way. The $DX dollar index will fall below 60, gasoline will rise above $5/gal, produce will be unaffordable, unemployment will jump, and much worse. We saw the effects of serious inflation in the 1970's, on a smaller scale. Marriages will come apart, children will be beaten by parents who don't know how to handle financial pressures, and people will kill each other over trifles. Better to let Wall Street collapse, and permit a run on commercial banks. The FDIC will take printed money to cover depositers' funds, and people will still lose jobs, but recession is inevitable.
It's another illustration of how violating basic rules of behavior leads to situations where there is no avoiding a lot of pain.
If the Fed takes Makin's advice, all bets are off but one: The dollar will go to zero and gold and silver will go places we never thought they'd see. The moment I know that the Fed is going to monetize directly, I'll mortgage my house to buy bullion.
Gabriel Gray